NP Business™ Tip: Employee of Contractor?

Has your business grown to the point where you are considering adding additional staff? Great! One of the questions you might be asking is if you should hire an employee or an independent contractor? Or perhaps, you are considering becoming an independent contractor yourself? Regardless of the situation, there are a number of factors to consider prior to making your decision.

You may be wondering why it is so important to choose one classification over the other. What difference does it really make? And who determines who is an employee and who is an independent contractor? Needless to say, the IRS cares a great deal how an individual is classified, and so should you. Ultimately it is the IRS who determines what constitutes a valid contractor vs. employee classification.

There are three areas to be examined when determining if an individual should be classified as employee or independent contractor:

1. Behavioral Control: Do you have control over or do you have the right to control what the person does and how the individual performs the job? In other words, what is the degree of instructions given to an individual?

   Some instructions might include when, where and how a job has to be performed, what work must be done and what tools must be used. The more detailed the instructions the more likely the individual would be classified as an employee. The greater the level of autonomy an individual has in performing a service, the more likely the individual could be classified as an independent contractor.

2. Financial Control: Do you have control over the business aspects of the individual's work? Are there unreimbursed expenses in the course of the service performed? Independent contractors routinely incur expenses as part of doing business. Does the individual perform services for other clients? If so, then he/she most likely can be classified as an independent contractor.
3. Type of Relationship: Does the individual receive compensation typically given to employees (insurance, vacation pay, pension plan, etc.)? Can the work the individual performs for the business be classified as a key aspect of the business' regular activities? If both answers are yes, than the individual most likely would be classified as an employee.

   Do you have a written employment contract in place clarifying the relationship as either contractor or employee? Having a written contract aids in defining the classification.

Classifying an individual as contractor or employee affects how the individual is paid. Independent contractors are not on your payroll and you, as the employer, do not have to withhold employment taxes.

As of today (January 2010), independent contractors may receive up to $600 in compensation from you before you are required to report the income on Form 1099-Misc.

Keep in mind, that if you are the independent contractor, you will need to file a W9 with the business you are contracting with. In turn, they have to report the income on a Form 1099-Misc. (Many of you already receive these from insurance companies that pay you.)

Determining the proper classification can be confusing and challenging. It is up to you, the business, to choose the proper classification. If you are unclear what classification to choose, seek proper professional advice. You may also file form SS-8 "Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding" with the IRS to help you determine the proper classification.

Further information can be obtained from the IRS.