Business owners must carefully consider how the people working for them are classified. There is a fine line between being identified as a contractor or employee on the job. Owners must know the difference to avoid being penalized.

Worker classification determines if an employer must withhold income taxes and pay Social Security, Medicare taxes and unemployment tax on wages paid to an employee. Businesses do not have to withhold or pay any taxes on payments to independent contractors. The earnings of a person working as an independent contractor are subject to self-employment tax.

There are federal and state rules for determining if a person is an employee or contractor. Employers must follow both sets of guidelines when classifying workers.

The general rule is that an individual is an independent contractor if the payer has the right to control or direct the result of the work, not what will be done and how it will be done. The IRS advises businesses to consider all evidence of the degree of control and independence in the employer/worker relationship. Whether a worker is an independent contractor or employee depends on the facts in each situation. Business owners must consider how much control they have over the person in the following areas.

• Behavioral control: A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.
• Financial control: A worker is an employee if the employer has a right to direct or control the financial and business aspects of the worker's job.
• Type of relationship: Both parties’ perception about the worker/employer relationship.

The Answers to These Questions Will Help

The IRS uses these answers to 20 questions to determine if a worker is a contractor or employee.

1. Can the worker make a profit or suffer a loss from doing the work aside from their pay for the project?
2. Does the worker have an investment in the equipment or facilities used to do the work?
3. Does the person work for more than one company at a time?
4. Does the worker offer services to the public?
5. Does the employer have the right to give the worker instructions about when, where and how to work?
6. Does the employer train the worker to do the job in a particular way?
7. Are the worker’s services so important to the business that they have become a necessary part of the business?
8. Must the worker provide the services personally as opposed to delegating them to someone else?
9. Does the company hire, supervise and pay the worker’s assistants?
10. Is there an ongoing relationship between the worker and the owner?
11. Are the worker’s hours set by the employer?
12. Must the worker spend all his or her time on the job?
13. Must the individual work on site, or can the employer control the route or location where the work must be performed?
14. Does the employer have the right to determine the order in which services are performed?
15. Must the worker provide reports accounting for his or her actions?
16. Is the worker paid by the hour, week or month?
17. Does the company pay the worker’s business or travel costs?
18. Does the company provide the worker with equipment, tools or materials?
19. Can the worker be fired?
20. Can the worker quit at any time without incurring liability?

If the answer is yes to the first four questions, the worker most likely is an independent contractor. An affirmative answer to questions five through 20 means that the worker may be classified as an employee in the eyes of the IRS.

It could be costly if federal or state authorities find that workers are improperly classified without reasonable cause. Owners could be held liable for paying employment taxes, as well as penalties and interest. It is in a company’s best interest to seriously consider if a contractor is really an employee. The money saved from not incurring employee-related costs is typically not worth the risk.