Contractor or Employee: What’s the Difference?
This article is meant to help you determine the difference between a person hired to perform a service as a contractor or employee. It is critical the business makes the proper determination in order to know what type of taxes will need to be withheld and paid on behalf of service provider. In general, an employee must have Social Security and Medicare tax withheld and businesses pay matching Social Security and Medicare tax, as well as unemployment taxes. Withholding of income taxes is optional depending on how the individual fills out their W-4. However, a business usually is not required to withhold or pay taxes on amounts paid to contractors. Information reporting on Form 1099-NEC is required for most payments made to contractors that total $600 or more per year. It is just as important to obtain identification and Social Security information for contractors as it is for employees. Businesses can request this information from contractors using Form W-9.
In 1987, the IRS developed a list of 20 items to be used in the determination of an employer-employee relationship, known as the “20-Factor Test.” The list of factors in Rev. Rul. 87-41 are as follows:
- Level of instruction
- Requirements for reports
- Amount of training
- Method of payment
- Degree of business integration
- Payment of business or travel expenses
- Extent of personal services
- Provision of tools and materials
- Control of assistants
- Investment in facilities
- Continuity of relationship
- Realization of profit or loss
- Flexibility of schedule
- Work for multiple companies
- Demands for full-time work
- Availability to public
- Need for on-site services
- Control over discharge
- Sequence of work
- Right of termination
A worker does not have to meet all 20 factors to be deemed an employee. There is not a single factor that would automatically deem a worker to be an employee. Facts and circumstances for each case are used to determine the weight of importance the IRS assigns to given factors.
Over the years, the IRS has condensed the above 20 factors into three main categories of control: behavioral control, financial control, and type of relationship.
Behavioral control focuses on the amount of control the company has over how, what, and when tasks are to be performed by the worker. The more control the company has over details of tasks to be performed, the more likely that the worker is an employee and not a contractor. This category also puts focus on the amount of training provided by the company to the worker. An employee would be trained on site to perform services in the manner set forth by the company. An independent contractor would seek training by their own manner outside the guidance of the company.
Financial control focuses on the amount of control the company has over the financial aspects related to completing tasks performed by the worker. This category puts focus on how the worker is compensated (hourly or flat rate based on job), whether the worker is reimbursed for expenses related to supplies/materials, and if services provided by the worker are available to the general public. A worker who is paid an hourly rate takes on the appearance of an employee, while a worker who gets paid a flat rate based on job takes on the appearance of a contractor. Independent contractors are more likely to incur unreimbursed expenses such as supplies/materials. In general, an employee only works for one company. However, an independent contractor seeks to provide services to multiple companies.
Type of relationship focuses on the relationship established between the company and worker. This category puts focus on written contracts between parties, whether the company provides the worker with employee-type benefits, the length of the relationship, and the extent to which the services performed by the worker are a key aspect of company. A company that provides employee-type benefits, such as vacation pay, sick pay, insurance, and pension plan, has workers deemed to be employees.
As previously mentioned, the IRS has not disclosed a specific set or number of factors that deems a worker to be an employee. The company must look at all the facts and circumstances related to each worker to determine whether the worker is a contractor or employee. Depending on the industry, factors that are relevant for one determination might not be relevant for another.
The company should look at all aspects of the control and relationship established with the worker in making the determination of contractor or employee. The facts and circumstances should be documented along with the factors that were used in making the determination.
If, after reviewing the three main categories of control or the 20-Factor Test, the worker’s status is still not clear, then either the company or the worker can file Form SS-8 with the IRS. Form SS-8 is used to determine worker status for purposes of federal taxes and withholding. The IRS will review all the facts and circumstances presented and then conclude whether the worker is a contractor or employee.
If you have questions about whether you have employees or contractors, please reach out to your BKD Trusted Advisor™ or submit the Contact Us form below. To learn how we can help small to midsize businesses, visit our Outsourced Accounting Services webpage.