Distinguishing Between Employees and Independent Contractors

You all know I’m a big fan of bootstrapping and utilizing independent contractors is one technique to help entrepreneurs accomplish that. However, it’s important to remember that, while the use of independent contractors can be of great benefit to businesses in certain situations, you need to make sure that these independent contractors are actually independent contractors and not employees whom you’re just avoiding classifying as such. This week’s video shares some basic rules that you can use to help you decide if a particular role should be classified as an employee or as an independent contractor so that you don’t get in trouble with the IRS.

The first criterion that the IRS uses to decide if someone is an employee or an independent contractor is behavior control: do you control how the person does the job they’re assigned to do or do you just care about the output? If you tell someone when, where, and how to work or provide detailed training, s/he is probably an employee.

The second criterion is financial control: if the person working for you is in control of his or her own business expenses, sends you an invoice for work, and can decide how much to charge and whether that rate means he or she makes or loses money, the person is probably an independent contractor. If, however, you provide all of the equipment and materials, set the rates, and pay without being invoiced, the person is probably an employee.

Finally, the way you structure the relationship is key to whether the person is considered an employee or an independent contractor. Does s/he work for you indefinitely at a set rate or are is s/he contracted on a per project basis? If someone is hired to do a specific project in a specific timeframe for a specific price, s/he is probably a contractor. If, however, you hire him or her for an indefinite number of projects lasting an undetermined amount of time and pay what amounts to a salary, you probably have an employee.

It’s important to make sure that you don’t mis-classify employees as independent contractors because the IRS is cracking down and you can wind up in a lot of trouble and facing stiff penalties if the IRS decides that you should have classified some or all of your independent contractors as employees and followed the relevant tax and employment laws.

4 Replies to “Distinguishing Between Employees and Independent Contractors”

  1. I see this problem all the time but there is one more thing that seperates an employee or a contractor. To be classified as a contractor they must have other clients that they are classified as a contractor as well.

    1. Hi Alex: Thanks for your comment! It’s a great point but I don’t think a contractor must have other clients. For example, if I hire a web developer who is completing a specific project for me at a set price and can do the work whenever and however s/he wants but I am his/her only client at this specific moment in time – maybe s/he only works part time, maybe s/he is just starting to build the business, maybe s/he is having a slow month – I can still classify him/her as a contractor because that’s what s/he is. If someone has other clients it certainly helps to show that s/he is, in fact, a contractor and not an employee, but it’s not absolutely necessary.

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