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As a business owner, one of the things I've learned is that I can't do everything myself. I've had to hire people to fulfill different roles to support the work I do. In some cases, the people I've hired have been independent contractors -- but in other situations, they've been employees.

While both independent contractors and employees provide services, there are big differences between them. For example, independent contractors aren't protected by most labor laws, such as wage and hour laws. Also, you don't have to withhold taxes for independent contractors, pay the employer's portion of FICA taxes, or obtain workers' compensation or unemployment insurance for them -- but you have to do all these things for employees.

Before you hire anyone, you must know whether that person will be an independent contractor or employee so you can comply with the law. And the most important thing to know is that you don't decide whether the person you hire is an independent contractor or an employee -- the law does.

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Worker classification rules determine who you're hiring

If you incorrectly classify an employee as an independent contractor, this is called misclassification. It has tax consequences and you could end up owing back wages to workers who weren't classified properly. You could be audited by the Internal Revenue Service and by your state's Department of Labor and could be sued. In some cases, there are even criminal penalties.

Bottom line: You don't want to mess with misclassification.

The good news is, the IRS has clear rules to determine what role each person you hire fits into. The IRS applies a so-called common law test. This used to require consideration of 20 different factors, but the IRS simplified things in 2004 and now there are three big considerations determining whether someone is an employee or independent contractor.

The three factors that matter include behavioral control, financial control, and the type of relationship between the employer and employee.

There are also a few other applicable rules. For example, some laws specify certain workers are always treated as employees. They're called statutory employees. There are also laws saying certain workers -- statutory non-employees -- don't ever need to be treated as employees. These rules, however, apply only to a limited number of businesses, such as commission-based real estate, so your company probably needs to follow the common law test, the three parts of which are explained below.

The behavioral control test

According to the IRS, when an employer has a high level of behavioral control over a worker, that worker is an employee -- even if the employer doesn't exercise that control. The factors that determine whether an employer has behavioral control include:

  • Whether the employer provides instructions on tools used to perform work, or on when and where to work or buy supplies. The more instruction provided, and the more detailed the instructions, the more likely it is the worker's an employee.
  • What types of evaluation systems are in place. If the end result is the only concern, the worker's probably an independent contractor. If a worker is measured on multiple aspects of performance, he's probably an employee.
  • How much training an employer providers. A worker who's provided with training is almost assuredly an employee.

The financial control test

If an employer directs financial aspects of work performed, the worker is probably an employee. For example:

  • If an employer makes a significant investment in equipment the worker uses, the worker's likely an employee. If a worker has many unreimbursed expenses, he's probably an independent contractor.
  • If a worker is guaranteed a regular wage for a time period -- even when supplemented by a commission -- he's probably an employee. If a worker instead makes a flat fee for work performed, that points to independent contractor.
  • If a worker is able to sell his services on the open market, seek business opportunities, and potentially make profits or incur losses, the worker's probably an independent contractor.

The relationship test

The final test measures the nature of the relationship between the employer and worker:

  • Written contracts specifying a relationship between the worker and company are taken into account, but aren't controlling.
  • If an employer provides benefits, such as a pension, sick leave, vacation, or insurance, this is a strong indicator the worker is an employee.
  • If an employer and worker understand their relationship will continue indefinitely, the worker's probably an employee. Independent contractors are often hired only for a fixed period or to complete a set task.
  • If a worker performs services considered a key part of a company's routine business, this is an indicator the worker is an employee.

What should you do if you're not sure?

If you're hiring someone and aren't sure how to classify him, you can submit Form SS-8 to the IRS. This form is called Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

The IRS will conduct an investigation, obtain information from all involved parties, and submit information to a technician who makes a decision.

This decision is binding on the IRS -- provided nothing changes -- so you won't have to worry about serious consequences for misclassification, such as owing back taxes you should've paid as an employer or penalties for failing to withhold taxes and not filing W2 forms for employees.

While misclassification has other consequences outside of the purview of the IRS, if you follow guidelines from the IRS in classifying workers, this should help shield you from most potential legal action related to employee misclassification.

Misclassifying workers isn't worth it

Remember, it doesn't matter if an employer and a worker agree that an employee is an independent contractor, or even sign a contract signifying the worker an independent contractor. Employers must follow worker classification laws.

Following the rules is worth it -- even though it means taking on additional responsibility associated with having employees -- because you don't want to face the consequences that come with misclassification.

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