INDEPENDENT CONTRACTOR VS. EMPLOYEE

By Sara Jacobi, CPA  - Director

The independent contractor vs. employee debate is not just limited to for-profit organizations. Not-for-profit or exempt organizations also find themselves in the middle of this age-old debate. Independent contractors and employees are not the same, and it is important that not-for-profit organizations understand the difference. Failure to properly classify a worker can result in the organization being responsible for the employment taxes associated with the payments to the worker, along with penalties and interest.

Generally, an organization must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay certain unemployment tax on wages paid to an employee. Taxes are not withheld on payments to independent contractors, nor is the paying organization responsible for payroll taxes on that worker. Many small not-for-profit organizations seek to classify workers as independent contractors to minimize the payroll tax withholding, payment and reporting requirements, as this route is easier for a small organization with limited resources. In addition, many workers seek out independent contractor status as it enables them to manage their taxes themselves rather than have taxes withheld out of their paychecks.

To determine whether a worker is an independent contractor or an employee, the organization must look at its relationship with the worker. Generally speaking, when the IRS looks at this issue, there are three areas of the relationship that are examined:

1. Behavioral control: Does the not-for-profit organization control or have the right to control what the worker does and how the worker does his or her job? Behavioral control looks at whether the not-for-profit organization has the right to directly control the work is performed. In determining the level of behavioral control exerted over a worker, the types of instructions given, the degree of the instruction, the evaluations systems in place and the training available to the worker are all evaluated. The more closely an organization controls the work that is done, the stronger the case for a worker to be classified as an employee.


2. Financial control: Are the business aspects of the worker's job controlled by the payer? Financial control refers to facts that show if the not-for-profit organization has the right to control the economic aspects of the worker's job. For example, does the worker make a significant investment of their own capital for tools or technology do the job? Does the worker incur unreimbursed business expenses? Does the worker have an opportunity to incur a profit or loss on the venture? How is the worker compensated? Is it a fixed fee arrangement or is the worker paid by the hour? Finally, does the worker perform the same or similar services to other organizations? The more it can be shown that the worker has the ability to control the financial portion of the relationship and stands to profit from the venture, the stronger the argument for independent contractor status.


3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Is the relationship intended to continue indefinitely and is the work performed by the worker a key aspect of the business? If it can be established that the position is intended to be permanent and the contracts and work performed indicate the same, this provides a strong argument for employee treatment.

It is often easy to define an employee, but there are very few instances where it is clear if a worker can be treated as an independent contractor. No one criteria can be used alone in the decision making process. All three areas (behavior control, financial control and the type of relationship) must be evaluated. No one single factor stands alone in the decision making process and there are no set number of factors that makes a worker an employee or independent contractor. All of the factors must be weighed.

Once a decision has been made, the not-for-profit organization should document its decision regarding the worker and the reasons the worker was classified as such. Also, the organization should take care to ensure that all agreements between the organization and the worker properly reflect the classification of the worker.