The Difference Between Sub-Contractors and Employees

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There are facts and circumstances most commonly used to determine the difference between an employee and sub-contractor. It's a 3 part subjective analysis and some facts may indicate that a 'worker' is an employee, while other factors indicate that the worker is actually a sub-contractor.

Understanding the difference between sub-contractors and employees is a very important area of employment law. Far too many business owners cut corners in this area and don’t think it’s a big deal – IT IS a big deal.  How you classify a ‘worker’ in your business, whether as an employee or sub-contractor, can have far-reaching effects to you AND your business.

I understand the business owner’s plight.  Many entrepreneurs are wary of the costs and extra paperwork to bring on an ‘employee’ in the business.   Terms such as SUTA, FUTA, FICA and Workers Compensation will often times deter the employer into making the ‘right’ decision, and it could ultimately be devastating to their business.

The IRS consistently warns taxpayers that if they are caught paying ‘employees’ as ‘sub-contractors’, they will pay stiff penalties on top of the taxes and interest owing for payroll withholdings that should have taken place. However, there are more risks than just the IRS. See my article “7 Deadly Outcomes of Treating an Employee like a Sub-Contractor”.

A 3 Part Subjective Analysis

There are facts and circumstances most commonly used by the Courts (known as ‘Common law’) to determine the difference between an employee and sub-contractor. It’s a 3 part subjective analysis and some facts may indicate that a ‘worker’ is an employee, while other factors indicate that the worker is actually a sub-contractor.  Thus, you need to weigh the issues with your tax or legal advisor to make the right decision and what path you’re going to take. These 3 factors or categories are as follows:

  1. Behavior of the ‘worker’ in relationship to your direction and guidance. Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial terms between you and the ‘worker’.  What are the business aspects of the financial relationship? Is the worker paid hourly or weekly?  Does it look more like pay that an employee would receive?  Do you reimburse for expenses and provide the work space, tools, and supplies?
  3. Type of Relationship in writing AND Understanding.  Would your ‘worker’ consider themselves an employee?  Could they be fired any particular day?  Do you have a sub-contractor agreement in place that clearly indicates the worker is an independent contractor?

The old adage regarding a duck couldn’t be more appropriate.  “If it looks like a duck, quacks like a duck and walks like a duck- It’s a duck!”  Same thing with employees.  If they act like an employee, are treated like an employee and are paid like an employee – they are an employee!

The IRS’s Position

The Internal Revenue Service define an employer/employee relationship as one in which the employer controls the workspace, the hours worked, the equipment to be used and directs the daily and weekly activities of the worker.

A Sub-contractor by contrast is one that typically carries their own tools, supplies, bills for their time and/or services, controls their hours worked and serve multiple customers or clients and aren’t supervised or directed by one employer in particular. To help explain these definitions further and provide examples, the IRS created an extremely helpful webpage with a number of resources titled: “Independent Contractor (self-employed) versus Employee”.

The State’s Position

California recently became one 12 states to have passed legislation to enforce a bright-line test regarding the difference between employees and sub-contractors. This landmark law (known as “AB-5”) became effective January 1, 2020, and created an aggressive “ABC Test” to capture more workers as “employees” and thus increase state tax revenue.

Under the new test, a worker is an independent or sub-contractor only if all of the following three elements are satisfied:

A. The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact.

B. The person performs work that is outside the usual course of the hiring entity’s business.

C. The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

If these 3 elements above are not all clearly met, then the worker by definition must be an employee. As such, the employer is then required to set-up bonafide payroll procedures and start withholding and paying the necessary payroll taxes. This test codified and expanded the California Supreme Court’s decision in Dynamex Operations West, Inc. v. Superior Court of Los Angeles (2018) 4 Cal.5th 903 (Dynamex).

Bottom line, if they are an employee… deal with it and get the proper paperwork and procedures in place. You’ll be far better off in the long run. PLEASE be careful and make sure you discuss this issue with your CPA and attorney when hiring a worker that may be falling within this grey area. This is not a situation you can ignore or take lightly.

Interested in Learning More:

* To sign up for Mark’s weekly Free Newsletter and receive his Free E-Book “The Ultimate Tax Strategy Guide – 30 Steps to Saving the Most Money on Your Taxes” visit www.markjkohler.com.

Mark J. Kohler is a CPA, Attorney, co-host of the PodCasts “The Main Street Business Podcast” and “The Directed IRA Podcast”, and the author of “The Business Owner’s Guide to Financial Freedom- What Wall Street Isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”, as well as several other well-known books. He is also the CFO of Directed IRA Trust Company, and a senior partner at the law firm KKOS Lawyers.

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