For a small-business owner, hiring an employee is a big step. Not only do you have to make sure you have enough money to pay the employee's wages, you also have to pay various employment-related taxes and contributions, including Social Security, Medicare, and unemployment insurance withholding. In addition, your state may impose additional levels of regulation on your business if you have employees, ranging from workers' compensation to disability insurance fund contributions. You may need to demonstrate your commitment to equal opportunity employment and create employee policies that comply with certain state and federal guidelines. On top of all this, your overhead expenses are also likely to rise, as your employee will probably need office space, equipment, and access to technology and communication to work with you.

Because of the added expense and increased administration involved with hiring an employee, it's tempting to try to avoid it. Yet when your business grows beyond the point at which you can perform all of your work on your own, you have to be able to find help to meet the needs of your clients.

The solution that many businesses use is to work with independent contractors. Independent contractors are not employees; rather, as the name suggests, they work independently, often classified as self-employed individuals with sole proprietorships. As a result of their status, independent contractors are not entitled to the same legal protections and benefits that employees receive. For instance, if you offer certain benefits to employees, such as an employer-sponsored retirement plan, health and disability insurance, or paid family medical leave, you do not need to offer the same benefits to independent contractors. Instead, you can negotiate compensation directly with the independent contractor, and once you pay the agreed amount, you have no further responsibility.

Obviously, this is an attractive solution for many businesses. However, as Microsoft (NASDAQ:MSFT) learned in a lawsuit that it eventually settled for almost $100 million, it's not enough just to call people working with you independent contractors. Because of the potential for abuse and tax evasion, the IRS has rules that define whether someone doing work for you is properly classified as an employee or an independent contractor.

How do you tell the difference?
The general idea in classifying a worker as an employee or independent contractor is that an employer has the right to exercise a high degree of control over an employee's work, while someone hiring an independent contractor must recognize the contractor's independence and must therefore give up control of at least some of the functions of the work the contractor is performing.

Although the idea behind the classification is relatively simple, interpreting the idea in practice is often challenging. The IRS uses a complicated list of rules and factors to determine whether a given worker should be considered an employee or an independent contractor. The rules fall into three basic categories: the worker's behavior, the financial relationship between the business and the worker, and way in which the business and the worker define their overall relationship through contracts or informal agreements.

Controlling how your worker works
In looking at the worker's behavior, the IRS looks at the level of control exercised by the business. Employees tend to get very specific instructions about how to do their jobs, and the business may insist that employees perform work in a particular way, using specified methods. In order to maintain quality control and ensure that work is being done correctly, businesses often provide training to employees to educate them about the way they should do their work. Also, employees tend to work for only one employer. In contrast, independent contractors are usually given general guidelines about the work they are to do; details such as exactly when and how the work is to be done and what methods the worker should use are generally left to the discretion of the independent contractor. Independent contractors also often make themselves available to work for multiple businesses at the same time.

How your worker gets paid
The IRS also looks at the financial relationship between the business and the worker. In general, employees bear little financial risk in their relationship with their employers; employees generally receive a fixed wage regardless of whether or not the employer is profitable, and employers generally reimburse employees for business-related expenses. Employees are rarely required to make a personal financial investment in their employer's business. Independent contractors, on the other hand, bear more risk. They often bid for projects on a fixed-cost basis; if the project proves to be more costly than anticipated, then independent contractors may lose money and not be able to obtain recompense from their client businesses.

How the parties define their relationship
The way in which a business formalizes its relationship with a worker also contributes to the determination of the worker's status. Employees tend to have permanent relationships with their employers. In addition, employers tend to hire employees to perform the most important functions of their business because they need to exercise a high level of control over these functions. Employees also generally receive benefits like paid vacation and sick leave, insurance, and pension. Independent contractors, however, usually have relationships over a fixed time period with defined beginning and end dates. They generally do not receive any benefits from the business, and they perform less critical business functions that require less control and oversight by the business.

What to do
If you wish to retain an independent contractor, it's important to have a written contract that states the terms under which the contractor is to perform work. To avoid any presumption that a worker is an employee, the contract should clearly state the intent of the parties to define the worker's status as an independent contractor. In addition, the contract should include terms that define the worker's relationship in ways that more closely resemble the characteristics of independent contractors given by the IRS.

If all of this leaves you stumped, you can get guidance directly from the IRS. By filing Form SS-8, you can ask the IRS to make a formal determination of whether or not a worker should be treated as an employee or an independent contractor. Even if you choose not to seek help, reviewing the form is a good way to learn how the IRS would make its determination in a potential audit.

Finding people to help you handle your workload is crucial to the success of your business. By understanding the rules governing employees and independent contractors, you can make sure your choice is the right one for you.

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Fool contributor Dan Caplinger hasn't hired any employees or independent contractors, but has worked as both. He doesn't own any of the companies mentioned in this article. The Fool's disclosure policy always follows the rules.