If you own a business, or are involved with personnel or human resource management, it is critical that you understand the difference between an independent contractor and an employee.

For both tax and liability reasons, you must properly designate an individual as an employee or an independent contractor. Intentionally misclassifying an individual as an independent contractor could expose your company to tax penalties with the IRS. The U.S. Department of Labor recently issued a memorandum discussing the test with which to determine whether an individual is an employee, with the main factors having to do with the degree of control the employer has over the worker’s job.

The benefit of classifying a worker as an independent contractor is primarily the money saved by a company in not having to pay group health and workers’ compensation insurance premiums, social security, and unemployment insurance taxes for that worker. However, if an individual is classified as an employee, the employer must:

  • Withhold federal, state, and local income taxes
  • Contribute half of the Federal Insurance Contributions Act taxes
  • Pay the full tax under the Federal Unemployment Tax Act
  • Pay state unemployment insurance tax
  • Pay for workers’ compensation insurance

In addition, an employer must file certain returns during the year with various tax authorities; and provide W-2s to the worker by January 31 of each year. The employer must also provide the worker with any employee benefits offered, including health insurance, vacation time, holidays, and participation in the company’s retirement plans. The failure to pay these taxes and provide such benefits can result in hefty penalties levied by the IRS.

Behavioral Control, Financial Control and Type of Relationship

The three main concepts that an employer must grasp in order to understand the differences between an employee and an independent contractor are behavioral control, financial control and the type of relationship they have with a worker.

If, as an employer, you instruct the worker as to when, where and how to work, or have control over how the individual’s work results are achieved, that person is considered an employee. If you as an employer provide training to that worker in order for him to perform the work in a certain manner, then they are considered an employee. These are examples of behavioral control over the worker.

Facts which point to how much financial control a worker has over his job include:

  • The extent to which they have unreimbursed expenses
  • The extent of a worker’s investment over their facilities or equipment used to perform their services
  • The degree to which they can incur a profit or a loss

These are just some of the issues that determine whether a worker is an employee or an independent contractor. If that worker has unreimbursed expenses and a significant investment in their facilities or equipment, chances are they are an independent contractor.

The type of relationship between the employer and the individual can be determined by examining the written contract which sets forth the parties’ relationship and whether or not the employer provides health benefits, vacation pay, sick pay or a pension plan point to an employer-employee relationship.

The IRS provides a method for employers to receive an IRS determination of whether an individual is an employee or an independent contractor. If desired, an employer may file the IRS Form SS-8 and request such a determination. The IRS may take up to six months to provide their answer, but in some cases it may be necessary to request such a determination. The IRS rules regarding such classifications can be found on their website here.

Contact the Milwaukee business litigation firm of Kerkman Wagner & Dunn if you have any questions about the differences between independent contractors and employees. We have over 50 years of combined legal experience representing business owners in Wisconsin. Let us show you how to properly designate your workers’ classification and avoid possible legal fees, back taxes, back wages, and legal and financial penalties in the future. Contact our offices today for answers to your questions.

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