If you are running a business you have probably hired someone to help you with work you either do not have time to or do not have the expertise in. Now did you pay them as an employee or a contractor? Were you sure that was the right way to do it? This is a common problem that small businesses come across and even some larger businesses have gotten in trouble with this issue. Usually it isn't even because they were trying to save time or money but instead because of a lack of understanding.
Sadly the IRS and the Department of Labor do not really care if you got it wrong because of malice or a lack of knowledge, either way it can end up with costly consequences. Classifying an employee as a contractor can result in back taxes, penalties, and interest payments due to the IRS. Then there are the potential legal issues with the Department of Labor.
So what is the difference?
The main thing to think about is control. Not the person's title, nor whether they invoice you, nor whether they work from home. The IRS looks at three main areas which all come down to control:
Do you control how the work gets done, not just the end result? If you're telling someone when to show up, how to do the job, and what tools to use, they are probably an employee.
Does the person have their own business expenses, work for other clients, and set their own rates? Or do they work exclusively for you, get reimbursed for expenses by you? Hint, the second one sounds like an employee and the first sounds like a contractor.
Is there a written contract? Are benefits involved? Is this work that's central to your business or a one-off project?
None of these factors alone makes the determination. The IRS looks at the full picture.
Here's the actual language the IRS uses:
"The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done."
IRS Publication 15-A
You can read the full IRS guidance here: irs.gov - Independent Contractor or Employee
A few things to think about
If someone works for you full time, does the type of work that is your core business, and you determine their schedule, they are more than likely an employee regardless of any contract that is in place. If on the other hand you are only having the person on for a specific project, you give them a timeline but not the hours they need to do it in, they have other clients, and they come equipped with some or most of the tools needed to do the job, they may be a contractor.
The difficult part comes where you have someone who works multiple projects with you, doing your core business type activities, but they invoice you and refer to themselves as a contractor. In that situation you should be checking with your accountant and or lawyer on how to handle things. Something to remember is if you are in Illinois (varies state to state) that even if they are a contractor, you need to have a copy of their personal workers' comp policy; otherwise they will be added to yours for the work they did for you during your annual audit.
State and location does matter
Some states have their own classification rules that are stricter than the federal standard. California for instance has AB5, the most well-known example, but it's not the only one. If you're in Illinois, like I am, the rules largely follow the federal framework, but it's worth verifying that no local rules apply to your situation.
This post is meant to help you understand how to think about worker classification, not to serve as legal or tax advice. Classification questions can have real financial and legal consequences. When in doubt, talk to your accountant or attorney about your specific situation.