Employee vs. Independent Contractor By Peter O. McDonald, CPA

A critical part of business operations is determining whether an individual who is providing services to your

business should be treated as an employee or an independent contractor. In general you must withhold and

pay Social Security and Medicare taxes, withhold income taxes and pay unemployment taxes on wages paid to

employees. Usually you aren’t required to withhold or pay any taxes on payments to independent contractors.

When determining whether your business relationship with an individual should be treated as an employee or

an independent contractor, information regarding the degree of control and independence must be considered.

The facts for each business relationship fall into three categories: Behavioral Control, Financial Control and

Type of Relationship.

Behavioral Control

Behavioral control is used to determine if the business had retained the right to direct or control how the

individual does the work and is further broken down into the following factors:

Types of Instruction Given

When and where to work

What tools or equipment to use

What workers to hire or assist with the work

Where to purchase supplies and services

What work must be performed by a specified individual

What order or sequence to follow when performing the work

Degree of Instruction

The more detailed the instructions, the more control the business retains

Evaluation System

Evaluation systems that measure details of how the work is performed point towards an employee

Training

Training provided on how to do the job and periodic and on-going training about procedures and methods provide

strong evidence of an employee relationship.

Financial Control

Financial control refers to the facts and circumstances whether a business has the right to control economic

aspects of the individual’s job. The factors of financial control fall into the following categories:

Significant investment

Varies by industry

Unreimbursed expenses

Independent contractors more likely to have unreimbursed expenses

Opportunity of profit or loss

The possibility of incurring a loss indicates independent contractor

Services available to the market

Independent contractor is usually free to seek other business opportunities, maintains a place of business,

and advertises

Method of payment

Employee is usually guaranteed a regular wage, independent contractor usually paid a flat fee per job

Type of Relationship

Type of relationship denotes how the individual and business perceive their relationship with each other. Some

of the factors to consider are the following:

Written contracts

- A contract is not sufficient to determine individuals’ status

- The IRS does not always follow a contract stating the individual is an employee or independent contractor.

Employee benefits

A business generally does not provide benefits to independent contractors

Permanency of the relationship

Is the relationship for an indefinite period of time or for a specified project or period

Services provided as key activity of the business

Individuals who provide services that are a key aspect of the business are more likely to have their activities

directed and controlled by the business which points toward an employee relationship

All of the above factors must be considered when determining whether an individual is an employee or

independent contractor. Facts and circumstances will vary with each situation. The key is to look at the entire

relationship, consider the degree and extent of control and to document each of the above factors used in

coming up with your determination.

If you are still unsure how to classify your business relationship with an individual, you can file Form SS-8 with

the IRS. The IRS will review the facts and circumstances of the business relationship and provide you with an

official determination.

Employees classified as independent contractors with no reasonable basis may cause the business to be liable

for employment taxes for the worker.

Employers who believe they have misclassified workers may want to take advantage of a new optional program

from the IRS called the Voluntary Classification Settlement Program. This program provides the opportunity to

reclassify workers as employees for future tax periods for partial relief from employment taxes. Certain

requirements must be met in order to participate in the IRS program.

Peter McDonald joined SEK&Co in 2000 and is a Manager in the Accounting Services Department of the Hagerstown, MD office. Previously, he gained accounting experience working as a Staff Accountant at Wilkinson and Company Chartered Accountants, Trenton, Ontario. Peter works with the firm’s small business and individual clients providing accounting, consulting and tax services. He also serves on the firm’s Accounting Services Committee.

Smith Elliott Kearns & Company, LLC is a full-service certified public accounting and consulting firm with offices in Hagerstown, Maryland; Hanover, Carlisle, and Chambersburg, Pennsylvania. The firm was founded in 1963 and was recently named a Top 200 Firm by Inside Public Accounting and a Pennsylvania Best Places to Work for 2010. With 22 partners and a total staff of 150, SEK&Co services individuals as well as business clients in a variety of industries including construction, financial institutions, healthcare, local government, manufacturing, and nonprofit. The Firm offers financial statement preparation, auditing and assurance services, small business accounting, tax and payroll services, QuickBooks® and Sage 50® training and consulting, tax return preparation and planning, estate planning and administration, business valuations, and employee benefit plan design, administration and auditing.