How to Correctly Classify Your Workers: Employee or Independent Contractor
Hiring independent contractors (ICs) can be a strategic move for business owners who want to tackle specific projects or ongoing business needs. While ICs offer some advantages over traditional employees, correctly classifying your workers is crucial.
The law treats employees and ICs differently regarding taxes, benefits, insurance, and liability. If an individual is misclassified, dealing with the fallout of back taxes, fines, amended tax returns, and even civil lawsuits can be expensive and stressful. As governments intensify efforts to optimize tax collection, proper worker classification becomes an increasingly essential aspect of business operations.
The Common-Law Classification Guidelines
Businesses must classify individuals providing services as either employees or independent contractors. This distinction hinges on the level of control the business exerts over how, where, and when the work is performed. There's no single definitive factor; rather, it's a multi-faceted analysis.
The Common-Law Test considers three key categories: behavioral control, financial control, and the nature of the relationship. By examining these criteria in their entirety, businesses can ensure accurate classification.
Below is a breakdown of the critical aspects to consider when classifying your workers as employees or independent contractors.
Behavioral Control
The primary factor in worker classification is the business's degree of control over the individual's work methods. Here's a breakdown of key indicators:
Level of Instruction: The extent to which detailed instructions are provided on how, when, and where to perform the work is crucial. The more detailed the instructions mirror those given to employees, the higher the probability that the individual is an employee.
Training: The amount and type of training offered, especially if it dictates how the work is done, is regularly provided, or mandatory, strengthens the case for an employee classification.
Performance Evaluation: Performance evaluations focused on how the work is done, rather than if the individual delivers the agreed-upon results, lean towards an employee relationship.
Scheduling: While deadlines and milestones are standard for ICs, micromanaging an individual's specific work schedule indicates an employee relationship. This will vary based on contract details.
Work Methods: While a business owner typically defines the desired result or outcome, the IC will generally determine how the work is accomplished. An employee relationship is more likely if the business owner manages the details of how the work is performed.
Financial Control
The level of financial risk an individual assumes also reflects their classification. Independent contractors generally shoulder more financial responsibility for the methods, tools, and outcomes associated with their work. Here are the financial factors to consider:
Market Availability: Does the individual offer their services to the broader market? Advertising, registering a business, and maintaining a market presence all suggest that the worker is an independent contractor.
Investment in Resources: Independent contractors typically invest in their own tools, equipment, and training. This financial commitment demonstrates their independent business operation. Conversely, if the business provides these resources, it suggests an employee relationship with benefits like training or equipment provided. There is no specific dollar limit used as a threshold.
Expense Management: Independent contractors typically cover their own business expenses, including fixed and ongoing costs, without reimbursement from the hiring business.
Payment Structure: Independent contractors usually receive flat project fees rather than periodic payments like salaries. Exceptions exist for professionals like lawyers or accountants with established fee structures.
Type of Relationship
While the nature of the relationship between a business owner and a worker can be informative, it shouldn't overshadow the control factors listed above. Some aspects of the relationship might appear in both employee and contractor scenarios. Here some things to consider when looking at the worker relationship:
Benefits: Employee benefits are usually not offered to independent contractors, and many benefit plans specifically exclude non-employees from participating.
Work Term: The relationship with an IC is often temporary or project-based, but temporary work alone doesn't determine classification.
Core Function: An IC's services are not typically a key aspect of the business, such as a law firm bringing on an attorney.
Can an Individual Be Both an Independent Contractor and an Employee?
This is a frequently asked question and typically applies to two unique situations. The first is when an existing employee offers additional services outside of their regular duties. For example, an administrative assistant might want to clean the office after hours. It is possible to classify the worker here as an independent contractor for the cleaning only if the control factors for those services have been clearly addressed. This situation presents two very significant ramifications:
Dual Tax Forms Raise Red Flags: Issuing both a W-2 (employee) and 1099 (contractor) form for the same person can trigger an audit by the tax authorities. Be sure to have everything clearly documented.
Misclassified Work Can Be Costly: If, after an examination, the agency determines that an employee/employer relationship existed for both types of work and rejects the IC classification for the cleaning work, the employer may be liable for overtime pay as well as back taxes on the 1099 income.
Similar considerations apply to retirees seeking part-time work. While classification as an independent contractor is possible if control factors are met, temporary or occasional work doesn't guarantee it. Issuing both a W-2 and 1099 in the same year for the same person again increases the audit risk.
Remember, the key factor in classifying someone as an independent contractor isn't the duration, frequency, or even the difference in work compared to their previous role. The control factors stated earlier (instruction, training, evaluation, scheduling) truly determine classification. Issuing both a W-2 and a 1099 for the same person in the same year raises a red flag for tax authorities and increases the chance of an audit and potential reclassification.
Recordkeeping and Reporting of Independent Contractor Payments
Here's what you need to know about record keeping and tax reporting for independent contractors.
Obtain a W-9 Form: This form collects the independent contractor's name and Taxpayer Identification Number (TIN). The TIN can be a Social Security number for individuals or a Federal Employer Identification Number (EIN) for businesses.
Report Payments Over $600: Use Form 1099-NEC to report payments of $600 or more made to the contractor in a calendar year.
Check State Requirements: States may have different filing requirements and deadlines for Form 1099. Always consult your state's tax authority for specific regulations.
Check Essential Deadlines: A copy of the 1099-NEC is due to the IRS and independent contractor by January 31st of the following year. State deadlines may vary.
Consequences of Misclassification
While independent contractors offer advantages in cost and management compared to employees, it's crucial to use this option correctly. Misclassification can lead to lengthy and expensive disputes involving taxes, worker's compensation, labor laws, benefits, and even lawsuits.
Worker status is a growing target for federal and state tax authorities. They are looking to close the "tax gap" – the difference between what should be taxed and what's actually reported. The IRS and Department of Labor's joint "Misclassification Initiative" target industries with high misclassification rates, like construction, healthcare, and landscaping. Here's what the initiative entails:
IRS Reclassification: The IRS identifies misclassified workers. Employers can avoid penalties by reclassifying them before being contacted by the IRS and consistently filing 1099 forms. Back taxes and penalties still apply, but some may be waived for small employers who cooperate.
Department of Labor Involvement: The IRS informs the Department of Labor (DOL) about reclassified workers. The DOL may investigate minimum wage and overtime violations, potentially leading to back pay for workers.
So, what happens if you misclassify a worker?
Back Taxes and Penalties: The IRS may assess Social Security and Medicare taxes on misclassified workers, leading to amended tax returns and higher tax deposits. Penalties might be waived for small employers who cooperate.
Wage and Hour Issues: The Department of Labor may investigate minimum wage and overtime violations, potentially resulting in back-pay awards to workers.
Since 2007, the IRS has also collaborated with states to share information from tax audits. States can investigate independently and trigger enforcement actions as well. This combined effort increases the risk of getting caught. These situations make it critical that both the individual and business clearly determine the work classification and thoroughly understand the ramifications of the business-contractor relationship.
The Bottom Line
Independent contractors offer small businesses a fantastic way to outsource projects, freeing up time to focus on core operations. Contracting is perfectly safe and effective when care is taken to determine the appropriate work classification.
The IRS website offers resources to help with initial classification and filing; however, the information can be overwhelming and confusing. Your attorney or tax advisor may be a better place to get started. As always, your PayWorks Payroll team is available to help you navigate complex situations and answer specific payroll questions.
PayWorks is not providing legal or tax advice. The information on this website is for informational purposes only and should not be relied upon as legal or tax advice. You should consult with your own legal and tax advisors before making any decisions about your financial situation.