I have often encountered the small and growing business owner who needs help but doesn’t want to manage employees.  Quite often, the business owner decides to pay workers as contractors and not worry about all the problems inherent in managing payroll.  This can be a disastrous move.

I will be the first to admit payroll is a minefield.  Federal and state regulations are confusing and the fines for getting it wrong can be severe.  It is so complicated that there is an entire industry focused on this part of the accounting. 

Of course, hiring a contractor is much simpler.  Once an agreement on terms is reached, the contractor does the work and the company pays them.  At the end of the year, the company sends out the required 1099’s, takes the tax deduction and gets ready for the new year, right?  Maybe yes, maybe no.

Because of abuse, whether intentional or not, the IRS has looked at this issue very closely over the years.  Many small business owners have found themselves in trouble because the IRS disagrees with their characterization of the relationship between company and “contractor”.  This has cost business owners to have to pay taxes and penalties that really hurt the bottom line, and there is no real defense.

IRS Guidance

The good news is that there is specific guidance on the subject.  On the IRS website, the IRS goes into a long discussion of the issue including consequences.  So how does one determine if a helper is an employee or a contractor?  I’m glad you asked.

There are three key categories that are important to the decision. None of these stands alone.  It can go either way depending on the big picture.  Let’s look at each in turn.

Behavioral control refers to who directs and controls the workflow.  These include the type of instructions, such as when and where, how detailed are the instructions.  Is the worker evaluated by a formal system? Finally, does the company train the worker on how to do the tasks at hand?

Financial control refers to who controls the financial aspects of the job.  Who pays for the equipment the worker uses?  If the worker pays direct expenses, is there any reimbursement? Can the worker work for this company and other companies at the same time?  What is the payment plan?  Does the company pay by the hour or a flat fee? True contractors may bill by the hour or the job and be paid that way, and it is their choice, not the company’s choice.

Finally, relationship refers to how both parties see each other.  If it is in writing, a lot of the ambiguity is gone. Are their workers given company benefits? A very important consideration is whether this relationship seen as permanent by both parties involved or is it a project agreement, like a busted water pipe.

How does this Work in the Real World

The key to deciding whether the worker is an employee (part or full-time) or a contractor is control and the big picture.  Let’s look at an example and see where it could cross the line between contractor and employee.

I have an assistant, Joan (not her real name), who comes in when I need some help with administrative work or a special project.  The work is generally done in my office.  We have come to an agreement on what I will pay, and I tell her how I want things done and check her work.  I also buy all supplies and provide a computer when needed.

She is a contractor.  First, when I call her, I ask if she is available.  She sometimes says yes and sometimes says no but offers another day.   She brings a certain skill set to the job and my instruction largely amounts to personal preferences.  As for financial control, she may have other clients for whom she performs services and is paid by them.  She is not paid on a regular basis, but generally after accumulating several hours.  There is no written contract and no benefits.  Neither of us see this as a permanent relationship. She will stay with me until something better comes along.

Switch to Employee

I would only have to make minor changes to our arrangement to make her an employee.  If I told her that she had to be here at a set time on set days, I have taken control of her time.  If I were to tell her, that this is now a long-term arrangement and I expect her to only work for me during the hours I am open, I have taken her services off the market.  This is all that would be needed to change her to an employee, and I would immediately have to set up a payroll situation.

As you can see, hiring help, while often beneficial and necessary, it must be done carefully with the full cost considered.  Talk to a professional tax or small business accountant before making this very important decision.  Don’t lose money to penalties because of an ill-conceived strategy.  Do it right and keep growing!