Independent Contractors vs. Employees: Keeping Them Straight

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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When the IRS looks at the contractors your business works with, it's looking for any signs that a contractor is misclassified. If there's even a sign that someone you're paying as a contractor might actually be classified as an employee, the IRS will reclassify him as such. That sort of decision can prove very expensive for a business owner: there are fines and penalties associated with the process, as well as a requirement that the business owner pay back payroll taxes. Because the IRS claims to lose millions of dollars in tax revenue every year due to misclassified contractors and employees, it takes reclassifying workers seriously.

But who the IRS considers an employee and who it considers a contractor doesn't always match what a business owner might expect. If you work with contractors on a regular basis, it's important to ensure that you and the IRS are on the same page.

Contractors Versus Employees

For the IRS, telling the difference between a contractor and employee is a matter of determining just how independent the individual is from the company he's working for. Paul Herman, a CPA based in New York, explains how contractors and employees typically differ:

[The] best way to put it is that an independent contractor is not under the employer's control. An independent contractor negotiates their rate of pay, can set their own schedule, can refuse work or projects, provides an invoice on their letterhead for services performed, often works for other people, uses their own supplies, may get reimbursed for expenses, usually works on a project by project basis rather than for an indefinite period. When an independent contractors services are terminated, they are not eligible for unemployment benefits, whereas an employee who is fired can collect unemployment.

Herman's description of an employee is significantly different.

An employee is under the employer’s direct control, whether they are full or part-time. Employer offers them a rate of compensation, they work a schedule determined by the employer, employer provides work space and tools and supplies needed for the job, maybe required to punch in and out or keep a time sheet, etc. An employee typically is provided benefits as may be provided to all employees such as health insurance and coverage in a retirement plan. An independent contractor is generally not eligible for such benefits.

Because each business is different, the IRS cannot simply declare that any worker with a specific characteristic is an employee or an independent contractor. If, for instance, you used whether a worker actually completed his work inside your office as the deciding factor, all telecommuting employees would be misclassified as independent contractors while contractors handling maintenance and similar tasks would be misclassified as employees. Instead, the classification of employees and contractors is a matter that must be considered carefully, often on a case-by-case basis.

Appealing Reclassification

If the situation has already progressed to the point where the IRS has reclassified an independent contractor as an employee, the employer does have the right to appeal. Herman says that a successful appeal is a matter of proving, once and for all, that the employee in question is actually a contractor.

You will need to provide documentation indicative of an independent relationship, which might include a contract spelling out the terms of the relationship, a business card from the contractor, invoices on the contractors letterhead, copies of advertising placed by the contractor advertising their services to the public, certificates of insurance that they carry on themselves and so on.

It's generally better to try to make sure that a contractor is clearly a contractor in the IRS' eyes than try to depend on the appeal process to ensure that your contractors are treated as such.

Keeping Your Contractors Compliant

Gail Rosen, a CPA based in New Jersey, says that the IRS is paying more attention:

The IRS has been spending more time reviewing whether people are paid correctly as an independent contractor versus an employee. There are tests that the IRS use but there is also the reality of the situation.

Those tests can include the percentage of sales a contractor makes from more than one client, as well as whether a contractor has un-reimbursed expenses. While you can't exactly ask to see a contractor's tax return for the last year or so, there are some indicators that Rosen points to as a way to make sure that your contractors would pass the IRS' test:

• Incorporation: If an independent contractor has incorporated his business, then the IRS will not question his status as an independent contractor.
• Written contract: A good written contract will help set an independent contractor apart from your company, although it is not a guarantee of how the IRS will consider your relationship with the contractor.
• Other clients: If your contractor can point to references or testimonials from other clients, it's a good indicator that the IRS will accept his status as an independent contractor.
• No benefits: A company providing benefits (such as insurance or vacation pay) to a contractor is a big red flag for the IRS.

If you work with multiple contractors, it can be useful to create a compliance system: as you start working with a new contractor, document his independence with a contract as well as copies of invoices, letterhead, and other proof that would be useful if the IRS questions the classification of a contractor. Keep such documentation on file, along with your other tax paperwork.

Another alternative is to work with service providers who may be employees of another company, avoiding the question of classification entirely. Typically, that would translate to working with a temporary employee or other staffer who files a W-2 with a professional employer organization, such as a temp agency. It's not always an option — many contractors will not take projects that require filing a W-2 — but it can make the paperwork easier.