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Tea & Tax Talk

Contractor vs Employee: How to Determine What Your Team Members Are

So your business is growing and you need to hire… exciting, right?! Overwhelming too, right? As a new and/or growing business owner, it can be difficult to determine if a team member is truly a contractor or an employee. Furthermore, misclassifying an employee as a contractor can be costly. Let’s talk about how you can tell the difference between the two. I’ll give you a hint though…. In the words of THE Janet Jackson, it’s “CONTROL”.

What is an Independent Contractor?

An independent contractor is a self-employed person or entity contracted to perform work for—or provide services to—another entity as a non-employee. Hiring an independent contractor can be quite beneficial from a financial standpoint, but that financial benefit isn’t what determines if this person (or entity) is actually a contractor.

When someone operates as an Independent Contractor,

  • You don't pay employer payroll taxes or withhold any taxes (unless they’re subject to backup withholding). They are responsible for calculating their income, expenses and paying their own payroll and income taxes.

  • You don't have to offer them the same benefits that you offer your employees (although you could if you chose to).

  • You're not subject to most federal and state labor laws requiring minimum wage or overtime.

  • They generally carry their own liability insurance policy, and if they have employees, they may also have workers compensation insurance.

  • They typically use their own equipment, work on their own schedule and establish their own rates… they maintain majority control of how they work, when they’ll work and/or their pay rate.

What is an Employee?

Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it’ll be done. Employees get paid a regular wage, receive employee benefits (if offered and if they are eligible), have taxes withheld from their wages, are covered by the employer’s workers compensation insurance if the state requires them to have it, and they have their work and schedule dictated by the employer.

Before you make any new hires or change the work status of any current employees, it’s important to know that employees are protected by many labor laws in New Jersey, including the Unemployment Compensation Law. Independent contractors do not receive such protection. That is why it's so important to make sure workers are properly classified.

How Do You Know What to Classify Your Workers As?

There’s a few different ways to determine if your current/future team members are independent contractors or employees. You are required to comply with both Federal (IRS) and state rules since your state may have more specific rules than the IRS. I’ll share the Federal (IRS) and NJ tests below.

The IRS uses 3 categories to determine how to properly classify a worker.

The first category is examining your Behavioral Control (are you seeing a theme here?!)

  • If you train the worker, direct their tasks with detailed instructions, set specific hours, and dictate how the work should be completed, the IRS is more likely to classify them as an employee.

  • On the other hand, if the worker sets their own hours and decides how and when to get the job done, that could mean they’re an independent contractor.

EXAMPLE: Consider how you work with your accountant. You don’t tell your accountant how to prepare your tax return, the time and day you want it prepared or the rate you’re willing to pay. Instead your accountant prepares your tax return using their equipment, according to their schedule and gives you the fee for preparation. Your accountant is a contractor.

The second category is Financial Control (can the business control the financial and business aspects of the worker’s job?)

  • Independent contractors are more likely to incur unreimbursed expenses than employees.

  • Opportunity for profit or loss often indicates an independent contractor relationship.

  • Independent contractors are generally free to seek out (and often have) other business opportunities to work with other clients.

  • If the worker is paid a salary or guaranteed a regular company wage, they’re probably classified as an employee.

  • If the worker is paid a flat fee per job or project, they’re more likely to be classified as an independent contractor.

  • Independent contractors usually also have what the IRS calls a “significant investment” in their business—whether it be equipment, training and licensing—and aren’t reimbursed for expenses like fuel, tools, and office supplies.

EXAMPLE: Consider how you work with your accountant. Your accountant should have training and licensing expenses, you shouldn’t be reimbursing them for purchasing a laptop or for business use of their vehicle and they probably aren’t charging you by the hour. They likely have many other clients too. Your accountant is a contractor.

Lastly, the type of Relationship you have with your team members can determine their employment status.

  • Written contracts help to define the relationship, but it’s important to note that they are not sufficient enough to determine the worker’s status.

  • If a worker provides you with services directly related to your business’ core work, that makes it more likely that the IRS will see them as an employee. Independent contractors generally provide services or expertise that are outside of your business’ core work (think about your relationship with your accountant, attorney, or your web designer).

  • If you grant someone benefits (like sick days and health insurance) that also makes it more likely for them to be an employee.

  • Independent contractors are usually brought on for the short term, to carry out a set amount of work. If you bring someone on board for the long term and expect them to work for you indefinitely, they’re probably an employee.

EXAMPLE: Consider how you work with your accountant. Unless you also own an accounting firm, your accountant is performing work that is outside of your business’ core services, isn’t receiving benefits like health insurance or sick days from you, and work on a specific task for your. Your accountant is a contractor.

NJ uses similar categories to determine how to properly classify a worker.

In New Jersey, we use The ABC Test to determine if a worker is an employee. Using this test, NJ evaluates if the worker is:

  • Free from control or direction over the work performed,

  • Performing work that’s outside the core work performed by the business or outside all the places where the business operates

  • Customarily engaged in an independently established profession or business

To determine this, NJ asks questions like:

  • What type of work the company does versus the type of work you do?

  • Do you work alone or have helpers/employees?

  • Can you send a replacement to the company or must you be the one to perform all services?

  • Do you work with other clients?

  • Do you use specialized equipment and if so, who supplies it?

  • Are you required to work fixed hours?

  • Do you have business cards, printed invoices, insurance, and/or filed tax returns?

What If I Misclassify an Employee as a Contractor?

Remember when I said that misclassifying an employee could be costly? Here’s what I meant: If you misclassify an employee with no reasonable basis for doing so, you as the employer become liable for the employment taxes and this often happens at the federal and state level.There can also be penalties involved.

Still not sure which is best for your business? Consult with #ASEGroup today and discuss the best business and financial options for you!


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