As we have worked with many clients over the years, we have noticed there is a lot of confusion on how to classify workers. The confusion usually lies with independent contractor versus employee. Along with the confusion, there are a lot of myths on this topic. No matter the myth, this topic is no small matter. Often enough, employees are misclassified as contractors — a critical mistake that state and federal government agencies take very seriously. Possible penalties can be quite costly.

In order to understand how to classify a worker, we first need to understand what is an independent contractor and what is an employee.

Independent Contractor

Independent contractors are business owners
Independent contractors are business owners who have built a business around their specialized skills and services they offer. Independent contractors may be classified as a sole proprietor or have an incorporated business. Independent contractors may also have a business name and may partner with others. They may have their own employees, subcontractors, or partners who help them complete a work task.

A relationship with an independent contractor is a business-to-business relationship. Often time it is easy to think of them as employees, but in doing so can put you at risk for misclassification.

Independent contractors have specialized expertise.
A great way to fill a business need is to hire independent talent. These individuals bring specialized expertise to a project or task—certification, special training, or education. As their client, you are not responsible for providing training to the independent contractor.

Independent contractors may work with multiple clients.
Since an independent contractor is running their own business, they have the right to take on multiple clients or contracts. Even though, you may have a long-term contract with them, does not mean you can limit them to work with others.

Independent contractors work on specific tasks and works without oversight.
Independent contractors are contracted to work on a specific job or services, generally outlined in an agreement that outlines expectations with both parties, time frame, and payment terms. Traditional employees generally receive instructions from a manager. However, a client cannot determine how an independent contract works. An independent contractor will also provide their own tools, equipment, etc.

Independent contractors determine their hours and submit invoices for payment.
Since an independent contractor are their own business entity, they set their own hours. A client cannot determine their work hours. The independent contractor must fulfill the work agreement. Independent contractors also do not work for a salary. Independent contractors will submit invoices to the client for their work as outlined in the contract.

Independent contractors are responsible for paying their own taxes and benefit plans.
Since the independent contractor is their own business entity, the client will have the independent contractor fill out a W-9, and will issue and submit a 1099-MISC on payments made to them. As the client you do not have to worry about withholding taxes like you would with a traditional employee. Another benefit to having an independent contractor is that you do not have to provide traditional benefits such as health insurance, stock options, or retirement plans.

Traditional Employee

The IRS defines an employee as “Anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action (allowing the employee to complete the services as they deem best). What matters is that you have the right to control the details of how the services are performed.”

Example: Donna Lee is a salesperson employed on a full-time basis by Bob Blue, an auto dealer. She works 6 days a week, and is on duty in Bob’s showroom on certain assigned days and times. She appraises trade-ins, but her appraisals are subject to the sales manager’s approval. Lists of prospective customers belong to the dealer. She has to develop leads and report results to the sales manager. Because of her experience, she requires only minimal assistance in closing and financing sales and in other phases of her work. She is paid a commission and is eligible for prizes and bonuses offered by Bob. Bob also pays the cost of health insurance and group-term life insurance for Donna. Donna is an employee of Bob Blue.

How to Decide

To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control:  A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:

  • Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
  • Degree of instruction, more detailed instructions may indicate that the worker is an employee. Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor.
  • Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
  • Training a worker on how to do the job — or periodic or on-going training about procedures and methods — is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Consider:

  • Significant investment in the equipment the worker uses in working for someone else.
  • Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
  • Opportunity for profit or loss is often an indicator of an independent contractor.
  • Services available to the market. Independent contractors are generally free to seek out business opportunities.
  • Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee (generally stated in the contract).

Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

  • Written contracts which describe the relationship the parties intend to create. Although a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
  • Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
  • The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
  • Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

Consequences of Misclassifying an Employee

Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Employers can also be liable for back taxes and penalties.

Protecting Your Organization

Partnering with an experienced bookkeeping and accounting firm can help you with classifications and ensure your payments are entered correctly. Contact SoCal Elite Accounting today to learn more.

The information provided in the SoCal Elite Accounting Blog does not constitute legal, tax or financial advice. It does not take into account your particular circumstances, objectives, legal and financial situation or needs. Before acting on any information in the SoCal Elite Accounting Blog you should consider the appropriateness of the information for your situation in consultation with a professional advisor of your choosing.

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