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FAQ: Is Your New Hire an Employee or a Contractor?

By Cristina Garza

We get questions all of the time asking about how to handle a new team member. Typically, when you are first starting out as a business it may seem like hiring contractors is the way go to; there are no payroll taxes to pay, no workman's comp policies to maintain, and it feels like a great way to add additional resources with very little risk.

Before you hire some one as a contractor, it is important to know who the IRS deems as a contractor and who is considered an employee. If you want to skip ahead, here is a super dry article from the IRS to put you to sleep: https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee

Let me go ahead and TLDR that for you...Before you can determine how to treat payments you make for services, you must first know the business relationship that exists between you and the person performing the services. The person performing the services may be -

  • An independent contractor
  • An employee (common-law employee)
  • A statutory employee
  • A statutory non-employee
  • A government worker
In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered:

Facts that provide evidence of the degree of control and independence fall into three categories:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?

Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another.

The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

So, ask yourself... How much autonomy does this person have in their day to day, do you provide the tools for them to do their work, does this person do this type of work for others, do you offer any sort of benefits, etc?

The IRS used to have a lot of ways to test the validity of the contractor vs employer relationship but it has become grayer and grayer over the years. Their 20 point test used to offer reasonable guidance, but it seems that this has been yanked from the IRS's site in lieu of less informative/clear guidelines. The rule of thumb is, if they have a business and/or does this type of work for other people- they are likely a contractor. If you are their main gig, you tell them when to show up, you provide the tools to complete the work, and you tell them how to do the work- they are likely an employee.

If you misclassify someone as a contractor vs an employee and the IRS finds out, the IRS will have you pay the employer and employee taxes plus penalties and interested starting at the point of hire (ouch) even if you didn't collect these taxes. This is often triggered by someone filing for unemployment when they have been paid as a contractor or by an audit of your tax return. Usually it is a simple mistake that creates an avalanche of problems. Keep in mind that not only does the IRS want their payroll tax, so does the state. The State of Colorado lists on their website that, "If an investigation finds that an employer has misclassified employees, the employer must pay all back unemployment insurance premiums owed with interest". Furthermore, "if the investigation finds that the employees have been misclassified with willful disregard of the law, the employer may be fined up to $5,000 per misclassified employee for the first misclassification and up to $25,000 per misclassified employee for a second or subsequent misclassification. In addition, upon a second or subsequent misclassification, the employer is prohibited from contracting with, or receiving any funds from, the state of Colorado for up to two years."

Don't let a simple mistake put you or your business in jeopardy. We are happy to hop on a call to chat more about the best ways to compensate your team and also stay out of hot water.