Do You Have Employees or Independent Contractors?

Getting this wrong can be costly

by Peter Girolamo, C.P.A., M.B.A.

This question comes up a lot, especially from new companies. It's a hassle and expensive to put your workers on payroll. You have to pay in social security and medicare tax, pay workers comp, pay a payroll service and make sure you file payroll tax forms on time. So it seems like an easy out to just set the workers up as independent contractors and let them worry about their own taxes.

Not a good idea!

There are significant penalties for paying workers as contractors when they should be employees. The penalties increase dramatically if this misclassification is found to be done purposely. On audit, there can be several years exposed to penalties. This is a world of hurt that you don't want to be part of.

In my experience it is not so easy to classify a worker as an independent contractor. The contractor must be truly independent of your organization and you must exert virtually no control over that person. And while this is certainly a possibility, most companies can't get by with just contractors. Independence on the part of workers generally does not make for good management or translate into a successful business.

There is no single definition of an independent contractor. Facts and circumstances dictate, but the IRS does provide some guidelines as to who should or should not be considered a contractor:

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

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. 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.)
  3. 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.

You can find more information regarding this issue on the IRS website, here (,,id=179115,00.html), here (,,id=179112,00.html) and here (,,id=99921,00.html).

Peter Girolamo, CPA specializes in bookkeeping, payroll, tax services and related advice for small businesses and their owners. His office is located in Thousand Oaks California, but he serves clients in several states. Peter can be reached or by phone at 805-778-9277.