Contractor versus Employee - IRS Rules

Here's what the IRS says about employees versus independent contractors:

Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors.

If you are a business owner hiring or contracting with other individuals to provide services, you must determine whether the individuals providing services are employees or independent contractors. Follow the rest of this page to find out more about this topic and what your responsibilities are. 

Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. This is so even when you give the employee freedom of action. What matters is that you have the right to control the details of how the services are performed. 

In determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered.

There is no hard and fast rule or checklist to determine whether a stylist is an independent contractor or employee. The IRS looks at Behavioral, Financial and Relationship factors to make their determination. Those factors are all listed below and I encourage you to take the time to read them.

Some stylist/owner relationships are fairly easy to figure out. If a stylist is paying booth rent to an owner and keeping his or her sales, it's a pretty safe bet that they are an independent contractor. The stylist has financial risk of loss - they are paying rent (just like a business owner) and if their sales aren't enough to cover their rent and other costs, they can incur a loss. Employees don't have risk of loss.

On the other hand, a stylist being paid hourly and working hours specified by the salon owner is almost definitely an employee.

The gray area is the commission stylist and the IRS will look at how much control the salon owner has based on the factors below. It's important to remember that you cannot claim independent contractor status based on a written contract that says the stylist is an independent contractor and is responsible for their own taxes. The IRS will always look at the relationship, not that piece of paper.

Here are the behavior factors the IRS looks at when making a determination: (with my comments in blue)

Types of Instructions Given

An employee is generally subject to the business’s instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work.

• When and where to do the work. Who sets the stylist's schedule?
• What tools or equipment to use. 
• What workers to hire or to assist with the work. Does the owner provide assistants?
• Where to purchase supplies and services. Is the owner providing supplies? Are certain products required (ie certain color line)?
• What work must be performed by a specified individual. Can the stylist pay someone else to do the work?
• What order or sequence to follow when performing the work. 

Degree of Instruction

Degree of Instruction means that the more detailed the instructions, the more control the business exercises over the worker. More detailed instructions indicate that the worker is an employee.  Less detailed instructions reflects less control, indicating that the worker is more likely an independent contractor. 

Note: The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.

Evaluation System

If an evaluation system measures the details of how the work is performed, then these factors would point to an employee.

If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.

Training

If the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way.  This is strong evidence that the worker is an employee. Periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship. However, independent contractors ordinarily use their own methods.

Here are the Financial factors the IRS looks at:

Significant investment

An independent contractor often has a significant investment in the equipment he or she uses in working for someone else.  However, in many occupations, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees. There are no precise dollar limits that must be met in order to have a significant investment.  Furthermore, a significant investment is not necessary for independent contractor status as some types of work simply do not require large expenditures. The fact that hairdressers usually supply their own tools is not, by itself, enough to get contractor status.

Unreimbursed expenses

Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform for their business.

Opportunity for profit or loss

The opportunity to make a profit or loss is another important factor.  If a worker has a significant investment in the tools and equipment used and if the worker has unreimbursed expenses, the worker has a greater opportunity to lose money (i.e., their expenses will exceed their income from the work).  Having the possibility of incurring a loss indicates that the worker is an independent contractor. This is a big one...a booth renter can obviously lose money if not busy enough. But can a commissioned stylist?

Services available to the market

An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market. Is the stylist permitted to provide services to others outside of this business?

Method of payment

An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly. Based on this factor, commissioned stylists would generally be categorized as employees.

And the Relationship factors the IRS looks at:

Written Contracts

Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker’s status.  The IRS is not required to follow a contract stating that the worker is an independent contractor, responsible for paying his or her own self employment tax.  How the parties work together determines whether the worker is an employee or an independent contractor. You should have a written agreement with your independent contractors outlining the conditions of their work, but just because you say they are independent doesn't make it so.

Employee Benefits

Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance.  Businesses generally do not grant these benefits to independent contractors.  However, the lack of these types of benefits does not necessarily mean the worker is an independent contractor.

Permanency of the Relationship

If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship. This one seems very relevant to salons. Generally a commission stylist is brought on with the expectation that they will be there indefinitely, which would indicate employee.

Services Provided as Key Activity of the Business

If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities.  For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work.  This would indicate an employer-employee relationship. This one is a little tricky. If someone gets their hair cut at Great Clips, they are giving their business to Great Clips, not to an individual in the salon. The haircut reflects back on the business more than the individual. In cases where the salon itself is a brand in it's community, I think we are leaning toward employee, even if stylists are paid on commission. Other salons don't really have a reputation of their own - it's the reputation of the individual stylists that drives business. This is very subjective.

If you're still not sure, you can fill out an IRS Form SS-8 and submit it to the IRS for a ruling. It may take 6 months or more to get a response. You can also print it out and go through the questionnaire on your own.

http://www.irs.gov/pub/irs-pdf/fss8.pdf