What Employers Need to Know About Contractor vs. Employee Classification

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Oftentimes, classifying a new hire as an employee seems like common sense—they’re working 40 hours a week in your office, after all. Some workers, on the other hand, might work primarily from home, or only work 25 hours a week. Does this make them a contractor? Well, it depends. 

As you grow your business and hire new employees, you’ll find yourself needing to distinguish how you classify some workers vs. others. It can get murkier than you might expect (see Uber’s 2015 legal battle with the California Labor Commission regarding whether or not their drivers are considered employees). How you classify new workers is something you’ll need to determine every time someone is hired, so it’s important that you understand the relevant factors. 

Worker classification depends on many variables and can get convoluted quickly. In this post, we’ll lay out the financial, labor law, and tax differences between an employee versus contractor and provide guidance to help you make the right decision for your next hire.

How Worker Classification Impacts Taxes

Ultimately, the main reason why correct classification is of such vital importance to businesses is its effects on taxes. 

Independent contractors are responsible for paying the taxes on their income. This means the business paying the worker doesn’t do much legal work. When paying a contractor, you aren’t responsible for withholding employee payroll taxes, paying the employer portion of payroll taxes, paying workers’ compensation premiums, or offering benefits. Simply pay the person and issue them Form 1099 at year-end. The contractor pays its own income tax on a quarterly basis

Conversely, when paying an employee you must withhold employee payroll taxes, pay the employer portion of payroll taxes, pay workers’ compensation premiums, potentially offer benefits and issue a W-2 at year-end. On average, there is an additional 15-20% cost to pay the same wage to an employee versus a contractor.

After learning this, many business owners see the short-term cost savings worth the risk to misclassify a worker. Don’t do it! Misclassifying employees and contractors can result in a business owing money to workers, so it’s important to get it right. Even if the worker verbally agrees to the contractor classification, if the business relationship goes sour, the worker can still file for unemployment benefits and you can still be liable for back taxes – not to mention an employment audit.

The Accurate, but Tedious Process of a Formal Worker Classification Ruling

The only way to get a formal worker classification ruling is by filling out Form SS-8 and sending to the IRS. You’ll answer 57 probing questions about the working relationship between you and the worker, then wait a few months for the IRS to respond. 

Don’t want to do this? Didn’t think so. Understanding the key differences between an independent contractor and an employee is all that is needed for a business owner to self-determine the appropriate worker classification of a new hire.

The Difference Between Contractors and Employees

It all boils down to control. If you control the working relationship and give clear direction to the worker they are an employee. If the worker controls the relationship and doesn’t take much direction from you, in most cases, they are a contractor.

Below are some clear factors that can help you make this distinction:

Contractors

  • Sets their own hours
  • Provide their own tools
  • Work on a temporary basis
  • Don’t take many directions from you

Employees

  • Don’t set their own hours, you dictate them
  • Are provided all tools, equipment, uniforms, etc. to perform their job
  • Work on a permanent basis
  • Are given direction by you

Where Things Get Complicated: How to Classify Workers
Who Don’t Easily Fit into One Bucket

If you look at the bullet points above showing the main differences between contractors and employers and find that you have some workers who share aspects of both, you’re not alone. Just having one of those factors doesn’t magically mean you can fit someone into one classification or the other.

The IRS recommends businesses consider three criteria to help them determine the proper classification per worker: 

1. Behavioral Control

As mentioned previously, a worker is more likely to be considered an employee when the business has the ability to control how the work is done. This can fall into the type of instructions given, the degree of that instruction, training, and how the work is evaluated. 

2. Financial Control

The rule of thumb here is that if a worker is paid a consistent salary, they’re probably an employee. If they’re paid a flat fee per project or per hours spent working, however, they’re likely considered a contractor. 

Independent contractors are typically allowed to work for multiple businesses simultaneously, incurring profits and losses. They also usually provide their own tools to perform their jobs, be that equipment or training. 

3. Type of Relationship

Relationship in this instance refers to written contracts, employee benefits, the permanency of the relationship (i.e. short-term vs. long-term), and whether or not services provided play a key role for the business. Based on these factors, a worker is more likely to be considered an employee if they receive things like PTO or benefits, or if their services related you the core product or service offering of your business. 

Classify Confidently

As a business owner, have a conversation upfront before you hire any worker. If you’re going to treat a worker as an independent contractor, get a signed agreement detailing the work to be performed, tax classification status, make certain the worker provides an invoice for their services and have them complete form W-9 for your records.

Have questions about your next hire? Drop us a line – we’re here to help!

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