If you own a business, you get to call the shots. Decisions about services, rates, location and staff are all yours to make. You can choose whom to hire, what jobs they’ll do and how they’ll be compensated. But you don’t get to say whether a given worker is considered an independent contractor or an employee. The IRS makes this distinction, and it’s based on an employee’s role and relationship to the employer.
Why Misclassification Happens
By law, employees and independent contractors can be treated very differently. Employees may receive benefits like health insurance and pension plans. An employer is responsible for withholding income, Social Security, and Medicare taxes from an employee’s wages, and must pay unemployment taxes and cover employees on workers’ compensation insurance. Employees are protected by labor laws like the Fair Labor Standards Act and may be able to access paid medical or family leave benefits.
Independent contractors get none of that. Employers don’t have to pay any taxes on a contractor’s wages and don’t have to provide any benefits. They have little responsibility to their independent contractors at all, other than the terms laid out in the agreement between the two parties.
Employers looking to save money sometimes decide to treat employees like independent contractors to save money on all those “extras.” Cutting benefits would save the average employer about 30% of its compensation costs. Employers that misunderstand how classification works see this strategy as a savvy way to save money without cutting staff. In other cases, employers misclassify employees simply because they don’t understand the difference between the groups.
Consequences of Misclassification
Misclassification is considered a type of wage theft. Benefits are part of an employee’s total compensation, and withholding the benefits to which an employee is entitled is illegal even if the employer does it unknowingly. Misclassification also deprives the government of tax revenue, so a report of this kind of violation will generally get the Department of Labor’s attention.
An employer that is found to have misclassified an employee will be required to pay any back taxes and back wages that are owed to the IRS and to the employee. It’s pretty rare to be fined for misclassification, although employers may be penalized if they fail to pay the back taxes and wages they owe.
Employees are often the ones who make the DOL aware of their own misclassification. Because these employees miss out on benefits and protections they’re owed, they’re likely to be angry with the employer. And because employer misconduct stories spread quickly over social media, even an unintentional misclassification could tarnish an employer’s reputation.
How to Classify Workers Correctly
Understanding the difference between employees and independent contractors is something a lot of business owners struggle with. The IRS suggests that employers consider three key categories when determining how to classify workers: behavioral control, financial control and the relationship between the employer and the worker.
There are key differences in all three areas that separate employees and independent contractors. When you’re trying to correctly classify a specific worker, ask yourself questions related to each of these areas:
Behavioral Control: As the employer, do you control how a worker does his or her work? Do you instruct the worker on when and where to work, what equipment to use and where to get work equipment from? Do you train the worker to complete the work in a specific way? If so, the person is probably an employee.
An employer controls the result of an independent contractor’s work, but not how the work is done. The contractor can work from anywhere and at any time, using whatever means he or she chooses.
Financial Control: As the employer, do you cover business expenses for the worker? Do you reimburse the worker for most or all of the business expenses they incur? If the business had a large loss one month and a large profit the next, would the worker’s earnings remain about the same? If so, the worker is probably an employee.
An independent contractor is self-employed and has a financial stake in his or her own business. Contractors are generally responsible for their own business expenses, unless they negotiate something specific with a client. They can deduct business expenses on their income taxes.
Relationship Between the Parties: As the employer, do you provide any benefits to the worker? Will the relationship continue indefinitely, as opposed to having a set end point or end goal? If so, the worker is probably an employee.
An independent contractor is typically contracted for a set period of time, with an expectation that the worker will either move on to other work or start another contract when the original contract is satisfied. And again, an independent contractor generally doesn’t receive any employer-provided benefits.
Employee classification is more complicated than many employers realize. Making a mistake now could leave you on the hook for thousands of dollars in back taxes later on. If you have questions about classifying workers, our team is here to help. Contact us and register for our free webinar Independent Contractors: Avoiding Misclassification on July 16 at 1:00 PM EST.