The classification of a worker as either an employee or a subcontractor is a distinction with significant legal and financial implications for taxation, benefits, and liability. Misunderstanding or misrepresenting this relationship can lead to substantial penalties and unforeseen costs. A clear comprehension of the differences is a requirement for compliant business operations and sound financial planning.
Defining an Employee
An employee is an individual who performs services for a business where the business has the right to control what will be done and how it will be done. The employer dictates the tasks, methods, and processes used, which can include setting work hours, providing tools, and supervising the work. This arrangement means the worker is economically dependent on the employer.
Employees receive a Form W-2, Wage and Tax Statement, each year. This form details the income earned and the taxes withheld by the employer on their behalf, including federal income, Social Security, and Medicare taxes. The employer handles the remittance of these taxes to the government.
Defining a Subcontractor
A subcontractor, often called an independent contractor, is engaged in their own independent trade or business, offering services to the public. When a business hires a subcontractor, the payer has the right to control only the final result of the work, not the methods of accomplishing it.
As self-employed individuals, they are responsible for their own business operations, often providing their own tools, setting their own hours, and working for multiple clients. A subcontractor who earns $600 or more from a single payer receives a Form 1099-NEC. They are personally responsible for paying their own self-employment taxes, which cover both the employee and employer portions of Social Security and Medicare.
Key Factors in Determining Classification
No single rule establishes a worker’s status. Instead, the Internal Revenue Service (IRS) and courts examine the work relationship by evaluating factors grouped into three main categories to clarify the degree of control and independence.
Behavioral Control
Behavioral control focuses on whether the business has the right to direct and control how the worker performs their tasks. This includes the level of instruction provided, such as dictating when and where to work, what tools to use, or which individuals to hire for assistance. Providing detailed, mandatory training on procedures and methods is also an indicator of employee status. If a business evaluates the details of how the work is performed, it suggests an employer-employee dynamic, whereas an evaluation focused on the final product aligns with a subcontractor.
Financial Control
Financial control examines who directs the business aspects of the worker’s job. This includes the worker’s investment in the equipment and facilities used, as subcontractors have a significant investment in their own tools and bear the risk of loss. The extent to which a worker is not reimbursed for business expenses is another indicator of subcontractor status. How a worker is paid is also a factor; an employee receives a regular wage, while a subcontractor is more often paid a flat fee for a project, giving them the ability to realize a profit or incur a loss.
Relationship of the Parties
The relationship of the parties is determined by how the worker and business perceive their interaction. Written contracts describing the relationship are considered, but they are not controlling if the facts of the work arrangement suggest otherwise. The provision of employee-type benefits, such as health insurance, pension plans, or paid time off, is a strong indicator of an employee relationship. The permanency of the relationship is another consideration, as an ongoing, indefinite relationship suggests employment. If a worker provides services that are a primary aspect of the business’s operations, it is more likely they will be viewed as an employee.
Why the Distinction Matters
The distinction between an employee and a subcontractor has significant financial consequences for both parties. For a business, classifying a worker as a subcontractor results in direct savings, as the company is not required to pay its share of payroll taxes, unemployment insurance, or workers’ compensation premiums. Businesses also avoid the costs associated with providing employee benefits like health insurance and paid leave.
For the worker, being a subcontractor means taking on full responsibility for self-employment taxes. They must also fund their own benefits, including health insurance and retirement savings. Subcontractors are not eligible for unemployment benefits if the contract ends.
Consequences of Misclassification
Misclassifying a worker can expose a business to severe financial penalties. If an employer improperly classifies an employee as a subcontractor, they can be held liable for the employment taxes that should have been paid. This includes the employer’s share of payroll taxes and the income, Social Security, and Medicare taxes that should have been withheld.
Beyond back taxes, businesses can face substantial penalties from the IRS and the Department of Labor, along with interest charges on the unpaid amounts. Workers who believe they have been misclassified can file Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding,” with the IRS. This prompts the agency to review the relationship and make a formal determination.