An employee works under company control with consistent wages, while contractors operate independently with project-based pay and flexibility. Misclassification risks fines, unpaid taxes, and lost worker benefits, emphasizing the importance of accurate classification.
By Brad Nakase, Attorney
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If you are the owner of a company and you are considering hiring a new employee, you will need to determine whether or not you will be hiring them as an employee or as an independent contractor. We’ll explain what an independent contractor is and how they differ from employees, as well as why these distinctions are important.
Misclassification is a major issue since it could lead to employees losing out on benefits and legal safeguards in the workplace. Employers may also have difficulties due to misclassifications, as they may be subject to penalties and legal action.
People who run their own businesses and work as independent contractors generally take on short-term contracts to complete specific projects for different companies. Employees, on the other hand, are those who have committed to working for a single employer on a consistent basis. Sometimes it’s easy to tell who’s an employee and who’s an independent contractor.
An information technology expert you hire to install a new network for your company is likely to operate as an independent contractor. Sometimes the line isn’t so clear. Imagine your company has been working on a large project for a few months, and you need to cover some ground, so you hire a temporary worker. There are a number of considerations that might determine whether this individual is an employee or a contractor.
The common law, the Fair Labor Standards Act, and the Internal Revenue Service (IRS) have all contributed to clarifying the distinction between an independent contractor and an employee. Several tests exist for determining whether an individual is an independent contractor, but they all have certain commonalities.
For instance, all of them focus on the extent to which the employer controls the employee, but they give little consideration to the parties’ own accounts of the nature of the relationship. So, it’s safe to assume that an employer-employee relationship is the best way to describe the dynamic between your business and an employee. It doesn’t matter if you had them as a contractor in mind.
When classifying a worker as an employee for federal tax purposes, the IRS considers three factors: the type of connection, behavioral control, and financial control.
As a kind of behavioral control, most employers have their employees work certain hours at a certain place. To get the work done, they make use of the resources and tools provided by the business. No one else can do the job; in most companies, workers can’t just hire help when they need it. Equally suggestive of an employer-employee dynamic is an assessment system that tracks specifics of job performance.
People who work for themselves, on the other hand, get a lot more say over when and how they get their jobs done. Workers are independent contractors who set their own schedules, bring their own equipment (e.g., consultants bring laptops, roofers bring hammers), and are responsible for their own safety. It is common practice for contractors to be able to maintain or employ their own workforce. Last but not least, an independent contractor’s performance review should focus solely on the final product.
Employers maintain tight financial control by paying their workers a salary or an hourly wage. The taxes deducted from employees’ paychecks and payments are scheduled to occur on a regular basis, usually every two weeks or month. Workers do not send bills to their bosses.
Contractors, in contrast to employees, have put money into their own firm, often by covering their own costs. So, they stand to gain or lose financially from its success. The conditions of payment for contractors can also differ. It is common practice for contractors to charge for time and/or deliverables, as opposed to salaried workers.
Hourly or project-based rates are one possibility; upon completion of the work, half of the total amount is due immediately; the remaining half is due thirty days later. Contractors who handle frequent demands and demand early payment often use retainers as well. When paying a contractor, businesses do not deduct taxes.
Employees can anticipate permanently continuing the relationship with the company, as well as performing work that is necessary to the operation of the firm. You may count on your cooks to work either part-time or full-time if you run a restaurant. After all, you can’t open for business without the individuals who will make the food!
Contractors carry out specialized, short-term tasks. For instance, you may employ an interior designer to spruce up your workplace or a grant writer to assist your nonprofit in submitting an application for a targeted grant. Although the distinction can be blurry, the Internal Revenue Service usually assumes an employment relationship when uncertain.
If you’re having trouble telling them apart, this useful guide should help:
Employee
Independent Contractor
There are no hard and fast laws, but these guidelines might help you decide if you need an employee or an independent contractor. Even though their time and location are flexible, an employee is typically still someone who uses a business laptop and works 40 hours a week from anywhere they choose. There are a lot of factors to think about when deciding whether someone is an employee or an independent contractor, such as the length of time the connection has lasted and how frequently they work for your organization.
Get in touch with a wage-and-hour attorney if you still have questions regarding employee classification or if your case is more complex.
Are you still confused? Submit a Form SS-8 to the Internal Revenue Service. Both the employer and the employee are required to fill out this form. After you submit the form, the Internal Revenue Service will look into it and provide you a ruling telling you whether the worker is an employee or an independent contractor.
The manner in which you pay, tax, and organize your working relationships is dependent upon the classification of your employees.
People who want more flexibility in their work hours and locations sometimes opt to become independent contractors. If a company simply needs help with a single project, they might save money by hiring a contractor. Misclassification of an independent contractor exposes them to liability in multiple areas, despite the fact that it might be advantageous for both sides. It is critical to classify your employees correctly for multiple reasons:
Assuming they aren’t planning on being an independent contractor from the start, workers typically seek out employee-only perks like health insurance, paid time off, and retirement savings plans. Workers who are incorrectly classified do not receive the same benefits that employees do, including wage and hour laws, overtime pay, workers’ comp, and unemployment insurance.
Is your employee a full-time employee, a freelancer, or someone who pops in a few days a week to lend a hand? In the end, the type and manner of your team’s work will determine their job classification, regardless of your arrangement or formal contract.
Even under a formal agreement, designating an employee as an independent contractor does not shield them from challenges brought by employees, the IRS, the US Department of Labor (DOL), or local or state authorities. Audits and litigation involving misclassification occur frequently and sometimes lead to significant financial fines and expenses.
It is customary for businesses to cover their workers’ tax obligations. Workers’ compensation and disability insurance premiums, as well as federal and state employment taxes, are part of this category. In contrast, businesses are exempt from paying these taxes on behalf of their independent contractors. On the contrary, contractors must pay their own taxes.
It is possible that you will be responsible for unpaid taxes if you incorrectly classify your employees.
Misclassifying an employee as an independent contractor could give them the legal right to sue you for unemployment benefits once their contract expires. In the event of an unintentional misclassification, penalties imposed by the DOL could go into the thousands of dollars. Misclassification of personnel, whether done intentionally or fraudulently, has resulted in hefty fines.
Around the corner, you suddenly hear someone shout out, “Ouch!” It turns out one of your employees just amputated their toe with a chainsaw. You are devastated that one of your workers was just injured at work. However, if you correctly classify them, the situation is generally not going to be as severe as it seems. Whether or not they are eligible for workers’ compensation benefits is dependent on their, and in most cases, only employees are eligible. While it is wise for contractors to have their own insurance, it is important to ensure that your workers’ compensation coverage covers all employees, regardless of their classification, as independent contractors may have the legal right to sue you in certain situations.
There are a lot of rules and laws that employees must follow in certain industries, such as education and health care. While this isn’t necessarily the case in every area, employers in highly regulated sectors may be required to hold more training sessions and keep more records related to their employees’ job.
It could be tempting to label your staff as independent contractors instead of employees when the cost of recruiting an employee can be as much as 30% higher. But unless they are in fact working as independent contractors, the prospective savings are not worth it. Between ten percent and thirty percent of businesses have misclassified workers, according to research by the National Employment Law Project 2020. For employers, this is of the utmost importance.
Your company might be in for some major trouble financially and legally if it misclassifies someone, whether on purpose or by accident. It could include paying back unpaid wages, including overtime pay, workers’ compensation benefits, employee benefits, retirement contributions, Medicare and Social Security contributions, health insurance, unemployment insurance, and any other costs related to the employee.
This would also include things such as back taxes and any penalties for federal and state income taxes. Under some conditions, you could even face legal action in a federal court.
Being proactive, rather than reactive, is the way to go when it comes to worker classification. Rather than putting off dealing with a possibly dangerous scenario until it happens, you should inform your employees of their classification from the get-go and ensure that their duties are defined in accordance with IRS and DOL guidelines.
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