Businesses do not decide whether a person is an independent contractor or an employee.
Whether a person is an employee or an independent contractor is a legal question—based upon how a person interacts with your company, performs work, gets paid, and other factors. And unfortunately, there is no clear-cut test on what determinates whether a person is an employee or independent contractor. Instead, courts, tax boards, and other agencies balance the totality of the circumstances of the work relationship.
Ideally, before you structure how a person will work with your company, you’ll consult legal counsel to understand this legal distinction. But even if you’re to the point where you’re hiring someone, it’s not too late to:
- discuss whether you can structure the work according to whether you want to hire an employee or independent contractor, or
- avoid making a very costly mistake by mislabeling personnel as an “independent contractor” when she or he is an “employee.”
Not too concerned? Look at companies like FedEx, UPS, and others, who ended up owing tens or hundreds of millions in back taxes, fines, and interest payments for treating personnel as independent contracts when the law viewed them as employees.
Even small businesses may face tens or hundreds of thousands for making this mistake. And the longer your business makes the mistake, the more the back taxes build once an audit or a disgruntled employee uncovers the mistake.
What Makes Someone an Employee or Independent Contractor?
The general distinction between an employee and an independent contractor is as follows:
Independent Contractor: A person who is involved in a specialized trade or profession, who is providing discrete services. By “discrete services,” we’re looking at specific tasks the person completes—as opposed to being paid a salary for daily work and “whatever needs doing.” A business does not tell an independent contractor how to complete the task (think of an electrician being hired to wire a building—that electrician has specialized knowledge she or he will use to complete the job, and has a discrete scope of work, that is, wiring this building).
Employee: A person who works for the company, at the company’s direction. A company exerts significant control over how the employee gets the job done.
But again, there is no bright-line rule. The above are rough generalizations (which may or may not be determinative of labels for the specific relationships you have with your personnel).
Down to Details
Courts will consider various laws and precedence in determining how personnel should be clarified. Most commonly, this distinction comes up for the purpose of taxes. With that, a good place to start is C.R.S. 8-70-115, which is Colorado’s classification for federal unemployment tax.
Under this statute, a person is likely an employee if any of the following are true:
- The person is required to work exclusively for the company.
- The company instructs the person on how to perform the work.
- The company pays a salary or hourly rate. Independent contractors more often are paid by completion of the task or milestones relating to it.
- The company terminates the work during the contract. Normally this occurs because the contract is not set up as discrete tasks, but as a contract for general work with no specific end in mind.
- The company provides training and/or the tools for the job.
- The company determines what time the work must be completed. The company can set deadlines for a contract; however, setting hours (e.g. person must work from 9am-5pm, M-F) implies employment.
- The company pays the person directly, rather than paying the business.
- The company combines the work provided by the person with its own work or products.
Why Would You Want an Employee over an Independent Contractor or Vice Versa?
There are great reasons to use independent contractors:
- It allows businesses to secure skilled labor and avoid reoccurring obligations; maintaining budgeting flexibility.
- Companies do not have to pay various taxes, including unemployment taxes, for independent contractors.
- It can shift some liability to independent contractors.
But there are also advantages to having employees:
- You have more control over how they complete their work.
- There are various tax benefits and write-offs for employees (consult with your accountant).
- If what you have your personnel do does not fall into independent contractor work, mislabeling them can lead to significant back taxes and fines. You put your business at risk by trying to label an “employee” as an “independent contract.”
If you’re looking to organize your business with the intent to use employees or independent contractors, there are ways you can structure how you use labor to foster one type of relationship over the other. Legal counsel can assist with that.
However, if you’re engaging with personnel as if, legally, they are employees, then they are employees. Pretending otherwise will only risk substantial fines and legal complications in the future of your business.