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Independent Contractor or Employee? The IRS Checks
By Jordan B. Zimbelman
If you are like most home builders, you hire many independent contractors. Unlike employees’ wages paid, when paying independent contractors, you don’t have to withhold payroll taxes (i.e., Social Security, Medicare) or income taxes.
 Not surprisingly, the Internal Revenue Service (IRS) wants these taxes. Consequently, the IRS monitors, with a skeptical eye, the way you classify your workers.
Misclassifying an employee as an independent contractor is no joke. The IRS forces violators to pay back taxes plus penalties. Plus, these violators can be assured that a full-blown audit will be coming their way.
So, how can you be sure that the IRS doesn’t think your subcontractors are employees?
The IRS defines ― rather vaguely — an employee as someone who can be told what to do and how to do it. The line between contractor and employee is somewhat gray and, according to the IRS, “the distinction depends on the facts in each individual case.”
Those facts fall into three categories: behavioral control, financial control and the type of relationship.
An explanation of these three types of facts — and some examples of how they can be applied — can help you determine whether to classify your workers as employees or independent contractors.
- Behavioral Control ― Evaluates whether or not you have the right to direct and control the worker. Independent contractors typically:
- Are not told how, where and when to provide their services.
- Do not need training to perform their trade. They have their own methods and train their own employees.
- Financial Control — Evaluates whether or not you have the right to control the business aspects of the worker’s job. Independent contractors typically:
- Have unreimbursed business expenses. This is especially true of ongoing fixed costs that are incurred whether or not the contractor is currently working.
- Have a significant investment in the facilities and equipment they use to perform their trade.
- Make their services available to the market. They have the right to seek out other business opportunities. They advertise and maintain a visible business location.
- Are paid a flat fee for each job, while employees, on the other hand, are guaranteed an hourly or periodic wage.
- Can realize a profit or loss.
- Type of Relationship ― This helps define the worker’s dependence on the business. Independent contractors typically:
- Are not provided with employee-type benefits (e.g., health insurance, a pension plan, vacation/sick pay, etc.).
- Do not have a permanent relationship with the business. They are hired for a specific job, not indefinitely as is usually the case with an employee.
- Do not provide a key aspect of the business’ operations. If a worker’s services are a key to your business, then you will likely assert some direction and control over them.
If you classify a worker as an independent contractor, you must have a reasonable basis for doing so.
In most cases, common sense is all that’s required. For example, most plumbers are hired to do all the plumbing in a house. They are not told where to put each pipe; you just give them the plans and say, “Have at it.”
They also have a significant investment in their business (e.g., a truck, tools, general liability insurance, etc.). Plumbers typically are independent contractors.
On the other hand, receptionists are employees. No matter how their pay is structured or what benefits they receive, the business retains the right to tell them how to do their job. They typically receive insurance through the business, and if they want to use vacation time, they must ask permission first. There also is no professional license for receptionists; they receive all the training they need on the job.
Some classification cases fall in between these two extremes.
Where to Find IRS Information
If you are concerned that you don’t have a reasonable basis to classify a worker as an independent contractor, you can file Form SS-8 with the IRS (found at www.irs.gov/pub/irs-pdf/fss8.pdf).
The form asks questions regarding behavioral control, financial control and the type of relationship you have with the worker. The IRS will then issue a determination letter on the worker’s status. For more information, visit the IRS Web site at www.irs.gov.
Jordan B. Zimbelman is a graduate student in Finance at Kansas State University. He is working with NAHB’s Business Management Department as an intern throughout the summer. For more information, e-mail Zimbelman, or call him at 800-368-5242 x8498.
Additional Resources
- Motivated, productive employees can boost your bottom line. If you need a hand with the “people side” of your business, visit the Human Resource Management Tools section of NAHB’s online Business Management Tools (www.nahb.org/biztools), available to NAHB members only. Members can access a collection of resources that can help you manage your workforce and stay on top of human resource management issues that are unique to the home building industry.
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 "Managing Your Employees: Human Resources Guide for Builders," available through BuilderBooks.com, contains a model personnel policies and employee handbook that you can customize for your company; and a section on legal and regulatory authorities that affect personnel policies, and suggested systems and processes for managing your workforce. It also contains a CD of forms and checklists for managing human resources policies and programs. To order online, click here, or call 800-223-2665.
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