Contractor or employee: What's the difference?

Here’s a warning to small-business owners who routinely use contractors.

The owner of a home care services agency contracted with 35 workers to provide services to her customers. An IRS audit determined that the workers she paid were actually her employees, not independent contractors. The tax agency then demanded that she pay federal employment taxes, including the employer portion of Social Security taxes and federal unemployment tax. 

If the IRS’s position holds, she would also be responsible for pay additional state unemployment taxes and workers’ compensation/disability premiums.

So, if you run a small business and hire workers, you’ll definitely want to be clear as to whether these workers are independent contractors or employees. For federal tax purposes, this really matters. It affects how and what taxes you pay and how you file your tax returns. 

When you pay a person as an employee, you’re responsible for paying additional taxes. They can amount to an additional 8 percent or more on top of what you pay the worker. In the case above, the additional cost was over $2,400 annually for each worker that the IRS determines is an employee rather than an independent contractor.

How does a small-business owner determine whether workers are in fact contractors and not employees? The IRS and tax courts have ruled that a number of facts must be considered. They’re grouped into three categories of control: behavioral, financial and relationship.

One of the main characteristics of employment is the method of compensation. If a worker is on your payroll and receives a steady, recurring paycheck, then clearly the worker is an employee. 

When it comes to control, ask yourself these questions. Do you exert a significant amount of control over when your workers do their work, and do you control the manner in which they do it?

  • Do you supply the necessary tools, materials or equipment for your workers to do the work?
  • Is the work temporary or permanent?
  • Is the work considered integral to your business?
  • Do you require workers to wear a uniform or drive a company-provided vehicle?

If you answer “yes” to any of these questions, chances are that your workers are employees. On the other hand, the more freedom workers have over such aspects, the more likely they are to be independent contractors. 

The IRS also publishes tips for business owners to help them classify hires as employees or contractors.   

The IRS has also recognized three statutory safe harbors that free business owners from being responsible for employment-related taxes for their workers. The first is judicial precedent in favor of the employer’s business. The second is when in a past audit the IRS ruled no employment taxes were due. And the third is where there’s is a long-standing recognized industry practice in which workers are recognized as contractors.

The home care service business owner challenged the IRS’s ruling that her workers were employees. Her argument included these points: 

  • Before starting her business, she was a home care service worker herself and had discussions with many other such workers who were also contractors, not employees.
  • She contacted other business in the same line of work and learned that most treated their workers as independent contractors.
  • She used an independent contractor agreement for each worker, which her attorney drafted.

Finally, she noted that during an earlier IRS audit, the agency had reviewed her business-related tax returns, was aware that she treated her workers are contractors and said nothing about having any issue with it at that time.

She argued her case in tax court, and the court decided in her favor. Small-business owners who hire contractors should take away some important lessons from this story. 

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.