Distinguishing between independent contractors and employees.

• Author: Bier, Rivka

Before a business entity pays for services rendered, it should consider this: Is it paying a contractor or has it hired an employee? This question arises every time a business pays a person for services rendered. At times the answer is dear, but often the minute details will present a challenge to the small business owner when classifying the service provider.

When expanding its workforce, a business will either hire an employee or retain an independent contractor. To categorize the "new addition" consider the relationship between the business (payer) and the individual (payee):Who holds the "right to control"?

The worker's classification is determined by analyzing three factors:

1. Behavioral control is ascertained by determining which party retains the rights to control where, when, and how a job should be done.

2. Financial control considers the business aspects of the relationship, including which party bears the financial risk, how the payment is structured, and whether or not the worker can realize gain or loss.

3. The type of relationship between the parties is defined by written agreements, contracts, benefit structure, expected time line and recurrence of such agreements, and the relationship of the services rendered to the nature of the business.

The IRS developed a 20-point guide that describes the ideal circumstances under which a worker is an independent contractor (see Rev. Rul. 87-41).The Service also provides a safe harbor to exempt a worker or business from the "20 questions" To qualify for the safe harbor, the business (1) must have consistently treated others on the workforce (of similar type) as independent contractors, (2) must have filed all necessary forms, and (3) must have reasonable basis in historical rulings, case law, or common practice in the specific industry (Rev. Proc. 85-18).

It is important that each worker is classified correctly so that the business complies with its income and employment tax obligations. The business must withhold employees' income, Social Security, and Medicare taxes (Secs. 3402(a) and 3102(a)). The business usually does not have these obligations to independent contractors.

The following example illustrates some of the issues surrounding the determination of independent contractor sums.

Example: C is a certification company that attests whether companies comply with required industry guidelines. C employs approximately 100 administrative and permanent employees and contracts hundreds...