EMPLOYEE (W-2) VS. INDEPENDENT CONTRACTOR (1099)
Hiring an employee can costs in the neighborhood of 25 to 30 percent more than hiring a independent contractor to perform the same work. The additional cost includes matching the employee’s Social Security and Medicare tax, paying for unemployment compensation and workmen’s compensation insurance, liability insurance, and providing medical and other employee benefits. If you contract to have work performed by independent contractors, you can eliminate the company expense associated with employee taxes and benefits. However, there is a risk involved.
There are many cases where a business classified their employees as independent contractors only to have it determined later that they were in fact employees. Remember that just because you call the people who work for you independent contractors, doesn’t always make it so. If you are audited by the IRS, of if an “independent contractor” gets injured on the job and applies for workers compensation, and the IRS or State department of Labor and Industry determines that your independent contractors are really employees, you could be in serious financial trouble and be looking at repaying all the back taxes, including the employee’s share as well as interest and penalties. This could put you out of business.
The IRS has developed a list of 20 factors it uses to determine whether a worker is an employee or a subcontractor. The Pennsylvania Department of Labor and Industry has a shorter test set forth below. Here are the twenty factors used by the IRS in the event of an audit which you should take into account when determining whether to go with employees or independent contractors:
1. Does the business require the worker to follow their instructions on how work is to be performed? If yes, this indicates employee status. An independent contractor will generally decide how the project should be completed and use his own methodology.
2. Does the business provide training to the worker? If you’re hiring a person for a job they are not trained for and providing them with the training to carry it out, that person is probably an employee. There can be exceptions based on the facts and circumstances, but if you fail this test, you might lose no matter how many of the others you pass.
3. Are the worker’s services a substantial or integral part of the business? This indicates employee status because it indicates the business maintains direction and control over the worker.
4. Does the business require the worker to perform all services personally? Independent contractors may have their own employees or at least should have the option of hiring other contractors to perform their work. Agreements for personal services indicate employee status.
5. Does the business hire, supervise and pay the worker’s assistants? If so, this is a strong indication of employee status. Let the independent contractor pay his or her own assistants.
6. Does the business have an ongoing relationship with the worker? This one is a stretch since many businesses maintain lifelong relationships with contractors whose work they like. But the IRS views this as an indication of employee status.
7. Does the business set the worker’s schedule and hours? Independent contractors generally set their own work schedules. If the contractor must work certain hours because of required interrelationships with your employees or to take advantage of down time for computer-related work, document these facts.
8. Does the business require the worker full-time? This is an indication of employee status because the business controls their availability and prevents them from working on other clients.
9. Does the business provide the workspace? Contractors who work off-site are more likely to be classified an independent contractor.
10. Does the business determine the order or sequence in which work is completed? Indicates employee status. If specific schedules are required, document them in the contract with the reasoning for doing so.
11. Does the business require oral or written reports? The IRS believes regular written or oral reports detailing the work completed indicates employee status. In reality, this is, and should be, expected from independent contractors as well.
12. Does the business pay by the hour, week or month? This indicates employee status. See our comments at the end of this article on this issue.
13. Does the business pay expenses? This is an indication that the business is directing the Independent contractor’s business activities. Make sure the independent contractor pays the expenses and bills you for reimbursement.
14. Does the business provide tools and equipment for the worker? Independent contractors would normally provide their own tools and equipment.
15. Does the worker have a significant investment in their own facilities? If the contractor maintains his own office space, computer equipment, tools, etc., this is a good indication that they are an independent contractor.
16. Does the worker have profits and losses independent of the business? This is an indication that the contractor is running his own bona fide business and is an independent contractor.
17. Does the worker have multiple clients? Working with multiple clients generally indicates independent contractor status.
18. Does the worker market their services to the general public? Employees do not generally market their services to the general public.
19. Does the business have the right to discharge the worker at any time? This suggests employee status. An independent contractor would only be discharged for failure to meet contract specifications.
20. Does the worker have the right to quit at any time? An independent contractor is under contract and cannot quit until the project is completed.
The purpose of these factors is to attempt to determine whether the employer has the right to control the worker, how, when and where the work is performed, and the amount of investment the worker has in his own business. The higher degree of control the employer has over the worker, the more likely the IRS will classify the worker as an employee. These factors are highly subjectivity.
The Pennsylvania Department of Labor and Industry provides the following direction: Under the Pennsylvania Unemployment Compensation (UC) Law, for both benefit and tax purposes, the term “employee” applies to every individual who is performing or has performed services for which he/she is or has been paid by an employer. Unless specifically excluded from coverage, all work for which wages are paid under any contract of hire, express or implied, written or oral, is covered by the UC Law.
Services performed by a worker will be exempt under the benefit and taxing provisions of the UC Law if the individual is, in fact, an “independent contractor.” In order to be excluded from coverage, the person who performs the services must meet two conditions pursuant to Section 4(l)(2)(B):
1. The individual must be free from control or direction over the performance of the services involved, and
2. The individual is customarily engaged in an independently established trade, occupation, profession or business.
Only if both of these conditions are met to the satisfaction of the Department will the relationship be regarded as an “independent contractor.” Unless and until those criteria are met, the services will be “employment” subject to the coverage of the UC Law.
As mentioned previously, just because you call your people independent contractors, does not automatically make it so. It is important to remember the following items are not conclusive in determining “independent contractor” status:
1. Employer designation, either verbally or in writing, that an individual is an “independent contractor”;
2. Statement by an individual that they are an “independent contractor”;
3. Issuance of a Federal Form 1099.
A written agreement does not prohibit an examination of the facts to determine whether the performance of the services is subject to control or direction of the employer. If the examination shows either the exercise of or the right to exercise such control or direction, then the worker would be considered an employee and not an independent contractor. It is immaterial if the services are performed on a full-time, part-time or casual basis.
This is not to say that a written agreement with a worker classified as an independent contractor is not a useful tool. In addition to confidentiality agreements and no-compete clauses, information in the agreement can set forth the conditions of employment so as to provide a case for the designation of a worker as an independent contractor. The important thing to remember is that even if the Independent Contractor Agreement sets forth conditions similar to those required by the IRS of State Department of Labor and Industry, you also have to follow those conditions so that in the event of an audit the terms of work actually being performed are in line with the Independent Contractor Agreement.
At Rominger & Associates, we have experience in drafting both employment agreements and independent contractor agreements. We can also review your current contracts and agreements to make sure you are protected in a variety of legal situations. Call our office for a free initial consultation at 717-241-6070.
Steven R. Snyder, Esquire
Rominger & Associates
155 South Hannover Street
Carlisle, PA 17013
Fax (717) 241-6878