Startups: Tax Implications of Hiring Independent Contractors vs. Employees

For federal purposes, if you have contractors working for you, there are three worker classification tests that you must be aware of: behavioral test, financial test, and relationship type test. Let’s talk about them separately:

1. Behavioral – Does the company control or have the right to control the way a worker performs his/her work? Companies normally have this control with employees. However, a company hiring an independent contractor normally defines an end goal or product, which the contractor achieves as they see fit.
2. Financial – Examine how the company controls the economics of the worker’s labor. Companies provide employees the tools to do their jobs. Employees are also guaranteed a regular wage weekly, bi-weekly or monthly, even if they receive commission. Contractors need to determine which tools to use and assume the costs and risks associated to complete the work. Independent contractors also work on an agreed-upon, fixed fee or cost/material basis.
3. Relationship Type – A company typically develops a long-term relationship with its employees and provides benefits such as health insurance, retirement plan contributions and paid time off. Independent contractor relationships center on a project that has a definitive beginning and ending, and they do not receive any of the employee benefits described above.

Misclassification is often deliberate because it is cheaper to have a contractor instead of an employee. If a business classifies an employee as a contractor, then it does not have the expense of employment taxes such as Social Security, Medicare, and unemployment taxes. In addition, it does not have to include the worker in the company’s healthcare and retirement plans, if there are any. Thus, workers’ classification between employee and independent contractors continues to be a top issue for the U.S. Department of Labor and the Internal Revenue Service.

No one fact or circumstance is dispositive in reaching a conclusion. 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.

With that said, here is example: You are a retired physician, and you have an excellent idea to treat a disease which you think is worth pursuing. You contact one of your friends at a research university and you get in contact with a couple of grad students. You ask them to come help you run some experiments.. It starts out as approximately 10 hours a week but very quickly they are working on your project 30-40 hours a week. You tell them exactly what to do and you gave them high performing laptops. You expect them to work on your project and they rely on the hourly payment that you provide. In this case, these grad students are in fact your employees. They do the work for you under your direction, with your equipment. They should be classified as employees and issued W-2s.

If your classification of a worker as an independent contractor is challenged by an IRS audit or a contractor, you may be entitled to a Section 530 relief. You will not owe employment taxes if all three of the relief requirements are met. The requirements are more nuanced, but here is just a quick summary:

1. Reporting consistency- you filed all 1099 Non-Employee Compensation (NEC) forms in a timely manner;
2. Substantive consistency: you classified similar workers the same; and
3. Reasonable basis: you must have a reasonable basis to treat a worker as an independent contractor based on a court ruling, an earlier IRS audit or industry practices.

Lastly, please keep in mind that there are filing requirements. If a worker is treated as an independent contractor, it is incumbent upon you or the company to issue a Form 1099-NEC to the contractor each January for the work performed during the previous year. With a few exceptions, this form must be issued for all unincorporated service providers who have received payments from the company that exceed $600. It is a good practice to obtain from the contractor a Form W-9, Request for Taxpayer Identification Number and Certification so that you have all the necessary data on hand.

While there can often be a fine line between what makes someone an employee or a contractor, it is imperative that you perform the necessary due diligence to make an accurate determination and avoid problems later with an IRS or state audits or a lawsuit from a disgruntled contractor.