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Independent Contractor vs. Employee

Updated: Jun 10

The Growth, Hiring, and Payroll Series will help give your company a much needed boost in order to make your daily, weekly, monthly, and annual processes more efficient. Each article will discuss common tasks that companies face while maintaining compliance with federal and local law. Give your company a leg up over the competition by checking out each article for valuable insights that will help bring your company to the next level.

It’s common for businesses to search for creative ways to cut costs wherever they can. Some companies have had apparent success hiring independent contractors instead of employees to save on payroll taxes. Unfortunately, the IRS dictates who can be correctly identified as an independent contractor or an employee, and there can be harsh penalties for misclassifying your team members. The Internal Revenue Service uses two key factors when checking for compliance during an audit: Control and Relationship.

Defining How the IRS Recognizes Control and Relationship

Control. The IRS states on their website, “if a business controls what work is accomplished and directs how it is done, it exerts behavioral control.” An independent contractor that works for a business, take an electrician for example, is informed by the business what needs to be done, and then the business does its best to stay out of the contractor’s way. Another way that control is ascertained is by looking into financial control. Many times, independent contractors have many specialized tools which they use to perform their specialized tasks. This investment is often completed before a contract has been made

with the business. The independent contractor usually is available to the free market for services and has potential to incur a loss from work that is completed. If a worker maintains behavioral or financial control over their work, they are likely considered a contractor by the IRS.

Relationship. The IRS also takes into account how the worker and the business view their relationship

with one another. If the relationship is viewed as permanent, the worker should be considered an employee. This will usually be stated in the contract between the two parties. The work being done by the worker may also be examined to ensure that it does or does not align with what the business performs as a normal day to day service, and if it does not the worker may be considered a contractor.

These are the primary things that the IRS considers in case a business is audited. To go an extra step to ensure compliance check out IRS Form SS-8 to get all of the information regarding Control and Relationship from the IRS.

What if Team Members are Misclassified?

There are a few issues that can arise when workers are misclassified. The business will have to pay back taxes from when the worker first started performing services for the company. The business will likely be fined for the misclassification. The back taxes plus applicable penalties and interest can lead to massive tax bills. When all of this is cleared up, the business will need to take the employee through an on-boarding process that includes presenting the employee with an offer letter, job description, and an employee handbook. Business leaders should carefully evaluate their independent contractor relationships and shift people to employee status when appropriate.

Defining the Relationship

If you are unclear whether someone would be a better fit as an employee or if they can qualify as an independent contractor, it’s important to have a conversation with them about the future of their relationship with your company. You need to either:

A) Align them with contractor status by reducing your control and redefining your relationship; or

B) Align them with employee status by formally hiring them, withholding and paying payroll taxes on their behalf, and following your local labor laws.

Defining Contractor Engagements

If a role meets the IRS requirements to be considered a contractor engagement, you should have a written agreement in place stipulating the work to be provided and the expectations surrounding the delivery of work. While the business may negotiate with the contractor, it is common for an independent contractor to set their own prices for their services.

Generally, an independent contractor does not require significant training to fulfill their duties, although the parties usually come to an agreement about how their services will apply to the business. They often experience a greater degree of freedom in fulfilling their duties. Independent contractors are required to pay their own income taxes and the employer does not withhold or pay taxes on their behalf.

Although a W-9 form is only required to be collected from an independent contractor who is paid at least $600 per year, we recommend you collect it for all independent contractors. At the end of the year, the business must issue a Form 1099-Misc to all independent contractors paid at least $600.

Defining Employment

Employees should receive an offer letter with job description and a defined wage, an employee handbook, and training on their responsibilities and expectations. The offer may include employer-sponsored benefits such as health insurance, 401K, or paid time off. Some states, such as California, require a certain amount of sick time off for employees. The employer needs to verify the candidate’s employment eligibility and file the new hire reports with their state.

Employees typically operate in an environment structured by the business, with a set schedule and consistent paycheck. their benefits include being more likely to receive an income tax refund since the business is withholding and paying taxes on their behalf. Additionally, it can be easier to build credit as an employee than as an independent contractor.

Doesn’t this all sound confusing? Converting an independent contractor to an employee can be a delicate process, both for you and for them. Make your life easier and schedule a chat with your accountant to make sure you do it correctly.

To learn more about minimizing your risk as an employer, click here to schedule a free introductory call with our team!

If you’re hiring employees, plan to be in it for the long haul because it often takes a few tries to get the right fit. The Growth, Hiring and Payroll series includes tools to empower you with Hiring Strategies, Contractors and Employee guidelines, Hiring Processes, Payroll information, and Benefits.

  • Hiring Strategy will give you information which saves time and money

  • Contractor Vs. Employees helps businesses to clearly define roles and maintain compliance

  • Hiring Process will give you good ideas about a process that works for your business

  • Payroll 101 will familiarize you with the process that is needed for compliance

  • Benefits 101 will allow you to be the most competitive company for the most qualified employees

Be sure to check out all of them, your business and your personal well-being will thank you for it!

Payroll is hard! Gusto makes it easy.

Here at Sonder Accounting, we partner with Gusto to make payroll a breeze for our clients.

Check it out and feel free to reach out if we can support you in your payroll journey!



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About the Authors

Sonder Accounting was founded in 2016 by Kara Janowsky to serve the financial maagement needs of the nascent cannabis industry. Our small and specialized team has partnered with over 250 businesses in similar industries to build functional financials that drive business growth:

Learn more about how we work with companies like yours:

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