Defining an Employee vs. an Independent Contractor
Your tax and reporting obligations vary significantly depending on whether a given individual you work with is an employee or an independent contractor. We will focus on the definitions of each for federal tax purposes. Generally, independent contractors bring less tax and reporting responsibilities, but you have less control over the work they perform.
Types of Workers
The Internal Revenue Service (IRS) classifies workers as being:
A local, state, or federal agency employs government workers. Statutory employees are individuals who may fit into the definition of independent contractors but whom the government still requires businesses to treat as employees. Certain delivery drivers, insurance sales agents, individuals who perform work on goods you directly provide, and traveling salespeople fall into the statutory employee category.
The IRS Independent Contractor Test
The federal government uses the IRS independent contractor test to determine a worker’s status as an employee or contractor. The test offers three factors to help decide whether someone is an employee or an independent contractor, based on all relevant circumstances.
These factors include:
Behavioral control—the degree to which the business has the right to control how the individual performs the work
Financial control—the degree to which the business has the right to control the economic aspects of the work
Type of relationship—the nature of the relationship, particularly with respect to the existence of written contracts, benefits, long-term expectations of the relationship, and how essential the services provided are to the business
These factors help demonstrate the worker’s relative degree of control and independence. Generally, the IRS considers function over form—it evaluates how the relationship actually works, not how you say it works. If you’re interested in a home business, read about these 7 home business ideas that double as tax write-offs.
Behavioral control
The government evaluates how much behavioral control a business has over a worker based on the following:
Type of instructions—the amount of direction given concerning when, where, and how to perform the work
Degree of instruction—how detailed any instructions are about how to perform the work
Evaluation systems—whether the business uses an evaluation system to measure how workers perform their assignments
Training provided—whether the business provides training and how extensive that training is
In general, the more instruction, training, and evaluation the business provides, the more likely the worker is to be an employee rather than an independent contractor.
Financial control
How much financial control a business has typically depends on:
Significant investments by the worker—whether the worker has invested their own money in equipment or tools they use to perform the work
Reimbursement of expenses—whether the business reimburses expenses
Opportunity to profit or lose—whether the worker may earn a profit or lose money from the work independently from the business’s profits or losses
Availability of services—whether the worker offers services to others
Payment method—whether you pay the worker a flat or an hourly rate
In general, the more separate financial control the worker has, the more likely they are an independent contractor.
Type of relationship
The specifics of the working relationship affect whether the worker is an independent contractor as follows:
A written contract declaring the worker is an independent contractor will not prevail over evidence that the relationship works like an employer–employee relationship.
Businesses typically do not provide benefits like insurance, retirement, sick leave, or vacation days to independent contractors.
Businesses typically hire independent contractors for specific projects or periods rather than indefinitely.
Independent contractors typically do not perform key business functions.
No one factor controls the determination.
