Independent Contractor or Employee?

Why does it matter?

It mostly boils down to money. Employers must pay half of the payroll tax (Social Security and Medicare, also known as FICA taxes) on all wages that they pay to employees. Contractors, on the other hand, are responsible for paying 100% of their own payroll taxes (in the case of a contractor these taxes are referred to as self-employment tax). This tax difference can be a big deal for an employer who is looking to hire. On wages of $50,000, an employer would have to kick in an extra $3,825 to cover payroll tax if the new hire was treated as an employee instead of a contractor. Multiply that number by 10 employees, and the employer is looking at paying an extra $38,250 in tax. In addition to the additional tax that employers pay for employees, under the Affordable Health Care Act (ACA), employers that have more than 50 full-time employees are required to provide heath insurance. The costs of having employees can really add up for a small business.

Although this may seem to incentivize employing contractors, employers can’t simply decide whether or not to pay a worker as an employee or contractor. The employee/contractor classification is regulated by the IRS and is based on the specific circumstances and the relationship between the employer and worker. In particular, the IRS considers the degree of control and independence that a worker has on the job when determining the proper classification. Is the employer in charge of the jobs assigned to the worker and how the worker performs these duties? Does the employer manage all business aspects of the relationship, such as payment, expense reimbursement, and providing tool/supplies? What sort of contract or agreement exists between the employer and the worker? Are benefits such as insurance or vacation pay provided and is there an understanding that the working relationship will continue?

If these three benchmarks seem vague or unclear to you, you’re not the only one. There is no rigid test for whether a worker is a contractor versus an employee, but in general a good determining question is does the worker work for himself or for someone else? An independent contractor is his own boss and hires himself out to businesses (frequently more than one at a time) for his skills, expertise, and time. A useful way to look at the distinction is in terms of risk; an independent contractor is self-employed, and as such has higher risk than an employee in terms of finding, securing, and maintaining an assignment.

If there is a question about the proper classification, either the employer or the worker can file Form SS-8 with the IRS. The IRS will then review the facts and make a determination as to whether the worker is an employee or contractor. Additionally, Maine now provides predetermination of independent contractor status through the State of Maine Worker’s Compensation Board, which workers can apply for by filing form WCB 266. It’s important to note that even if the worker has been predetermined to be a contractor through form WCB 266, that alone to does not guarantee contractor status. If the facts regarding the relationship are misreported or if they change over time, the IRS may reclassify the contractor as an employee.

What happens if you've misclassified a worker?

As with all things related to tax or law, getting it right the first time is always less expensive (and less stressful) than fixing the problem later. In the case of the employee/contractor classification, an employer who has misclassified an employee as a contractor will face stiff penalties. To encourage compliance with these laws, the IRS has implemented a new Voluntary Classification Settlement Program that allows employers an opportunity to reclassify their contractors as employees for future tax purposes and receive partial relief from penalties.

If you’re an employer and you’re not sure if you’ve properly classified your employees or contractors, it’s worth talking to a tax lawyer or CPA who can explain the rules and make sure you’re in compliance. And course, if you have any questions about whether you’ve classified workers correctly, don’t hesitate to call our office. We’re happy to walk you through it.