One of the most frequently asked questions I get from business owners is whether they can hire an independent contractor instead of an employee. This is particularly when they are first starting out. Companies are interested in using independent contractors because of the savings it provides and because at the early stages of their company, workload is uncertain. It can also help companies obtain services from workers that have special skills.
If you’re thinking of hiring an independent contractor for your company, you must ensure that you are properly classifying your worker as an independent contractor. You want to make sure that the person you are hiring is not considered an employee. In California, if you misclassify your workers as independent contractors when they should be classified as employees, you can face stiff penalties, including $5,000 to $25,000 per violation. You may also be liable for back taxes, back pay, penalties, be exposed to liabilities, and can even go to jail.
Some businesses think that having a worker sign an independent contractor agreement shields them from misclassifying employees, but this isn’t true! Rather, the IRS and EDD will look at the reality of the relationship between you and the employee. The IRS and EDD looks at similar factors to determine whether a worker is correctly classified as an independent contractor.
The three factors that the IRS looks at to determine whether a worker is correctly classified as an independent contractor is as follows:
Behavioral Control - The most important factor is behavioral control. This is the right to direct and control the worker even if the right isn’t exercised. This factor looks at whether you are paying for a particular outcome or providing detailed instructions on how to do the job.
When you hire an independent contractor, you are paying for a particular outcome. Let’s say Starbucks has a problem with its plumbing and it’s causing the toilet to overflow. Starbucks doesn’t care how the toilet is being fixed, it only cares that the toilet is fixed.
On the other hand, if Starbucks is hiring a barista, it doesn’t want the barista to roll up in whatever it chose to wear that morning. It wants them wearing all black clothing with a green Starbucks apron, so that customers can get the experience they expect from a Starbucks. The baristas are also trained in other parts of providing a Starbucks experience, including addressing customers in a certain way, and making drinks according to Starbucks’ standards. Thus, Starbucks exercises behavioral control over its workers.
Financial control - Financial control is the right to control or direct the financial and business aspects of a worker’s job.
When an independent contractor takes a job, he or she has the opportunity to make a profit or a loss. They are usually paid on a flat fee basis or by the job, whereas an employee receives a regular wage. While employers are not expected and sometimes even prohibited from accepting work outside of their employment, independent contractors have multiple clients and are not dependent on a single source of income.
In addition, Independent contractors tend to provide their own equipment and tools, whereas employees use the equipment and tools provided by the employer.
Type of relationship - Finally, the IRS looks at the type of relationship a company has with its worker. If a worker provides services that are key to your business, this suggests that the worker is an employee rather than an independent contractor. Going back to the Starbucks example, the barista provides key services, whereas the plumber does not.
In addition, an employee’s relationship with an employer is for an indefinite time-frame, whereas an independent contractor is for a specific period--for example, until a particular job is complete. Finally, employees are entitled to a company’s benefits plan, but independent contractors are not.
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This article is provided for informational purposes only and should not be construed as legal advice. Read our disclaimer here.