How to Classify Your Workers: Independent Contractor vs. Employee

Let’s face it: the gig economy is radically transforming the way we work. Gone are the days of full- and part-time employees as the overwhelming majority of the workforce. With that shift in the workforce comes an increased level of complexity for small businesses.

Recent studies show that modern companies are indeed changing with the times. SCORE’s 2017 Report on America’s Small Businesses found that participating businesses chose to hire gig workers or contractors 37 percent more than in the prior 6 months. And workers are adapting too: a recent Gallup poll estimates that nearly 30 percent of U.S. workers have an “alternative work arrangement” as their main source of work.

Business owners are likely considering some mix of contractors and employees to fulfill all their needs. But how can they decide on the right fit for each role? Here we’ll walk you through the key points to consider when classifying your workers.

Your ultimate guide to SMB accounting

Let’s get those books in order.

What’s the difference between a contractor/gig worker and an employee?

The line between employee and independent contractor isn’t terribly clear-cut. It’s based on answering a handful of questions and making a judgment call.

According to the Internal Revenue Service (IRS), the answers to these three questions dictate the status of a worker:

  1. Does the company have behavioral control of the worker, or the right to control what the worker does and how he or she does it? Examples of behavioral control include where the work is completed, what time it’s done, and what tools the worker uses.
  2. What level of financial control does the company have over the worker? These are things like investments made by the worker, unreimbursed expenses, and/or an opportunity for profit or loss.
  3. What type of relationship does the company have with the worker? Written contracts, benefits such as health insurance, vacation and sick time, an indefinite length of the relationship, and key services all determine the type of relationship.

The answers to these questions are important to know, but what it all boils down to is this:

  • A worker is classified as an employee if the company controls what the worker will do and how he or she will do it.
  • A worker is classified as a contractor if the company only controls the result of the work (not what will be done or how).

Let’s say a store sales associate is required to be at a certain store during specific hours to perform her work. In this case, the company has behavioral control, making this worker an employee. Another work arrangement might involve a data entry clerk who creates an output (like a spreadsheet) on her time, in her desired location, and with her own tools. The company does not have behavioral control, making this worker a contractor.

What are the tax implications for independent contractors versus employees?

Once you’ve answered questions about worker status, you’ll need to consider how taxes work for each type of worker. Fortunately, the tax differences between employees and contractors are pretty straightforward.

Workers classified as employees file a W-4 with the company when they start employment. The company is then required to withhold and pay a series of taxes on behalf of that employee. That means the company pays higher taxes for workers classified as employees.

Workers classified as contractors file a W-9 with the company when they begin work. The W-9 allows the company to report to the IRS what they paid to the contractor; however, the contractor is required to pay his or her own taxes.

How do you know whether to hire employees or independent contractors?

Hiring employees gives businesses a lot of behavioral control – at the cost of higher taxes. That includes federal income tax, payroll taxes (like Social Security and Medicare), unemployment insurance, and worker’s compensation insurance. Hiring contractors offers companies access to workers without those taxes, but with no behavioral control.

In order to know what type of worker is the best fit, ask yourself these questions:

  • Do I need to supervise the worker?
  • Is it necessary to dictate the hours, location, and tools used for work?
  • Does the work fill a short- or long-term need?
  • Does the work constitute a vital part of the company?

If you answered “yes” to any of these four questions, consider hiring an employee for the work. If you answered “no” to at least the first two questions, consider hiring a contractor. The first two questions determine the level of behavioral control, which is tantamount in making the distinction between employee and contractor. The other two questions will inform your decision, but they aren’t deal-breakers.

For example, you might consider hiring a consultant to run the marketing function of your business. You don’t need to supervise his work or dictate where, when, and how he does it, but he may be filling a long-term need that’s a vital part of the company – and still be classified as a contractor.

Are there any other major details to know?

There are a couple of cases where what you might think of as a contractor may actually be classified as an employee. A worker classified as a contractor may still be considered what’s called a statutory employee if the worker meets one of the following criteria:

  • a driver who delivers and/or picks up certain types of goods and acts as your business’ agent (or is paid commission);
  • a full-time life insurance salesperson;
  • a home-worker that works on goods your business supplies and then returns to you;
  • And, a full-time salesperson who sells goods for your business and returns orders to you to be fulfilled.

Another category called statutory non-employee (meaning self-employed for tax purposes) refers to workers that are direct sellers, licensed real estate agents, and some types of companion sitters. Direct sellers and licensed real estate agents are considered statutory non-employees as long as all of their income is tied to sales and they provide a service under a written contract. Companion sitters are also considered statutory non-employees if they aren’t employed by a companion-sitting service.

Classifying your workers is a crucial exercise.

Making an incorrect choice when classifying employees and contractors could have financial consequences for your business. Misclassifying a worker as a contractor when they really should be an employee could cost you in tax penalties. On the other hand, making an assumption that “employee” is the right delineation for all workers could represent a missed opportunity for cost savings.

If you could use an extra hand in evaluating a new hire, ScaleFactor’s powerful forecasting tools are here to help. Contact us today to request a demo.

Reader Interactions

Put your accounting on autopilot

Schedule a free consultation today.

Scalefactor dashboard desktop graphic