Employee vs. Independent Contractor: What’s the Difference and Why’s it Important?

If you are reading this article, then you likely own or administer a health care practice. It may include workers of many stripes:  some may be treated as employees and others as independent contractors. But do you know why they are treated that way? If the IRS or the Alabama Department of Revenue audits your practice, you will need to know.

Many companies use independent contractors whenever possible. Why? Employees are much more expensive than independent contractors. Employees cast many burdens on their employers: health care benefits, minimum wage limitations, fringe benefit costs. None of these issues arise with independent contractors. In addition to administrative burdens, employees also cost their employers more in employment tax than independent contractors. All employers must generally pay employment taxes (Social Security and Medicare) of 7.65% of each employee’s salary/wages. There is no similar requirement related to independent contractors; they are responsible for their own employment taxes. Based on a salary of $43,000, an average employee costs its employer approximately $3,700 more than an independent contractor in tax-related costs alone. Thus, all other things being equal, businesses that treat their workers as independent contractors have a competitive advantage over those treating similar workers as employees.

But what makes one worker an employee and another an independent contractor? In a word: control. If a company has control over how a worker performs his or her job, then that worker is most likely an employee. The substance of the worker/employer relationship therefore determines the worker’s classification, no matter how the employer and the worker decide to define the relationship. That is, you cannot simply label your worker an independent contractor and expect the IRS or other government agency to take your word for it.

Since 1987, the IRS has used a “20 Factor Test” to analyze worker classification matters. Each factor indicates control or a lack of control, and, in turn, either employee or independent contractor status. For example, if you require your workers to attend formal training, then your control indicates employee status. Control is also evident if a worker must work set hours, gets paid by the hour, or can be terminated at any time. On the other hand, if a worker gets paid on a per-task basis, does the same type of work for other companies, and provides his/her own tools and equipment, then there may be insufficient control to trigger employee status.

Improperly classifying a worker as an independent contractor, when in fact the individual is an employee, can create significant withholding and tax exposure. That exposure could include liability for failing to withhold the employee’s unpaid income (around 28% of the employee’s salary) and employment taxes (7.65% of salary), in addition to the employer’s employment tax share (7.65% of salary) mentioned above. A range of penalties – from failure-to-file (25% of the tax due), failure-to-deposit (15%), accuracy (20%), to even fraud (75%) – as well as accrued interest may drastically increase the exposure.

Practices can prepare for government scrutiny by reviewing their compliance procedures and contracts with independent contractors. You may be able to avoid costly penalties by disclosing past missteps to the IRS before an audit, or the practice can clarify its relationship with the individual based on IRS guidance to better document the individual’s independent contractor status.

Article contributed by Allen Sullivan, partner with Burr & Forman LLP practicing in the firm’s Corporate and Tax Group. Burr & Forman LLP is an official partner with the Medical Association.