The receptionist who sits behind a company’s front desk for 40 hours a week is clearly its employee, and the consultant who came in for a one-day job is clearly an independent contractor. But what about remote workers, or traveling salespeople, or temps, or tipped service workers?
The difference between employees and independent contractors is a subject that confuses even seasoned business owners. Some employers mistakenly believe that it’s their choice whether or not to classify workers as employees or independent contractors. In actuality, employers must make this distinction based on a set of criteria provided by the IRS. How workers are classified is determined by how an employer defines their roles.
Who’s an Employee?
The majority of American workers are classified as employees. Whether or not the employer controls how, when and where work is done is a big part of determining classification. If an employer requires workers to use its equipment and to be at their work stations during set hours, those workers are being treated as employees and have to be paid and taxed as such.
Employees may or may not get employer-provided benefits like paid vacation time, health insurance coverage and pension plans. They’re protected by labor laws like the Fair Labor Standards Act and should be covered by their employers’ workers’ comp insurance.
How Employees are Paid and Taxed
An employer may pay an employee a salary or an hourly rate, with payments based on a set pay period. State and federal laws determine how often employers must pay employees. (Here in Massachusetts, employees must be paid weekly or bi-weekly. They must be paid within six or seven days of the end of each pay period, depending on how many days they worked.)
An employee who starts a new job or has a major life event must submit a W-4 with her Social Security number and information about any withholding allowances she’s claiming. It’s the employer’s responsibility to withhold income tax, Social Security and Medicare taxes from an employee’s pay, with the employee contributing an equal share of Social Security and Medicare taxes. The employer must also pay federal unemployment taxes for any employees. At the end of the year, the employer reports the employee’s earnings on W-2 forms.
Who’s an Independent Contractor?
Independent contractors are self-employed. Employers have less control over these workers than they have over employees. They control the result of the work that independent contractors do, but not the actual work itself.
Contractors decide when, where and how they work. They use their own equipment, rather than using employer-provided equipment, and they can take tax deductions for business expenses. These workers aren’t given benefits as part of their compensation, so they tend to charge higher rates than what an hourly or salaried employee would earn for the same amount of work. They’re not protected by labor laws and they’re not eligible for unemployment or workers’ comp benefits.
How Independent Contractors are Paid and Taxed
An independent contractor is paid according to whatever agreement he makes with the employer. He may be paid weekly or monthly, or in a lump sum when the work is completed.
An independent contractor isn’t paid in the same way that an employee is. When the contractor begins work for an employer, he submits a W-9 form. It asks for the contractor’s Taxpayer Identification Number, which may be a Social Security number or an Employer Identification Number. The employer reports a contractor’s annual earnings using Form 1099, if it paid the contractor more than $600 during a calendar year, and is not required to withhold any taxes from the contractor’s pay. It’s the worker’s responsibility to pay income and other taxes.
Making the Distinction
An employer that misclassifies an employee as an independent contractor can be required to make up any unpaid employment taxes on those employees. (It’s far less common for an employer to misclassify an independent contractor as an employee.) Misclassification cases may involve lawsuits and penalties, too. It’s not a mistake that any employer wants to make.
When an employer is uncertain about a worker’s proper classification, IRS guidelines provide clarity. The IRS requires employers to consider three categories when making classification distinctions: behavioral control, financial control and relationship of the parties.
Behavioral Control: If the worker receives specific instructions about how to do the job, is trained by the employer and is evaluated over the course of the work (as opposed to just the end result being evaluated), the worker is probably an employee. Independent contractors have more behavioral control over their own work processes.
Financial Control: If the worker has business expenses covered by the employer and is paid a regular weekly or biweekly wage, the worker is an employee. An independent contractor may be paid a flat fee, can pursue other work without the employer’s permission, is responsible for business expenses and has the opportunity for profit or loss.
Relationship of the Parties: If the worker is eligible for benefits and is understood to work for the employer indefinitely, the worker is probably an employee. An independent contractor may work on a set project or for a set time period but is not generally understood to have a permanent work arrangement with the employer.
Even with IRS guidance, making this distinction can be tricky for businesses. That’s especially true for employers with unconventional organizational structures. But while misclassifying a worker might be an honest mistake, that explanation won’t shield you from the consequences – so it’s really important to get this right from the start with each worker.
If you still have questions about worker classification, our team is happy to help. Contact us today, and sign up for our free webinar Independent Contractors: Avoiding Misclassification on July 16 at 1:00 PM EST.