Know the Difference: Employee or Independent Contractor
Manager and Lori A. Sheets, CPA, A&A Senior Manager
Understanding the difference between two kinds of labor relationships becomes more important in a business environment like this one.
In a struggling economy, companies will try almost anything before they resort to laying off workers. Concern for employees and their families, as well as the need to minimize disruption, leads the company to raise prices, cut more waste, borrow money and take other measures before letting people go.
But in a deepening recession these steps may not be enough, and then companies are forced into a well-defined pattern. At first a hiring freeze and attrition may be enough to reduce the payroll, but when they’re not, companies lay off. And they sometimes cut too deep.
In the economy as a whole, manufacturing activity may slow, but it never stops. Business and commerce go on, marketing efforts bear fruit and orders must be filled.
Not Hiring. Help Wanted. When new orders come, a company may find itself in need of labor quickly. But no one knows initially whether those orders represent the start of a real recovery or merely a short-lived spike, so the company may be reluctant to hire (or rehire) regular full-time employees.
Under such circumstances companies often look to temporary contract workers, who are either employed by a temporary staffing agency or working, on their own, as independent contractors.
The latter category presents a unique set of problems, which Microsoft knows all too well. In 1993, the corporation’s “permatemp” workers — independent contractors with long tenure — sued for the benefits, 401(k) contributions and ESOP participation rights that regular employees enjoyed. The courts upheld the ESOP claim, saying the workers were “common law employees,” and two years later Microsoft settled the benefits and 401(k) claims for $97 million.
The IRS maintains a detailed and complex set of rules that determines a worker’s relationship with an employer. The stakes can be substantial: The determination governs the employer’s responsibility to furnish benefits, as well as to withhold and pay income, unemployment, Social Security and Medicare taxes. The employment relationship also establishes the employer’s obligations under various labor laws, as well as its liability for a worker’s negligence. And mistakes in categorizing can draw fines.
What’s the Difference? The main principle that determines whether workers are employees or independent contractors is the “right of control” in three areas: behavioral, financial and type of relationship.
- Behavioral: If an employer dictates when, where and how work is to be performed, the worker is most likely an employee. But if the employer controls only the result of the work, and not the means and methods of accomplishing it, that indicates the worker is an independent contractor.
- Financial: Control also applies to the financial aspects of a job. Obviously, an employer controls all of these for its employees. But if a worker incurs unreimbursed expenses, invests in or maintains separate facilities, or has an opportunity for profit or loss, that worker is more likely an independent contractor.
- Type of relationship: The “perceived relationship” is important, too. The job’s permanency, the worker’s availability for other work and how integral the worker is to the business itself are some of the key factors that contribute to this perception.
Why the Ambiguity. The reason these tests point to “likely” or “unlikely” conclusions is that the IRS considers multiple factors within each of the above categories. Some might assign an individual to employee status even while others indicate an independent contractor. The tax agency stresses that the “totality” of these various tests must be considered.
The rules cover many areas. Employees generally report at specified times and use the employer’s tools. Independent contractors set their own schedules and usually have their own tools and a “significant investment” in the facilities where the work is performed. Employees sometimes receive paid training, but independent contractors rarely do. And while employees perform their own work, contractors are typically free to assign the work to their own employees or subcontractors.
While an employee receives compensation at regular intervals, via paycheck, independent contractors are usually paid by the job. Employees generally work for one employer at a time, and aren’t available to the general public, but a contractor might serve several companies at once.
Even brief upturns call for more labor in manufacturing and distribution industries. When that happens, hiring or contracting decisions are posed quickly, because a company’s agility is a critical competitive advantage in these times. To avoid the consequences described above, make sure you address these decisions with all the facts.
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Employment relationships can be tricky, and mistakes can be costly. If you’d like to know more about your company’s options, please contact either Paula Divencenzo or Lori Sheets at 330.762.9785 or by email.