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Early Stage 7, Part I: Just what is an employee?

Editor's note: This is the seventh in a series of articles on developing start-up companies in the technology or biotechnology sectors. The most recent article focused on business taxes.

Madison, Wis. - Your entity is formed and you are ready to begin hiring workers. As discussed in the previous article, you generally must withhold and pay federal income taxes, Social Security and Medicare taxes, and unemployment taxes on wages paid to employees. You also must provide worker's compensation coverage for your employees, but you do not have to pay withhold or pay any taxes on payments you make to independent contractors, nor are you required to provide them with worker's compensation coverage.

However, you cannot transform an employee into an independent contractor merely by applying that label. The substance of the worker's relationship to your business will govern the worker's status. If you misclassify employees as independent contractors without any reasonable basis for doing so, you may be liable for the employment taxes related to that employee and other penalties. In order to be sure you are treating your workers properly for tax and other purposes, you will need to understand the nature of the relationship between you and each of your workers.

This is a complex area. In Part I of our presentation on employees, we will discuss the income issues. Subsequent columns will cover other definitional issues related to employee versus independent contractor status.

Controlling authority
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Tax authorities generally apply “common law” rules to determine whether a worker is an employee or an independent contractor. Generally, anyone who performs services for your business will be considered an employee if you retain the right to “control” what the worker does and the means by which the worker does it.

You may be familiar with the Internal Revenue Services' “20-factor” test, which until 2006 was the standard method used to make the determination of employee status. The IRS now has adopted a simplified test using three categories - behavioral control, financial control, and type of relationship - to analyze the degree of control and the degree of independence in the relationships that a business has with its workers.

Facts that will show “behavioral control” include instructions that are given to the worker, and training that the business provides for the worker. The kinds of instructions that will be considered include when and where to do the 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, and what order or sequence to follow in doing the work.

Even if no instructions are given to a worker, sufficient behavioral control may still exist if the employer has the right to control how the work results are achieved. In addition, if workers are trained to do the work in a specific manner, this generally indicates employee status. Independent contractors generally use their own methods to do the work.

Facts that will indicate “financial control” over the worker include the extent to which the worker has unreimbursed business expenses, the extent of the worker's investment, the extent to which the worker makes his/her services available to the relevant market, how the business pays the worker, and whether the worker can realize a profit or loss.

Independent contractors generally have the ability to realize a profit or loss based on the relationship of their compensation to their costs. If a worker has unreimbursed expenses and/or fixed, ongoing costs that are incurred regardless of whether the worker is currently performing services, this is likely to signal independent contractor status.

In addition, independent contractors are generally free to seek out other business opportunities, often advertise, maintain a viable business location, and are available for work in the relevant market. Although independent contractors are generally paid a flat fee for the job, this is not necessarily determinative. It is considered common in some professions, such as law, to pay contractors by the hour.

Relationship negotiations

Facts that will show the “type of relationship” between your business and a worker include written contracts, if any, that describe the kind of relationship the parties intended to create; whether the employer provides the worker with employee-type benefits - such as insurance, pension plan, vacation pay, or sick pay; the permanency of the relationship; and the extent to which services performed by the worker are a key aspect of the regular business of the company. The more permanent the relationship and the more important the worker's duties are to the core of the business, the more likely it becomes that the worker is an employee.

The Internal Revenue Service provides several useful publications to assist business owners in determining whether their workers are employees or independent contractors. In particular, Revenue Publication 15-A, revised January 2007, contains a helpful discussion with various hypotheticals that illustrate how the new three-factor test is applied in different circumstances. Publication 15-A is available from the IRS website.

To obtain a determination from the IRS as to whether a particular worker is an employee or an independent contractor, you can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Cross-purposes

As you can well imagine, the existence of so many individual tests for independent contractor status creates a significant possibility that a worker may be classified as an independent contractor for some purposes, but as an employee for other purposes.

Although these tests are similar in some respects, you should not rely on a single test for classifying your workers for all purposes. In all cases, you should review the specific applicable criteria to be sure that the workers you employ are properly classified.

Next time, we will explore this issue for other contexts.

Previous articles by Joe Boucher

Joe Boucher: Early Stage: Step 6 - Taxes, taxes, taxes!

Joe Boucher: Early Stage: Step 5 - Forming the entity

Joe Boucher: Early Stage, Step 4: Cautionary trademark tales

Joe Boucher: Early Stage, Step 3: Naming the entity

Joe Boucher: Early Stage Step 2: Choosing a domain name

Joe Boucher: Starting a tech business? Step 1 is minding the intellectual property

Joe Boucher: Madison is flourishing while Marinette is dying

Joseph Boucher is a CPA and an attorney with the Madison law firm Neider & Boucher, with expertise in estate planning and business law, including early-stage business formation. He has a law degree and an MBA from University of Wisconsin-Madison and a bachelor's degree from St. Norbert College.

Bonnie Wendorff also is an attorney with Neider & Boucher, and her areas of expertise include employment law and litigation. She has a law degree from the University of Wisconsin-Madison and a bachelor's degree in education from the University of Wisconsin-Eau Claire.

The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of Wisconsin Technology Network, LLC.

WTN, LLC accepts no legal liability or responsibility for any claims made or opinions expressed herein.

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