The first thing you should know about the difference between being an employee and being an independent contractor is that the choice may not be up to you. You should also know that you have distinct and important obligations with either classification. Use our guide here to determine your legal obligations and your tax liability, but consult an expert if you are at all unclear on how to classify your situation.
What determines whether someone is an employee or independent contractor is the level of control an employer has over the worker. Generally, what constitutes an employee is that the employer has the right to discharge the employee and also provides a place to work and tools to work with.
If you are an employer and have incorrectly categorized your employees as independent contractors, you could be liable for back taxes and penalties. An employer categorizing her workers as employees must comply with certain regulations. An employer must withhold federal, state, and social security taxes from an employee’s check, as well as pay a portion of unemployment taxes. An employer also must pay for worker’s compensation insurance, a fund that covers employees injured in the line of work.
Independent contractors are required to pay their own income taxes on a quarterly basis (the employer does not withhold taxes from a paycheck). You need to estimate your total year’s taxes and pay the amount in equal quarterly installments. If you fail to pay the taxes or pay an amount far below what you owe, you could be subject to a fine. At the end of the year, the employer provides independent contractors with a 1099 form, indicating the year’s earned wages. An employee receives a W-2 form at year’s end, which shows total wages earned and all monies withheld.
When filing year-end tax returns, an independent contractor will obviously have more deductions. She can deduct from her gross income monies that she spent out of her pocket on expenses. This “adjusted gross income” may lessen the independent contractor’s tax liability.
Employees must report tips they receive each month in excess of $20. This includes both tips received in cash and those that charge customers add to the bill. Taxes are still due on tip earnings. There are strict rules regarding reporting tips, although the thrust of the law is aimed at food and beverage establishments, where tipping is customary If you need more information on this subject, consult an IRS publication entitled “Employer’s Annual Information Return of Tip Income and Allocated Tips” (Form 8027).
The IRS provides 20 categories by which it judges the employee-employer relationship. The criteria are outlined as follows: Instructions. You are considered an employee if you must abide by instructions about where, when, and how to work. If there are no implicit rules but the employer has the right to set those rules, you are an employee.
Training. An employee is trained to perform services in a particular manner. Independent contractors receive no training and perform their services by their own methods.
Integration. An employee’s services are integrated into the business operation because the services are important to the success or continuation of the business. This shows that the employee is subject to direction and control. An employee who is integrated in the salon would follow the salon’s rules and regulations, keep a permanent work area, attend salon meetings, etc. An independent contractor would not necessarily be required to follow certain in-house rules or attend meetings.
Service rendered personally. An employee renders the services personally. This shows that the employer is interested in the methods as well as the results. An independent contractor may or may not perform services herself. If she is ill or unable to work, she may hire a substitute; whereas if an employee is sick or unable to work, it is the responsibility of the employer to get a substitute.
Hiring assistants. An employee works for an employer, who then hires, supervises, and pays assistants. An independent contractor hires, supervises, and pays her own assistants. This means that if you’re an employee and you require an assistant, the hiring is done by your supervisor. If you’re an independent contractor requiring assistance, you hire that person yourself (and are responsible under a separate contract to that person).
Continuing relationship. An employee has a continuing relationship – where work is performed at frequently recurring intervals — with an employer.
Set hours of work. An employee normally works full time for an employer (however, there are part-time employees) during times determined by the employer and wholly at the employer’s discretion. An independent contractor can work when and for whom she chooses.
Work done on the premises. An employee works on the premises of an employer or works on a route or at a location designated by the employer. While most independent contractor nail technicians do work on the premises of the employer, the freedom not to do so indicates an independent contractor relationship.
Order or sequence set. An employee must perform services in the order or sequence set by an employer. (Note the recurring theme of employer control.)
Reports. An employee submits reports to an employer. This shows that the employee must account to the employer for his or her actions.
Payments. An employee is paid by the hour, week, or month. An independent contractor is paid by the job or on a straight commission. Be careful: Just because someone is paid commission doesn’t mean she’s an independent contractor.
Expenses. An employee’s business and travel expenses are paid by an employer.
Tools and materials. An employer furnishes an employee with tools, materials, and other equipment.
Investment. An independent contractor has a significant investment in the facilities he or she uses in performing services for someone else.
Profit and loss. An independent contractor can make a profit or suffer a loss.
Works for more than one person or firm. An independent contractor gives his or her services to two or more unrelated persons or firms at the same time. While an employee may work two jobs, a characteristic of independent contractors is that they have several employers.
Offers services to the general public. An independent contractor makes his or her services available to the general public.
Right to fire. An employee can be fired by an employer. An independent contractor cannot be fired so long as he or she produces a result that meets the specifications of the contract.
Right to quit. An employee can quit his or her job at any time without incurring liability An independent contractor usually agrees to complete a specific job and is responsible for its satisfactory completion, or is legally obligated to make good for failure to complete it.
If you have doubts as to where you or your workers fall, you can let the IRS determine your status by filing form SS-8, entitled “Information for Use in Determining Whether a Worker Is an Employee for Purposes of Federal Employment Taxes and Income Tax Withholding.”
When In Doubt, Ask
Be careful. If you classify an employee as an independent contractor with no reasonable basis for doing so, you may have to pay employment back taxes for that worker. Further, if you do not withhold income and social security taxes from his or her wages, you may be held liable for a penalty of 100 percent of the tax if you are the person responsible for the collection and payment of withholding taxes.
Let’s look at a couple of examples that are typical of the nail industry.
Barbara, a nail technician, signed a lease to rent a booth at Helen’s Nails. Helen bears all the shop expenses, including rent, utilities, advertising, linens, and other supplies.
Their agreement provides that 70 percent of Barbara’s booth receipts go to her and 30 percent to Helen. All receipts are put in Helen’s cash register. At the end of the week, Helen pays Barbara the agreed percentage of the receipts.
Shop hours are displayed on the shop door. Barbara is expected to comply with them. She must take customers in turn, maintain clean premises, use clean towels and sterile equipment, and keep a clean personal appearance. Although Helen does not actually supervise Barbara, she can dismiss her for acting in a manner that would cause Helen’s Nails to lose customers. Barbara can also be dismissed for any other reason.
Although Helen does not control or direct Barbara in the performance of her duties, she does have the right to dismiss her. Helen’s income depends on a percentage of Barbara’s receipts; thus Helen retains the right to direct and control Barbara to protect her investment and to be assured of a sufficient profit from the shop, Barbara has no investment in the shop, assumes no liability for its operation, and furnishes nothing except personal services. These circumstances indicate that Barbara is an employee of Helen.
In the case of Tony and Sarah, Sarah owns World of Beauty. The two professionals have an agreement under which Tony, a nail technician, furnishes nail care services to shop clients during business hours.
According to the agreement, Tony regulates his own hours, furnishes his own equipment and supplies, and keep the proceeds from his work. He does not use the shop cash register nor does he report his earnings to Sarah. He does not have to perform his services personally but can hire a substitute. Sarah cannot direct the way Tony performs his services. Either Sarah or Tony can end the arrangement at any time.
Although Sarah has the right to dismiss Tony by ending the agreement, and although she furnishes a place for Tony to work, she does not have the right to exercise the degree of direction and control over his work necessary to establish an employee-employer relationship. Therefore, Tony is an independent contractor.
Besides how the IRS views your status, there are important legal divisions between employees and independent contractors. If a worker is classified as an employee, her employer is responsible for abiding by the Fair Labor Standards Act, which assures that workers are paid minimum wage and are subject to overtime laws (which vary from state to state). Also, salons with employees are obliged to abide by federal, state, and local laws that prohibit job discrimination based on race, color, religion, sex, national origin, pregnancy, handicaps, or age. Sexual harassment laws also apply.
The IRS can be unforgiving when it comes to money owed, so you do not want to find yourself on the wrong end of compliance. Use this guide to help determine the classification in your own salon, and consult an IRS counselor or an accountant for further clarification.
Besides the tax status and legal definition of employees and independent contractors, there are other considerations. First make sure that your current system is correctly defined, and we’ll cover these other matters in a future issue.
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