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Employee Or Independent Contractor?

A friend recently picked up and moved her life across the country to take a job with a start-up company. Though the move was risky, the opportunity was too amazing to pass up.

Initially she was hired as a full-time employee, but eight months later, the company changed her role to that of an independent contractor. For me, this raised two questions: Is it better for a worker to take a position as an independent contractor or a regular employee? And why might an employer choose one over the other?

Over the past 40 years, Congress has passed several laws that outline the distinctions between employees and independent contractors with regards to their compensation, benefits and relationships to their employers. Section 530 of the Revenue Act of 1978 laid the initial groundwork for the regulations we follow today.

In the 1960s and early 1970s, there was a growing concern for the future of the Social Security program. Some blamed the funding issue on independent contractors skimping on self-employment tax. This perception led to an increase in audits by the Internal Revenue Service. This, in turn, led to criticism that the IRS was too aggressive in classifying workers as employees, rather than as self-employed independent contractors, and that it applied its criteria inconsistently. Congress responded by enacting Section 530, providing safe harbor for employers by preventing the IRS from retroactively reclassifying independent contractors as employees. Section 530 protected employers from large penalties and back taxes as long as they met the law’s standards.

In order for employers to qualify for safe harbor under Section 530, the IRS required: a reasonable basis for treating the workers as independent contractors; consistency in the way such workers were treated; and proper tax reporting using 1099 forms for those categorized as contractors. Though Section 530 was initially intended to be an interim measure for the audit issue of the ‘60s and ‘70s, it became the enduring baseline for today’s worker classification regulations. Subsequent legislation, such as the Small Business Job Protection Act of 1996, further clarified the language in Section 530, as well as the rules of safe harbor availability and the question of who holds the burden of proof for classifications.

Many employers use the following rule of thumb to distinguish between a contractor and an employee: If an employer has the right to control both the means by which the worker performs his or her services and the ends that work produces, the worker is considered an employee. In 1987, the IRS released a 20-factor list, based on prior cases and rulings, to help employers resolve some of the “gray areas” that this rule does not resolve. Some of the factors included on the list were: training; set hours of work; payment by the hour, week or month; furnishing tools or materials; doing work on the employer’s premises; and payment of business expenses.

For example, if the employer requires the worker to go through a training class before commencing work, or to use particular tools or materials the employer provides, the worker would qualify as an employee. Similarly, if the employer requests the worker be on site at the company headquarters from 8 a.m. to 5 p.m. each day, the worker is an employee, not an independent contractor.

The overarching theme of all these factors is that an employer has the right to control how an employee produces his or her work. When hiring an independent contractor, the employer gives up this control. Independent contractors have a strong focus on the final result, not the process to complete the project. Overall, the IRS’ 20-factor list helped many employers create a baseline to evaluate the role of their hires and avoid misclassification.

In 1996, the IRS took the list a step further by identifying three broad categories of evidence to be used in discriminating between an employee and an independent contractor. The three categories are behavioral control, financial control and relationship of the parties. In general, employers can only minimally regulate contractors’ behavior. Contractors have the freedom to subcontract the work they receive, complete the work in the way they feel is most efficient, and set their own hours and work location.

Financial control means that contractors’ payment standard is based on a “per task” or “piece work” pay. Therefore, the amount of time and energy contractors expend on the work they produce is up to the contractors, not their employers. In contrast, employees are typically paid an hourly wage or a salary, which their employers monitor and control, along with the number of hours worked. Employees also may receive additional benefits, such as health coverage or retirement plans, which independent contractors do not receive.

The third category, relationship of the parties, refers to the increasing practice of employers requiring employees to sign non-compete clauses or non-disclosure agreements. Generally, independent contractors are not required to sign such legal contracts. Contractors can work with multiple employers if they so choose - even competing employers. An employer does not have the right to control the relationships an independent contractor may develop outside of their work for that particular employer.

The legal distinction between employees and contractors is clear. Why, then, would a worker or an employer prefer one situation over the other? There is no right or wrong answer when it comes to a contractor or employee role, merely preferences for each situation.

An independent contractor enjoys more flexibility than a full-time employee. The contractor can essentially be his own boss, by developing his own schedule, working without close supervision, and taking on as heavy or light a workload as he sees fit. This provides open-ended earnings potential. Working for multiple employers also gives contractors more job security in one sense, because one employer going broke or cutting back on staff will not destroy the contractor’s whole stream of income. For an employee, on the other hand, it may be more appealing to have a predictable schedule, the possibility for advancement, and a more stable income flow.

From an employer’s perspective, an independent contractor may be a good fit if the employer does not have the resources or manpower to pay, monitor or use an employee full time. The employer may simply need someone to complete projects on an occasional basis. In contrast, if an employer prefers to maintain close supervision and needs a worker who is available on a regular and predictable basis, and if the employer has the means to pay the worker a stable salary or hourly wage, then hiring the worker as an employee would be a more logical decision.

Employers and workers must also weigh factors such as taxes, health care and retirement benefits into their decisions. When hiring an independent contractor, the employer does not pay the worker’s taxes; rather, independent contractors are responsible for paying the tax themselves through the self-employment tax on Schedule SE, which covers their Medicare and Social Security tax. An employer withholds the equivalent tax from an employee’s paycheck. Contractors can deduct the employer-equivalent portion of the self-employment tax when calculating their adjusted gross income. However, this deduction only affects income tax, not self-employment tax. All self-employment income is then reported on Schedule C.

Generally, employers are responsible for providing a 1099 form to contractors for their income reporting on Schedule C, in particular for income amounts over $600. However, the burden falls on the contractor to keep accurate records, regardless of whether they received the tax forms or proper documentation. Independent contractors must also be conscious of making estimated tax payments throughout the year, which can be a challenge when income is not as steady as an employee’s would be. And when they purchase equipment or materials, or use a home office for work, independent contractors must track their expenses so that they can be deducted properly.

Independent contractors deduct their business expenses directly against their business receipts, reporting the information on Schedule C of Form 1040. Employees sometimes incur unreimbursed business expenses too, such as for tools or union dues. Employees get less favorable treatment, handling such expenses as miscellaneous itemized deductions on Schedule A. Most such expenses are deductible only if they exceed 2 percent of the employee’s adjusted gross income. Overall, independent contractors face a more complex tax situation, even if it is sometimes more favorable.

The recent passage of the Affordable Care Act raised concern and uncertainty regarding which insurance and care programs will be available to independent contractors or to those seeking individual coverage. We may see a change, too, in what options employers will provide for their employees in the future, particularly within company-sponsored group plans. The complication and uncertainty of the new health care landscape will take some time to play out, for independent contractors and employees alike.

Additionally, workers should consider the impact of operating as an independent contractor or as an employee on their retirement planning. Many employers provide access to 401(k) plans or profit sharing plans, which assist employees in saving for their retirement (on top of individual saving they may pursue via IRA or Roth IRA accounts). Independent contractors will need to save for their retirement entirely on their own. Though certainly manageable, this arrangement places greater responsibility on independent contractors to ensure not only that they save enough, but also that they follow regulations to ensure they are contributing properly. Otherwise, they may end up paying penalties for overcontributing or contributing to the wrong type of account, depending on their income levels.

Considering the pros and cons of each type of work, I return to my original question. Was it better for my friend to end up as an independent contractor instead of an employee? Maybe. The change offered her flexible work hours, less supervision and the opportunity to contract with other companies, with the resulting potential for additional income. In exchange, she lost a stable salary, as well as her health and retirement benefits. The only person who can say if the trade was worthwhile is my friend. As for why the start-up company preferred her as a contractor, I can only speculate. My instincts say the primary factor was probably cost. By cutting health and retirement benefits and paying her piecemeal, they will likely save money, allowing them to put more funds back into the young firm.

Provided she is happy with her switch in position, I would say the end result is a win for both parties. When workers and employers have compatible goals, everyone can benefit, whether that worker is an independent contractor or an employee.

Senior Client Service Manager Melinda Kibler, who is based in our Fort Lauderdale, Florida headquarters, is among the authors of our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. Her work includes Chapter 5, “Estate Planning”; Chapter 10, “Financing Long-Term Care”; and Chapter 17, “Retiring Abroad.” She also contributed to the firm’s book The High Achiever’s Guide To Wealth.