Paying an independent contractor for services, rather than hiring an employee, has its advantages. You don’t have to withhold taxes, and you don’t have to pay social security, Medicare or workers’ comp premiums. At the end of the year, you provide independent contractors with a 1099 form, as opposed to a W2, which leads some business owners to refer to independent contractors as “1099 employees.” But employees and independent contractors are two distinct categories of service providers under the law, and the IRS is going to insist that you classify them accurately. And before your PEO can move forward with your payroll services, they’ll need to know who you’re working with.
Though hiring an independent contractor saves expenses and administrative time, you don’t just get to declare that a worker is an independent contractor as opposed to an employee—even if the person in question agrees to the title. There are legal guidelines regarding the status of service providers, and therefore there are legal and financial consequences to misclassifying them. The easiest and most efficient way to ensure your workers are properly classified is to work with your PEO.
The IRS determines employee status based on three basic categories: behavioral control, financial control, and worker/business relationship.
Behavioral control: According to the IRS, “An employee is generally subject to the business’s instructions about when, where, and how to work” and may also receive on-the-job training. Independent contractors operate on their own merits and have more freedom to determine the way a task or service is performed.
Financial control: Generally speaking, employees can often expect reimbursement for expenses and don’t have to invest in their tools or facilities. Employees can also expect a guaranteed regular wage. An independent contractor may invest in their equipment, and therefore may experience profit or loss (as when their own investment is larger than the fee they receive). An independent contractor is also typically hired on a task-by-task basis, and can also seek out other business opportunities in the same market.
Relationship: How much you rely on the worker’s services, and for how long, may determine employee status. If you expect to receive the services ongoing and indefinitely, rather than for a specific, finite task, then it’s likely that the worker should be classed as an employee. Moreover, if the worker is performing tasks that are essential to your business, and you can therefore closely direct the way those tasks are performed—ie behavioral control—then you will more than likely have to classify them as an employee.
(For more information, see the IRS’s Employer’s Supplemental Tax Guide here.)