Entrepreneurs prefer to classify workers as independent contractors in the ‘gig economy’ to minimize taxes and liability. As a result, startups want to know how to make sure someone is an independent contractor and not an employee. Unfortunately, there is no quick and easy test. However, if you get it wrong you might owe the IRS. In addition, if you are an independent contractor beware of the self-employment tax trap if using an LLC.
Just labeling someone an independent contractor does nothing. So, what do you do? Start by looking at how much you control the worker and job. Do you provide space, tools, etc. and actively manage their work? If so, they are likely an employee. If you tell them what you want done and when but they control how they do it they are more likely independent contractor. As a result, there are a 50 shades of grey in between. Therefore, you ALWAYS should have a written independent contractor agreement.
Start with these 3 factors to show a worker is independent contractor.
There are three areas to focus on to see if a worker is independent contractor: Behavioral Control, Financial Control and Relationship. This is based on how the IRS decides. The government starts with assumption that an employee = more taxes owed.
Behavioral Control looks at whether the business has the right, regardless if exercised, to direct and control the work. More control, more likely an employee.
- What types of instructions do you give, broad or specific?
- Who determines how to complete the work and what tools, equipment, office space, etc. to use?
- How detailed are the instructions provided by business?
- Does the business decide ‘how’ to do the work and its progress or just the finished work?
- Does the business train the worker how to do the job or require training in procedures and methods, or does worker use own methods and procedures?
Financial Control: looks at whether the business directs or controls the financial aspects of the job.
- Who pays for the equipment used?
- Does the worker incur expenses, deduct as COGS or operating expenses on its financials?
- Do you pay the worker a set hourly/weekly wage or a flat fee for the job?
- Does the worker have a profit or risk of loss?
- Is the worker an LLC, Corporation or Sole Proprietor?
- Does the worker offer its services to the market?
Relationship: looks at how the business and worker view it. A well drafted contract helps!
- Does the written contract describe in detail the relationship the parties intend?
- What is the nature of the worker’s services? Are they a key to the business?
- Does the contract address key aspects outlined above?
- Does the business provide employee-type benefits – insurance, pension, paid vacation/sick time?
- Is the relationship finite, limited to a project or fixed term or is does the relationship ongoing?
What if you get it wrong? Claiming a worker is an independent contractor without a reasonable basis creates liability for the business and worker for non-payment of employment taxes (Withholding, FICA,Medicaid, SUTA, FUTA and state taxes) plus penalties and interest. If you think have gotten it wrong, the IRS has a Voluntary Classification Settlement Program to reduce the taxes and penalties for certain businesses.
Obviously, the best method is to properly classify and document the relationship from the start with a well drafted contract. Also as an independent contractor, a legal review of your agreement helps ensure you are fully protected and not an employee.
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Until then, Keep it Legit!
Bob