Matt Vaadi breaks down the IRS's three-factor test for classifying workers: behavioral control, financial control, and the relationship between parties. Misclassifying someone to dodge taxes and benefits can trigger back taxes and penalties. A true contractor knows their status and files their own taxes.
So we get the question all the time. Should this person be classified as an employee or as a contractor? Well, the answer is it depends. The IRS tells us that there are 3 main things they're looking for when trying to determine if your workers should be classified as an employee or as a contractor. Those 3 things are the behavioral control, the financial control, and the relationship with the worker. I tell people all the time to think about it this way. Think about it like you're a general contractor. So you've got a project, you're gonna build a school. So when you put out the project, you hire subcontractors like electricians to come in and do the electrical work, run all the wires through the building. Now while those electricians agree to show up at a specific time, do the work, have it done by a certain time, they're experts. They don't need to be trained in your way of doing things. They need to know the rules of the worksite, sure, but they're not somebody that you train and you don't give them tools. They show up and do the work for a specific amount of money on a project basis. If you're hiring somebody, for example, if you're hiring a social media manager who has all their own tools, they're using their own platforms, they're using their own logins, their own computer, and they're doing projects based on when you tell them to have them complete, but they're being measured on results and when it's done, then that might be a contractor relationship. But if they're showing up every day to your office this, you're supplying the machine, you're supplying all the logins, their company passwords, you're training them, you're providing them with more resources, then they may be an employee. So going back to that construction analogy, I'm gonna be an expert, I'm gonna show up every day with my own tools, that makes me a little bit more likely to possibly fall into that contractor bucket. But the IRS looks at it 3 different ways. They look at behavioral control, financial control, and the relationship between the two. So when I talk about behavioral control, that boils down to that training. Who has control of how the teammate or the worker behaves? If I'm going to train you that you're going to, you know, answer the phone this way, you're going to do your job this way, and here are the hours you're going to show up, and here are the things you're going to use to do your job, it's likely that you're an employee. But if you're a contractor, and once again you're an expert in something that you do, and you're going to do it the way you've always done it, and I'm just hiring you to take care of that project or that then that behavioral control could go more towards the contractor side of things. And so financial control, when we look at it from that construction project example again, so if I'm the electrician and I just bid $100,000 to get the job done, my general contractor doesn't care about any of my expenses that I have inside of that $100,000, what my margins are, etc. But if I'm an employee then, and I incur an expense related to work, then I'm likely to get reimbursed by my employer, and my employer is going to pay pay for things like my equipment. They're not going to expect me to show up with all my own tools to do the job. They're not going to expect me to buy my own, uh, software subscriptions or whatever it might be. So that financial control becomes another element that the IRS is going to look at if they're ever auditing you for whether or not your employees should be classified as a contractor or vice versa. And finally, the relationship. So a lot of this comes down to contracts and what's agreed upon. I've often said if somebody doesn't know they're a contractor for you, then they probably shouldn't be a contractor because people who Contractors tend to know, they enter into that agreement knowing that this is what they do. They're gonna file their own taxes at the end of the year. It should never be a surprise when I go to file my own taxes to find out that my employer hasn't been paying my unemployment or that they haven't been paying any taxes for me whatsoever because they were trying to make me a contractor to not have to pay taxes. And for the record, that is the way that this conversation typically starts is, "Yeah, I'd like to make this person a contractor." Well, why would you like to do that? "Well, I don't wanna pay any taxes on 'em. I don't wanna give 'em benefits. I don't wanna pay for any time off." Well, those are not the right reasons, and those are the reasons that the IRS is looking for to come knocking down on your door and figure out why you're not paying any taxes. And so what happens if you do classify somebody as a contractor that should be an employee? Well, you're gonna owe back taxes on all those wages, and you're gonna owe penalties for failure to file and failure to pay. So is it really worth those few bucks in the long run of not paying into the taxes and not taking care of somebody who should be be treated as an employee on your team? I don't know, I'll leave that up to you. But if somebody is a contractor, then by all means classify them as a contractor, but just do so with caution and understanding that at some point it's almost always not the IRS who's going to be the one who's gonna come knocking on your door and say, "Oh, should this person have been an employee or a contractor?" It's gonna be that individual who once again goes to file their taxes, who starts to realize like, "Ah, maybe I don't like paying all my own self-employment taxes and having to deal with this burden, why am I not an employee? I'm checking all the boxes here and I should maybe be a member of the team and get those benefits that the other team members do. So these are all the things that you really want to consider when you're trying to decide whether or not to classify somebody as an employee or a contractor. And startups, this is a special message just for you. Just because you're a startup does not make somebody a contractor versus an employee. Go back to all those things that we talked about. Do they have— who controls financial? Who controls behavior? What's the relationship? If they look like an employee, they smell like an employee, they probably are an employee. Just because you're a startup and you don't wanna pay taxes does not make them a contractor just because of the stage of your business. That has literally nothing to do with it. And we see that abuse happening all the time in startup communities all around the country. So be cautious out there. Make sure that you do the right thing by your teammates and by your organization by understanding whether or not your team should be classified as a contractor as an employee. And if you need further help, I'm going to link to some guides in the comments on the IRS's checklist of what they're looking for when trying to determine if somebody should be a contractor or an employee, and also some other things that might help you along the way. Thanks so much for stopping by. We appreciate your time, and I'll look forward to you next time. Thanks.
