The Difference Between an Employee and an Independent Contractor

Congratulations! Your organization has identified a new CFO to help bring your accounting department into line at a very reasonable price. Although you had budgeted for a full-time employee, the prospective CFO has told you that she would like to be hired as an independent contractor. At first thought, this sounds wonderful. Hiring an independent contractor means the organization won’t be responsible for that person’s payroll tax liabilities. Think of the money that would save!

After the deal is struck, you excitedly head into the next board meeting to let members know that there is extra money in the budget to further the mission. Instead of the expected praise you thought the board would provide however, you are confronted with a restless quiet and palpable concern.

Steve, the board president, is the first to speak. “I thought we needed an actual employee, so that you could manage the person’s hours and control how she’s doing things around the office. Plus, we just bought a brand-new take-home laptop for that position.”

Confused, you respond. “Well, the CFO is going to be doing the same thing that an employee would be doing. Plus, I’ll be controlling their work schedule and duties as I had planned before… and she can still use the computer…”

For a moment, you hear the whispers of protest among members as they react to what you have just said. Then like a rising chorus, the questions and comments start flooding in from around the table.

“You know that both the state and federal government have very specific and strict rules about what defines an employee vs. contractor, and a mistake on that classification can result in large fines, interest, and penalties…,” Steve said.

Susan, the treasurer, chimed right in. “Steve is right. At a bare minimum, you need to consider the business relationship with this person and what kind of control and independence they will have.  Generally, there are three ‘tests’ to determine if the relationship will be employer-employee or organization-contractor.”

“The first test is behavioral,” she continued. “Will our organization control, or have the right to control, what the new CFO will do and how she does it?”

“Yes, I was planning on that,” you say sheepishly.

“Well that wouldn’t pass the first test… if you have control over what a worker does and how they do it, regulatory agencies will see that as an employer-employee relationship, and we could get into big trouble for not classifying her that way,” Susan said.

“Well we certainly don’t want that,” you say sincerely.

“The second test is financial. For example, will the business aspects of the CFO’s job, things like how we will pay her and whether we provide her with needed tools and supplies, be controlled by our organization?

“You mean like letting her use the organization’s take-home laptop?”

“Exactly,” Susan said. “The third test is to consider the type of relationship our organization will have with her. Is your intention to provide the CFO employee-type benefits, things like access to our pension plan, vacation time, or insurance? Also, is the relationship intended to continue into the foreseeable future, and is she going to be performing a key aspect of the business?”

“Well, the CFO position is pretty key to our executive leadership. And yes, we were going to provide insurance,” you say, now understanding why the board is so concerned.

You leave the board meeting feeling deflated, but also thankful this was caught before the CFO’s start date. Your plan is to discuss the job responsibilities and expectations with her in more detail. If she still insists on being classified as a contractor, then unfortunately you will need to let her know that this is not the best fit for the organization.

Discussion

The decision to hire an employee vs. an independent contractor at your organization needs to be considered carefully. It is true that hiring a true independent contractor relieves you of the requirement to pay Social Security, Medicare, and unemployment taxes, and that might make the idea of hiring a contractor more attractive. However, regulatory agencies such as the Internal Revenue Service, Washington State Labor & Industries, and the United States Department of Labor all have specific guidelines and ‘tests’ to determine what constitutes an employer-employee relationship vs. an organization-contractor relationship. Overstepping these rules is extremely easy to do, and unfortunately, the rules can vary between departments, and even state by state.

This is why it is so important to understand the difference between employees and independent contractors. Not doing so could result in potential regulatory fines, penalties, and lawsuits.

For More Information

IRS: Independent Contractor or Employee?

United States Department of Labor Wage and Hour Division: Missclassification of Employees as Independent Contractors

Washington State Department of Labor and Industries: Is Your Subcontrator Really an Employee?

If you have further questions, contact Clark Nuber for guidance.