If your business is looking to expand, you first have to decide whether to hire employees or work with independent contractors.
This article explains everything you need to know to make an informed decision and avoid the potential consequences of misclassification.
Learn the Basics of Workers Classification
In this section, we explain the basic terms involved and also provide definitions given by the IRS.
What is Worker Classification?
The IRS calls the decision of whether someone is an independent contractor an employee a matter of "classification." If the person you hire is not classified correctly, the Internal Revenue Service views that as a matter of "misclassification."
In many states, intentional misclassification of an employee as an independent contractor is a criminal offense that can have serious legal and financial consequences.
For this reason, it is important to know the difference between independent contractors and employees, so your business can stay compliant with federal and state laws.
What is an Independent Contractor?
An independent contractor is a working professional who owns and operates a business. Consultants, accountants, carpenters, and other professional service providers are common examples of independent contractors.
In more general terms, contractors:
- Work on their own terms to complete a given task
- Set their own hours (though a project deadline is often part of the contract)
- Use their own equipment and tools
- Are self-employed, and pay self-employment taxes
According to the IRS, "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."
What is an Employee?
An employee is someone your business hires to perform a specific role or set of roles within your company. Employees are compensated in terms of hourly wages, an annual or monthly salary, commissions, other benefits, or a combination of the above.
Employers provide structure to an employee’s role in one or more of the following ways:
- Setting specific working hours (i.e. Monday - Friday, 9am - 5pm).
- Supplying equipment, such as a computer, desk, or cellphone.
- Training the employee to handle certain responsibilities.
- Offering benefits packages, including paid vacation time, health care, retirement plans, etc.
The IRS defines an employee as "anyone who performs services for you … 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."
How to Make the Right Classification
There are a number of different factors to determine if an individual should be classified as an independent contractor or an employee. In this section, we go over the main questions you will need to consider to make the best decision.
Who Controls Worker Behavior?
The first and most important factor that determines whether a person is an employee or a contractor is behavioral control.
When it comes to employees, the employer has a significant degree of control over how a particular job is performed. For example, an employer may:
- Offer on-the-job training and instruction
- Provide employees with work-related equipment or software
- Set specific working hours (e.g. 9 a.m. - 5 p.m.)
These and other similar factors suggesting strong behavioral control almost always indicate an employer-employee relationship.
A contractor, on the other hand, will typically:
- Bring their own expertise to the job
- Use their own equipment
- Set their own hours
Who Determines Financial Compensation?
The next factor to look at when assessing employee classification is financial control.
When hiring employees, an employer has a large degree of control over how the employee is compensated. They can freely give raises or bonuses, or even implement pay cuts if they are dissatisfied with the worker's performance.
With a contractor, however, financial compensation is often arranged on a per project basis. It is common for multiple contractors to make bids for a given project, and then the paying company selects which contractor it wishes to hire. Once terms for the agreement are set in writing, both parties must abide by the contract.
In this way, a contractor retains a significant amount of control over how they are compensated.
Are There Any Other Factors Influencing the Relationship?
Finally, there are a number of other factors to consider in order to determine whether or not a worker is properly classified.
The following items suggest an employer-employee relationship, and these should be avoided when working with contractors:
- Offering benefits, such as paid vacation days, a gym membership, or a health insurance package.
- Paying a monthly or annual salary that is not directly tied to a specific set of assignments/projects
- Providing a designated co-working space
Unfortunately, the distinction between independent contractors and employees is not always perfectly clear-cut. According to the IRS, "There is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor, and no one factor stands alone in making this determination."
It is all the more important, therefore, to be careful when classifying your workers. When necessary be sure to seek outside counsel from a lawyer or certified public accountant.
Recommended: Learn more about worker classification by checking out our summary of the full set of factors listed on the IRS website.
Why is Classification Important?
Worker classification is a very important decision that can have far-reaching consequences for your business. In this section, we will look at the main reasons why you should take worker classification seriously.
Worker Tax Withholding?
The way that a business pays and withholds taxes differs for both employees and independent contractors.
Employee Tax Withholding
For employees, the employer needs to:
- Withhold FICA taxes from the employee’s paycheck
- Render those taxes to the state and federal governments on the employee’s behalf
- Match the amount of FICA taxes paid (this is known as the employer’s contribution)
Then, at the end of the tax year, employers must send a completed W-2 form to all employees so that they can complete their personal tax filing.
Contractor Tax Withholding
The general rule is that companies need not withhold taxes for their independent contractors. This is because the vast majority of contractors operate as self-employed workers, and thus they pay the entirety of their FICA tax obligations.
The Risks of Worker Miscalculation
Because employees cost employers a significant amount in payroll services and tax obligations, many small businesses in the past have attempted to misclassify their employees as contractors. In this way, they attempt to avoid the paperwork and costs associated with hiring employees.
However, if the IRS finds out a company has done this, and if it disagrees with the classification decision, then the employer may be held liable for back taxes.
The range of penalties varies depending on whether or not the misclassification was a mistake or intentional, but it can be up to 200% of what the employer was supposed to pay during the duration of employment, plus an additional fine.
As the IRS clearly states, "If you classify an employee as an independent contractor and you have no reasonable basis for doing so, you may be held liable for employment taxes for that worker."
For more tips on worker classification, including a number of industry-specific examples (construction, trucking, computer technology, automotive, law, etc.), check out the IRS Employer’s Supplemental Tax Guide.
Protection Against Miscalculation
To avoid the risks of worker misclassification, here are four easy steps you can follow:
Step 1: Understand the Law
It is essential to have a thorough understanding of the differences between an employee and an independent contractor so that your business can avoid making the mistake of worker classification.
Step 2: Document Decision Factors
Creating a record documenting why you made a worker classification decision can not only help you make a reasonable choice, but also help you defend your decision in case you are ever challenged by the IRS.
Note: Many hiring decisions are straightforward and will not require extensive documentation. Keeping a written record of classification factors will be especially helpful whenever a case is borderline or otherwise uncertain.
Step 3: Collect Documentation from the Worker
If you do decide to classify a worker as a contractor, you may wish to collect from them additional documentation, such as:
- Entity filings with your state (Articles of Organization/Incorporation, or even a DBA form filed with a local county)
- Business or professional licenses they hold
- Insurance policies showing that they have their own coverage
- A list of other entities the contractor has serviced
- Business cards or other advertising materials which portray them as a contractor
Step 4: Have a Written Agreement
A written agreement with the worker can serve several functions. At the most basic level, this type of agreement says that the worker is an independent contractor and not an employee.
An Independent Contractor Services Agreement typically outlines a number of factors that will serve to classify the worker as a contractor and not as an employee.
Free Independent Contractor Services Agreement Template
TRUiC offers a number of free legal forms to help entrepreneurs like you, including a sample contractor agreement.