Preface: Employee or subcontractor classification is often an ambiguous area of the tax code. In this blog, relationship factors relevant to the tax classifications are considered, e.g. should Eli be an employee or a subcontractor?
Credits: Jake Dietz
Help Wanted: Tax Considerations When Adding Workers
Has your business grown so much that you are ready to bring in more help? If so, consider if you should hire employees or get independent contractors to assist you. The IRS cares about how you classify workers. They do not want you to merely classify a worker as an independent contractor to save on taxes without first determining if the worker is truly an independent contractor.
Determining the classification of your new worker may take some thought, but the IRS provides some guidance and factors which should be considered. For some workers, certain factors might point towards the employee classification, while other factors point towards the independent contractor classification. Although it can be unclear at times, employers should make a good faith effort at classifying correctly.
There are three factors that the IRS considers. These factors are behavior control, financial control, and type of relationship. We will drill down on each of these three categories.
For the behavior consideration, the IRS looks at whether or not the employer may control what work is done and how it is done by the worker. The IRS asserts that a worker is an employee if the company has the right to tell the worker how to do the work, regardless of whether or not the company actually does tell the worker how to work.
Let’s look at an example. If you own a farm and hired a new employee, you can tell him exactly how to do the work. You may tell him to bale hay using a specific tractor with a certain baler, even in a certain gear. You may give detailed instructions on what to do, how to do it, and when to do it. Even if the new employee is experienced and you do not need to give as many instructions, you still have the right to give the instructions.
On the other hand, if a custom operator comes to your farm to bale hay, you may not have the right to give as many instructions to him. The custom operator may choose which tractor, which baler etc. to use. If the custom operator runs out of twine, then the custom operator, not the farm owner, gets to decide where to buy twine and how much to buy.
If your company is providing training to the worker, that indicates an employee. You don’t need to train the custom operator how to bale hay. If the custom operator needs training, it is the operator’s responsibility to get it.
The IRS also looks at financial control. How much investment does the worker need to do the job? If the worker needed a significant investment in tools, software, etc., then that is evidence pointing towards an independent contractor. Our hay baling employee had no investment in the equipment, but our custom baler operator had to purchase a tractor and baler and supplies. Certain jobs, however, may require investments of workers who are employees. Construction worker and mechanic are two such jobs.
Does the worker regularly incur expenses that you don’t reimburse? Is it possible that the worker will lose money on the job? Is the worker paid by the job instead of by the hour? If these questions can be answered “Yes” it points toward a contractor. If our custom operator has too many breakdowns, it could lead to a loss for the year. If the employee has breakdowns, they still receive the same hourly rate as if there were no breakdowns.
Type of Relationship
Does the relationship look like a long-term relationship between an employer and employee? If so, that points to an employee classification. If the relationship is a based on a contract to do a certain job, then that points to a contractor. Just because a contract is signed, however, does not guarantee that the worker is an independent contractor.
Another factor is if the work provided is a product or service of the business. For example, an accountant doing work for an accounting firm is likely an employee of that firm.
Unfortunately, there is no bright line rule for determining if someone is an employee or independent contractor, but fortunately the IRS does give guidance. For additional guidance, please contact our office.