Employee vs. Subcontractor:
What's the difference, and why you should care

Correctly determining whether someone is a subcontractor or an employee has many important consequences for your business. It will affect:

• Company FICA, FUTA and SUTA payments
• Workers' Compensation insurance cost
• Liability insurance cost
• Benefits coverage, such as paid time off and health insurance
• Quarterly and/or year-end filing with the state and IRS
• What kind of records you must keep

Businesses may receive significant economic benefits by working with independent contractors instead of hiring employees. These include reduced or no employer contribution to FICA, FUTA or SUTA, no need to provide benefits, no need to provide tools and equipment or training, and no need to keep paying someone when a job is completed or pay out against unemployment claims.

Because of these incentives,many businesses have tried to classify workers as independent contractors when they should treat them as employees. This can result in major problems down the road, especially if the worker files an unemployment claim or doesn’t pay their own self-employment or income taxes, or if the business is audited by the IRS or DUA (Department of Unemployment Assistance) - even if you felt someone was clearly a subcontractor, you may have to defend classifying them that way. There may be serious workers' compensation issues, especially if the worker opens a claim against the company’s policy. Liability may also be an issue, especially if the worker does not carry their own general liability insurance or does not have sufficient coverage.

IRS Guidelines

The IRS has developed a list of 20 factors it uses to determine employee or subcontractor status. The Mass DUA generally conforms to these, as well.

• Does the business require the worker to follow their instructions on how work is to be performed? This will generally indicate an employee; an independent contractor makes their own decisions on how best to complete a task or project.
• Does the business provide training to the worker? An independent contractor generally provides their own training and/or certification.
• Are the worker’s services a substantial or integral part of the business? If yes, it suggests the business maintains control and direction over the worker, making them an employee.
• Does the business require the worker to perform all services personally? An independent contractor should have the option of subcontracting out portions of a job to others, or of having their own employees perform various tasks.
• Does the business hire, supervise and/or pay the worker’s assistants? This suggests the worker is an employee, since an independent contractor should hire and supervise their own assistants.
• Does the business have an ongoing relationship with the worker? Even a seasonal relationship suggests the worker may be an employee.
• Does the business set the worker’s schedule and hours? Independent contractors set their own work schedules.
• Does the business require the worker full-time? This suggests the worker is an employee because the business controls their work and prevents them taking on other clients.
• Does the business provide the workspace? Someone who works off-site in their own office or workspace is more likely to be an independent contractor.
• Does the business determine the order or sequence in which work is completed? Routines and schedules established by the business for a worker suggest the worker is an employee.
• Does the business require oral or written reports? Regular written or oral reports detailing work completed indicate employee status.
• Does the business pay by the hour, week or month? This will suggest someone is an employee; independent contractors are often paid a flat rate for completion of a specific project.
• Does the business pay expenses? Independent contractors may bill for reimbursement for certain expenses, but if if the business they are providing services for purchases routine supplies, arranges and pays for travel, etc. it usually means it has the ability to regulate and direct business activities, indicating an employee status.
• Does the business provide tools and equipment for the worker? Independent contractors generally provide their own tools and equipment. Employees generally use tools and equipment belonging to the business.
• Does the worker have a significant investment in their own facilities? If a worker owns and maintains his own office space, computer equipment, tools, machinery, etc., they are probably an independent contractor.
• Does the worker have profits and losses independent of the business they are providing services to? If they do, they are running their own business and are probably an independent contractor.
• Does the worker have multiple clients? Working with multiple clients generally indicates independent contractor status.
• Does the worker market their services to the general public? Employees don’t generally market their services or make themselves available to the general public.
• Does the business have the right to discharge the worker at any time? This suggests employee status; an independent contractor can not be discharged until the contract is completed, unless they are not meeting contract specifications.
• Does the worker have the right to quit at any time? An employee may quit at any time while an independent contractor may be liable for failure to complete their contract.

What all these factors try to determine is whether or not an employer has the right to control what a worker does, and how and when he or she does it, as well as how much financial risk the worker has taken on for themselves or how much investment they’ve made in their own business. The more control a business has over a worker, the more likely the worker should be classified as an employee. The more financial risk the worker has in terms of business profit and loss, or the greater their own investment in tools, equipment and facilities, the more likely they are to be classified as an independent contractor. If a person falls into the employee status on more than 8-9 of the IRS guidelines, you should probably play it safe and pay them as an employee.

If you are working with an independent contractor:

• Ask for a written contract. At a minimum, the contract should include the independent contractor's business name and address, specify what constitutes successful completion of the work and how much the work will cost. You may also request that it include wording indicating that the person doing the work is an independent contractor not eligible for employee benefits, and that they have control over how, where or when the work will be completed and who does it, except where they have scheduled specific meetings or time with the business in order to facilitate completion of work. Your contract could say something like "all work to be completed by June 1st" or "Phase One of this project to be completed by May 15th, Phase Two by May 30th" etc. but you could not say something like "contractor is to perform work every Monday, Wednesday and Friday from 9 to 5" though you could probably say "contractor is to perform work on Monday, Tuesday or Wednesday between the hours of 9 and 5, with all work to be completed by Wednesday at 5pm" if, for example, they were painting an office and you had agreed those were the days it would be empty for them to do their work.
• Get a completed I-9 form from the subcontractor (I usually ask for one when I receive their first bill or accept a contract, and won’t send out payment until the form’s been completed). This should include their social security number or employer identification number and mailing address (not a PO Box). You will need this information to file a 1099 at the end of the year. You don't need to file a 1099 for corporations, but can still ask them for an I-9.
• Ask for a certificate of insurance. Sole proprietors without employees often don’t carry workers comp insurance. However, many contractors will at least have their own liability insurance, and this will help you show they should not be classified as an employee, and may save you money on both your worker's compensation and general liability audits. Again, ask for that with the contract or before sending out your first payment. The certificate of insurance should come from the subcontractor's insurance company, include both their business name and your business name (as certificate holder), and their policy numbers, coverage limits, and policy expiration dates. If you continue to work with someone past the date their policies expire, get updated certificates.
• Ask for business cards or other materials which help establish that the worker markets to the general public. Save these materials with the contract in case you need them for an audit, since these will help establish that the subcontractor markets to the general public.
• Get invoices for all work, especially if there isn't a contract. The invoices should include the independent contractor’s business name and address.
• In the case where an independent contractor is providing materials as well as services, ask them to separate this on their invoices, even if the total cost is based on a single flat fee. If you do end up having to include payments to them as part of your workers comp premiums, it only applies to what was paid for services, not materials.
• Make all payments to the company name. A sole proprietor may be doing business under their own name, but any time there is a separate business name, make the checks out to that name. If the name includes "Inc." "LLC" or anything else indicating it is NOT an individual, make sure that is included in the name you put on the check.

Despite following the guidelines and creating a sufficient paper trail, you may still run into problems with your workers compensation insurance. Insurance companies often take the stance that if someone doesn’t have their own workers comp coverage, you need to cover them, even if they are clearly an independent contractor. This is apparently because independent contractors have won worker's compensation claims against client businesses, even though they were clearly not employees of the business. I have not confirmed the following, but have been told that as of 2006, the state insurance commission sent down a ruling that allows insurance companies in Massachusetts to REQUIRE businesses provide workers compensation coverage for ALL subcontractors who do not have their own coverage. So again, very important to have invoices show materials separate from labor!

As of 11/2003, Massachusetts independent contractors and sole proprietors are able to insure themselves and make claims against their own workers comp policies; sole proprietors no longer have to be incorporated and paid through payroll to have their own workers comp policies. However, these policies can be quite expensive and are not required, so many won't have them.

If someone doesn't have their own coverage, you should factor in the expense of covering them on your policy. Although for clerical-type work (bookkeeping, graphic or web design, etc.) the cost is nominal, it can be extremely expensive for roofers, carpenters, etc. who are more at risk for accident or more likely to cause property or other damage (as much as 20-30% of whatever you paid them could be added to your insurance premiums at audit). You should check with your insurance agent on the cost before entering into an agreement with someone in a high-risk classification, and keep those additional costs in mind when comparing quotes for work. Although two quotes may be for the same price, the one done by the person with their own workers compensation coverage is going to be cheaper when you factor in your cost to cover someone on your insurance policy.

Even if someone does have their own coverage, make sure your contract specifies that they must also cover all THEIR workers and/or provide proof of coverage for any subcontractors they use on your job. Otherwise you may find yourself having to cover an accident or injury caused by one of their workers if it happened while work was being done on your property or at your request, even if you never directly contracted with or paid that person yourself.

More Information

For more information, see the IRS brochure Independent Contractor or Employee? - note: this may be out of date. For the most current IRS information or if you have more questions, visit the IRS web site at www.irs.gov. For Massachusetts law, visit the Massachusetts Dept. of Unemployment Insurance web site or review their booklet Simplifying the Unemployment Insurance Law - A Guide for Employers (revised 9/06 - page 9 talks about who could be classified as an independent contractor). If your business hires a lot of independent contractors, schedule a meeting with your insurance agent to discuss how that impacts your policies, their costs, and the coverage you need.

If you want to see what an employee really costs you after taxes and benefits, check out the Employee Cost Calculator.