For federal employment tax purposes, businesses must examine the relationship between themselves and their workers. Worker classification is important as it determines if an employer must withhold income taxes and pay Social Security, Medicare taxes & unemployment tax on wages paid to the employee.
In general, if a business has the right to control or direct only the result of the work, then the individual performing the work may be classified as an independent contractor. The worker is thus responsible for which action items need to be completed, and how they need to be completed in order to achieve the desired result. Businesses normally do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax.
The drive for efficiency, a growing economy as well as innovations in the tech sector are putting pressure on business to engage independent consultants. As explained by Eric Rumbaugh on Staffing Industry Review, there are several challenges affecting independent contractor engagement. These include:
- In California, the Supreme Court has adopted a new test for employee status. Employers need to prove that the worker will have the freedom to control and direct the work, that the worker is customarily engaged in a business of the same nature as the work that needs to be completed, and that the worker will perform work that is outside the usual course of the business.
- Typically, workers classified as contingent workers/independent contractors are excluded from participation in employee benefits. It is however recommended that businesses periodically review their benefit plans and assure that they do not favor highly compensated employees or violate any rules that govern nondiscrimination.
- Businesses should not reimburse independent contractors for any expenses that may occur while the contractor is performing work for the business. ICs make a profit because of their engagement on a project or assignment. Any expenses that accrue should be considered as the cost of doing business, so ICs should factor potential expenses in when negotiating their pay rates.
- Contracts with independent contractors are business-to-business contracts and not business-to-employee contracts. They should thus follow appropriate language and terminology.
In order to determine how to correctly classify a worker, the Internal Revenue Service recommends considering three categories:
- Behavioral Control
A worker is an independent contractor when they have the freedom to choose when and where to work, what tools to use, where to purchase supplies or services. ICs typically receive less detailed instructions from the business that hires them, and, they tend to use their own methods instead of receiving regular or periodic training.
- Financial Control
Independent contractors should invest in their own equipment and tools and should not submit expenses. They have the freedom to offer their services to the market and are paid a flat fee for their services instead of receiving a regular hourly or weekly wage.
The relationship between the worker and the business should be in place during a specific project or period, without an expectation that the relationship will continue indefinitely.
Surveys suggest that independent consultants are the most satisfied worker group in the US. Nevertheless, businesses should consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation.