Employee vs Contractor…and Why You’d Better Know the Difference

“What is the difference between an employee and a contractor?”

Over the years, the question of employee vs contractor has left many business owners scratching their heads and hoping that they aren’t inadvertently setting themselves up for legal trouble.

Changes in technology, the ability to work remotely, and the growth of the gig economy have all contributed to a shift in recent years from workers serving as full-time, on-staff employees to more independent contractors. In many cases, companies have also chosen to classify their employees as contractors in order to save on taxes and benefits.

While IRS’s fact sheet “Understanding Employee vs. Contractor Designation” is helpful, it’s an area that has always had the potential to get a little complicated.

In January of 2021, the U.S. Department of Labor released the final version of a document that hopes to provide some clarity to the situation. It was scheduled to go into effect on March 8th.

Economic Reality Test

The new rule includes a confirmation of the long-standing “economic reality” test used as a rule-of-thumb in determining if someone is an employee or a contractor. (It basically depends on whether they are in business for themselves or economically dependent on a single employer.)

New Core Factors

It further establishes two “core factors” that clarify who is self-employed and who is in business for someone else:

  • The nature and degree of control over the work.

    An independent contractor can set their own schedule, select his/her own projects, and work for others (including the potential employer’s competitors).

    An employee’s schedule, workload, and exclusive non-compete status are all determined by the employer.

  • The worker’s opportunity for profit or loss based on initiative and/or investment.

    A person is considered an independent contractor to the extent they are able to earn or lose money based on their own efforts, business knowledge, and management of their own helpers, equipment, and materials.

    A person is considered an employee to the extent they are only able to affect their earnings by working longer hours.

Additional Factors in Determining the Difference Between Employee vs Contractor

The new rule also includes three additional factors to help resolve any potential confusion.

  • The amount of skill required for the work.

    A person may be considered an independent contractor if the work requires specific skills that the employer does not provide.

    An employee, on the other hand, will be engaged in work in which the employer provides the necessary training or does not require any specific skill.

  • The degree of permanence of the working relationship between the individual and the potential employer.

    An independent contractor will likely work sporadically or for a limited period of time. (However, working “seasonally” by itself is not enough to classify someone as an independent contractor.)

    An employee is understood to be in a particular role continuously and indefinitely. (Unless, of course, they are terminated or resign.)

  • Whether the work is part of an integrated unit of production.

    Basically, someone is an employee if their work is essential to the overall mission of the organization to provide particular goods or services.

    A person is considered an independent contractor if the work they do can be segregated from the employer’s production process.

Your Responsibility

As a business owner, it is in your best interest to make sure you are properly classifying the individuals who work for you. There are significant legal and tax ramifications for confusing employees with independent contractors (and vice versa).

Mountains of complicated laws and regulations like this one can make HR services and payroll some of your most time-consuming nightmares. If you think you might need to re-examine the classification of some of your workers, give us a call.

Our team at CRS CPA makes it our business to stay on top of changes in the law so that your business can continue to thrive.

Schedule a call today to discover what partnering with us can do.

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