The federal government's interpritation of an employee versus a contractor is becoming more stringent. This article by Peter McDonald, CPA of Smith Elliott Kearns & Co., LLC explains several key questions which will help you understand the difference.

1. Employee vs. Independent Contractor
By Peter O. McDonald, CPA
A critical part of business operations is determining whether an individual who is providing services to your
business should be treated as an employee or an independent contractor. In general you must withhold and
pay Social Security and Medicare taxes, withhold income taxes and pay unemployment taxes on wages paid to
employees. Usually you aren’t required to withhold or pay any taxes on payments to independent contractors.
When determining whether your business relationship with an individual should be treated as an employee or
an independent contractor, information regarding the degree of control and independence must be considered.
The facts for each business relationship fall into three categories: Behavioral Control, Financial Control and
Type of Relationship.
Behavioral Control
Behavioral control is used to determine if the business had retained the right to direct or control how the
individual does the work and is further broken down into the following factors:
Types of Instruction Given
When and where to work
What tools or equipment to use
What workers to hire or assist with the work
Where to purchase supplies and services
What work must be performed by a specified individual
What order or sequence to follow when performing the work
Degree of Instruction
The more detailed the instructions, the more control the business retains
Evaluation System
Evaluation systems that measure details of how the work is performed point towards an employee
Training
Training provided on how to do the job and periodic and on-going training about procedures and methods provide
strong evidence of an employee relationship.
Financial Control
Financial control refers to the facts and circumstances whether a business has the right to control economic

2. aspects of the individual’s job. The factors of financial control fall into the following categories:
Significant investment
Varies by industry
Unreimbursed expenses
Independent contractors more likely to have unreimbursed expenses
Opportunity of profit or loss
The possibility of incurring a loss indicates independent contractor
Services available to the market
Independent contractor is usually free to seek other business opportunities, maintains a place of business,
and advertises
Method of payment
Employee is usually guaranteed a regular wage, independent contractor usually paid a flat fee per job
Type of Relationship
Type of relationship denotes how the individual and business perceive their relationship with each other. Some
of the factors to consider are the following:
Written contracts
- A contract is not sufficient to determine individuals’ status
- The IRS does not always follow a contract stating the individual is an employee or independent contractor.
Employee benefits
A business generally does not provide benefits to independent contractors
Permanency of the relationship
Is the relationship for an indefinite period of time or for a specified project or period
Services provided as key activity of the business
Individuals who provide services that are a key aspect of the business are more likely to have their activities
directed and controlled by the business which points toward an employee relationship
All of the above factors must be considered when determining whether an individual is an employee or
independent contractor. Facts and circumstances will vary with each situation. The key is to look at the entire
relationship, consider the degree and extent of control and to document each of the above factors used in
coming up with your determination.

3. If you are still unsure how to classify your business relationship with an individual, you can file Form SS-8 with
the IRS. The IRS will review the facts and circumstances of the business relationship and provide you with an
official determination.
Employees classified as independent contractors with no reasonable basis may cause the business to be liable
for employment taxes for the worker.
Employers who believe they have misclassified workers may want to take advantage of a new optional program
from the IRS called the Voluntary Classification Settlement Program. This program provides the opportunity to
reclassify workers as employees for future tax periods for partial relief from employment taxes. Certain
requirements must be met in order to participate in the IRS program.
Peter McDonald joined SEK&Co in 2000 and is a Manager in the Accounting Services
Department of the Hagerstown, MD office. Previously, he gained accounting experience
working as a Staff Accountant at Wilkinson and Company Chartered Accountants, Trenton,
Ontario. Peter works with the firm’s small business and individual clients providing
accounting, consulting and tax services. He also serves on the firm’s Accounting Services
Committee.
Smith Elliott Kearns & Company, LLC is a full-service certified public accounting
and consulting firm with offices in Hagerstown, Maryland; Hanover, Carlisle, and Chambersburg,
Pennsylvania. The firm was founded in 1963 and was recently named a Top 200 Firm by Inside
Public Accounting and a Pennsylvania Best Places to Work for 2010. With 22 partners and a total
staff of 150, SEK&Co services individuals as well as business clients in a variety of industries
including construction, financial institutions, healthcare, local government, manufacturing, and
nonprofit. The Firm offers financial statement preparation, auditing and assurance services, small
business accounting, tax and payroll services, QuickBooks® and Sage 50® training and consulting,
tax return preparation and planning, estate planning and administration, business valuations, and
employee benefit plan design, administration and auditing.