Independent Contractors vs. Employees

By Helen Reeves

For early stage companies, labeling new hires as “independent contractors” may seem like the easiest way to onboard team members. By hiring independent contractors, companies avoid withholding tax obligations and are not required to provide employment benefits, which can pose financial strain for a business that’s counting every dollar.

Unfortunately, the IRS, state and local tax authorities do not take a generous view when it comes to the classification of workers as independent contractors instead of employees. While many founders assume that their emerging growth business will fly under the radar of these authorities, all it takes is one terminated independent contractor filing for state unemployment benefits to trigger a tax-related investigation. Founders could be in for a rude awakening when they learn that their earliest hires were in fact employees to whom the company now owes past due payroll taxes, related penalties and interest.

How do you know whether a new hire should be classified as an employee and not an independent consultant? The answer will always depend on the facts and circumstances associated with that particular hire and on the multiple legal tests that might be applicable to the services relationship. For the IRS, the key issue is “control”; the more supervision, direction and control that an employer imposes on a worker, the greater the likelihood the IRS would classify that hire as an employee. The IRS has provided a twenty factor test listing key elements to control. These key elements include, but are not limited to:

  • the level of instruction about when, where and how the work will be performed;
  • the extent to which worker must undergo training to perform the services;
  • the establishment of set hours;
  • any requirement that work be performed on the hiring company’s premises; and
  • any requirement that the services of the worker be exclusive.

Entrepreneurs should also be aware of the state-level tests that could also apply. For example, in some states the key factor is the “economic realities test”, which states that where a worker is highly dependent on the employer for their livelihood that relationship will be treated as an employer-employee relationship.

Founders of growing companies are well-advised to review and carefully consider how they classify their new hires. While labeling all new hires independent contractors can seem like a quick fix, failure to properly classify workers as employees can create costly and complex tax burdens down the road. In the case where an entrepreneur is concerned about potential or prior misclassifications, consulting with legal counsel is a prudent course of action for determining and implementing corrective actions. If you would be interested in a complementary white boarding session on this issue in the US, please reach out to Nick Pujji in our Los Angeles office.