If you are a small business owner, you likely have been the mainstay of the company’s operations, handling many (if not all) aspects of marketing, sales, customer service, HR, accounting, and so forth. In the beginning, this is a great scenario, as you have the opportunity to know your business inside and out, both for good and bad. However, after a while, you may come to a place where you need to hire one or more people to assist you with your operations, whether they are for a specialized project or for general day-to-day operations.

In deciding to bring someone else on board, there are two major categories that these individuals can fall under: employees and independent contractors. The primary distinction between the two comes down to the fact that an employer has more CONTROL over employees than independent contractors. Each category has its benefits and downfalls, and all are worth weighing during the decision-making process. In order to better understand the difference between the two, let’s first take a look at the primary difference between employees and independent contractors. We will then take a look at IRS Revenue Ruling 87-41, which utilizes a number of questions to help determine what category an individual working for a company falls under.

Defining An Employee and An Independent Contractor

First and foremost, let’s get one simple reality out in the open: As an employer, when deciding whether to hire an individual as either an employee or an independent contractor, you must take great care, as misclassification of workers may lead to serious legal consequences. Having said that, let’s quickly define the difference between an employee and an independent contractor.

In a broad sense, an employee is an individual who is primarily committed to the organization that employs him/her, evidenced by the employer possessing a higher level of control over this individual. More specifically defined, an employee is hired by and works strictly for one company in exchange for wages or a salary. Furthermore, the employee performs a specific job set forth by the employer, and the employer wholly controls the job performed. Typically, workers classified as employees are subject to regular supervision and are usually lower paid and lower skilled and thus highly economically dependent upon employers, although this may vary by situation.

An independent contractor, on the other hand, usually has a much greater level of freedom compared to an employee. These individuals agree to perform work for a company, but more commonly decide on the means and methods used to achieve the desired outcome. Furthermore, independent contractors are free to offer their services to any company and are not limited to performing work for just one employer. Finally, a worker under the status of independent contractor should not be performing work that is an integral part of the employer’s line of business and should retain complete control over his work, displaying autonomy at all times.

Given these brief definitions it seems clear that, from an employer/small business owner’s perspective, having an employee is the better choice, as you the employer have more control to decide how, when and where the employee will perform. However, there is no such thing as a free lunch, and that certainly applies here. When an employer chooses to hire a worker at the independent contractor status rather than at the employee status, a significant amount of money can be saved. The employer is not required to provide workers’ compensation, unemployment, or job benefits. Additionally, the employer does not have to pay any Social Security or Medicare taxes. However, the decision of whether to hire someone as an employee or an independent contractor is usually not simply a question of control and cost savings, but is more a question of the type and nature of work the individual will provide. This is most clearly answered by utilizing the guidelines laid out by the IRS in its Revenue Ruling 87-41, as follows:

IRS Revenue Ruling 87-41: Let’s Play 20 Questions!

In order to determine the categorization of a worker, the IRS in its Revenue Ruling 87-41 has defined 20 specific questions/categories that will assist you as an employer in knowing whether or not you exercise enough control over an individual for him/her to be considered an employee. Note that not all 20 categories must be met in order for someone to be technically considered an employee, but utilizing these rules should serve as a great tool in determining the categorization of your help. So, with that, let’s take a look at the list:

1. Instruction: Is the individual worker required to comply with your rules on when, where and how to work? Whether or not you choose to implement this control is not relevant; simply possessing the power to exercise this control is enough to indicate that the worker is an employee.
2. Training: Does the individual receive training directly from you or your company regarding your requirements or your company’s rules or methodologies? Typically, an independent contractor is free to perform his work as he wishes, and does not receive any formal training from the company for which he is working.
3. Integration: Is the work of the individual directly integrated into the fundamental business operations? Is his work considered critical for the business’ successful operation? The more important the individual’s work is to the success of the business, the more control over his work is presumed to exist, and the more likely it is that he is an employee.
4. Services Rendered Personally: If an individual is required to perform his work in person, odds are that the employer is interested not only in the results but also in how the work is being completed. This indicates that a higher level of control is being asserted on the employer’s part, pointing toward an employer-employee relationship.
5. Hiring, Supervising and Paying Assistants: If an assistant for the worker is hired, supervised and paid directly by the employer (not the worker), then the worker is most likely an employee.
6. Continuing Relationship: A continuing relationship between an employer and a worker, even if the relationship is at irregular intervals, suggests that the worker is more likely to be seen by the IRS as an employee.
7. Set/Established Work Hours: If an employer establishes the hours that a worker must perform, then the worker may be an employee.
8. Full Time Requirements: An individual worker who performs for an employer on a full-time basis may be presumed to be an employee, as an independent contractor should have free time to pursue other work/interests.
9. Location of Work: Regularly performing work on the premises of the employer’s business location indicates an increased level of control and may point toward an employer-employee relationship.
10. Working in an Established Order or Sequence: Performing work in a sequence or order established by the employer again indicates a lack of control on the worker’s part, pointing to employee status.
11. Oral or Written Reports: Requiring that the worker deliver regular oral or written reports of work or progress indicates employer control.
12. Payment by Hour, Week or Month: Payment for service/work on an interval basis, rather than upon the completion of work, points toward a higher level of control.
13. Payment of Expenses: If the employer regularly and/or directly pays for business and/or traveling expenses, the worker may be an employee rather than an independent contractor.
14. Provision of Tools and/or Materials: By providing tools/materials to a worker, this individual may be seen as an employee; independent contractors typically provide their own tools/materials.
15. Providing a Significant Investment: If the worker provides a significant investment, such as in the rental of a work facility, this indicates independence as an independent contractor.
16. Profit or Loss: If a worker can incur a profit or a loss based on the work performed, he/she is likely an independent contractor; typically, employees bear no liability for the losses of a business.
17. Simultaneous Work for Multiple Firms: If the worker has the opportunity and ability to work for multiple unrelated firms, this is a sign of independence.
18. Availability of Services to the General Public: The ability for the worker to provide services to the general public again is indicative of autonomy and independence.
19. Right to Discharge: If the employer has the right to discharge the worker, this is likely an employer-employee relationship; most employer-independent contractor relationships can only be terminated if the work to be contractually performed is not executed satisfactorily.
20. Right to Terminate/”Quit”: If the worker can end his/her business relationship with no liability for contractual performance, he/she is most likely an employee.

Hopefully you now have a better understanding of the difference between employees and independent contractors, and will be able to use this information to make the wisest hiring decisions for your business. For more information on employee versus independent contractor status, feel free to click here to view the “Present Law and Background Relating to Worker Classification for Federal Tax Purposes”.

Author's Bio: 

Michael Capps is a graduate of California State University’s MBA in Entrepreneurship program, the #4 ranked MBA Entrepreneurship program in the US by Entrepreneurship Magazine & The Princeton Review. Michael has assisted numerous businesses and organizations in taking their operations to the next level through his unique approach to and outlook on business planning and strategizing. To find out more about the services he can offer you and your organization, please visit http://www.meg-enterprises.com or email him directly at mcapps@meg-enterprises.com.