Hiring new talent is an exciting milestone for any company. Whether bringing on your first team members or expanding an established business, one critical decision you’ll face is how to classify your workers: employees or independent contractors. This is not just a choice but a responsibility that impacts everything from tax obligations to compliance with labor laws and can even affect the efficiency of your operations.

The IRS emphasizes the importance of considering the “degree of control and independence” in three key areas when making this determination: behavioral, financial, and relational.

Behavioral Control

Training, instruction, and evaluation are the three primary criteria in the behavioral bucket.

1. Training: Employees typically receive structured onboarding and ongoing training, ensuring they align with company standards. In contrast, independent contractors are expected to handle their learning and bring specialized skills to the table.
2. Instruction: Employees are usually directed when, where, and how to perform their tasks. Conversely, contractors have greater flexibility, focusing more on the result than the process. They also generally provide their own tools and equipment.
3. Evaluation: Employee performance is often evaluated based on the process and adherence to company procedures, while contractors are judged primarily on the outcomes they deliver.

Financial Considerations

The financial component of this decision is less ambiguous.

1. Compensation: Employees are paid regularly (e.g., weekly, bi-weekly) with a fixed salary or hourly wage. Contractors are paid for the work performed, which may be detailed in a contract as a lump sum, installments, or billable hours.
2. Tax Implications: Employers are responsible for withholding and paying taxes for employees, including Social Security and Medicare, and must provide W-2 forms annually. Contractors handle their own tax contributions and receive a 1099 form from each company they work for.

Relational Dynamics

Defining your relationship with workers from the beginning sets the tone.

1. Time: Employment implies an indefinite relationship. Contracting specifies start and end dates. Furthermore, contractors often complete work for more than one company simultaneously.
2. Key Activities: If a worker is involved in the “key activities” of your business, they are likely an employee. Contractors complete more specialized outsourced work or single-instance projects.

Sometimes, the choice between an employee and an independent contractor is obvious. However, several factors create a gray area that calls for an expert opinion. For example, regulatory agencies, like state unemployment agencies, follow different rules in making this determination.

Ensure Correct Classifications with Lutz’s Client Advisory Services

Understanding the complexities of worker classification can be challenging, and the implications of getting it wrong are significant. At Lutz, our Client Advisory Services team is here to help you make informed decisions that align with IRS regulations and your business goals. Contact us to ensure your business is set up for success and fully compliant.

Contributor: Kira Pavlik, Accounting Intern