Mid-sized business owners have all kinds of reasons to bring on independent contractors versus employees, and vice versa. But before employers decide to bring in new faces, they have a big decision to make: How do you know if new talent should be classified as independent contractors or employees?
If a company’s workers are misclassified, you, whether you’re heading up the corporation’s HR department, or are a mid-sized business owner, could be in some hot water with federal officials who regularly clamp down on companies that have run afoul of the rules.
The U.S. Department of Labor, for instance, required a Michigan-based general contractor to pay $137,230 in back wages and liquidated damages, in part, because some of its employees were misclassified as independent contractors.
In fact, plenty of companies are getting it wrong. One study found that 10 to 20 percent of employers incorrectly classify at least one employee as an independent contractor.
If you plan to bring on board additional people for your mid-sized business, corporation or startup, here’s what you need to know about correctly classifying employees and independent contractors.
Why does the federal government care how my employees are classified?
It all comes down to money. When you bring on a new employee, you’ll need to withhold taxes from their paycheck, including income taxes, Society Security payments, Medicare taxes and unemployment taxes.
When you hire an independent contractor, you typically don’t pull out those items from the payments you make to them. Instead, the independent contractor pays self-employment tax, which is determined by using the net earnings from their work.
What’s the difference between employee status and independent contractor status?
To determine how to classify your new worker, you’ll need to understand how the Internal Revenue Service considers employees and independent contractors. To decide how a worker should be treated, the IRS consults three categories.
Your worker is an employee if you direct and control the work they perform.
Here are some questions to ask yourself.
- Where and when the individual will work?
- What tools or equipment they must use?
- Where they will purchase supplies and services?
- Who will do the work that you’ve assigned?
- What order or sequence the worker must follow to get the job done?
If you answered yes to one or more of these questions, it’s likely your worker is an employee.
Independent contractors typically decide where they’ll work, provide their own equipment, complete the work on their own time and can delegate tasks to others if needed.
The second category determines whether the business has a right to “direct or control the financial and business aspects” of a job, according to the IRS. Has your mid-sized business, for instance:
- Significantly invested in the equipment the worker is using?
- Reimbursed the worker for expenses?
- Paid the worker a regular wage or for hourly or weekly work?
If you’ve answered yes to any of these questions, there’s a good chance your worker is an employee.
According to the IRS, independent contractors typically don’t get their expenses reimbursed; are often, but not always, paid a flat fee for a job; and can seek out other business opportunities beyond your workplace.
The third category focuses on how the worker and business “perceive their interaction” with each other.
Here are three questions your mid-sized business should consider as you contemplate your relationship with the worker:
- Do you provide the worker benefits such as health insurance, workers’ compensation and a retirement plan?
- Is it expected that the worker will work for you indefinitely?
- Does the worker provide services that are an essential function of the company?
If that describes your relationship with the worker, it’s likely they are an employee. Independent contractors typically don’t receive benefits and don’t work for an employer indefinitely.
If you’re still not sure whether your worker is a contractor or employee after reviewing the three categories, you can file Form SS-8 with the Internal Revenue Service, which will then establish which category your worker falls under.
What are the consequences of misclassifying an employee?
When you misclassify an employee as an independent contractor, mid-sized businesses can face costly back-taxes and penalties from federal regulators. If you plan on bringing on more workers to help your mid-sized business, get familiar with the IRS rules and consult a trusted advisor, including an attorney, to ensure you’re making the right decision to protect your business.
How can your lawyer help you?
Have your attorneys create solid Employee Offer Letters, Employment Agreements, and Independent Contractor Agreements so that the relationships between your company and your talent (employees and consultants) are clearly documented.