In the U.S., there are many different types of employment. For instance, some workers are part-time while others are full. Some are salaried employees while others work on an hourly-bases (also called exempt or non-exempt, respectively). Among the highest-level of employment classification is the distinction between employees and independent contractors.
These differences may seem like simple labels used merely to categorize the American workforce; in reality however, they have wide-ranging implications for employers (and employees, for that matter) in terms of worker rights, compensation, and state and federal taxation.
Classifying your new hire as an employee or an independent contractor is an important first step in the onboarding process. Employers that misclassify their workers—whether by-accident or with malign-intent—can face financial penalties and other legal ramifications. For this reason, it’s crucial that employers understand the difference between an employee and an independent contractor.
Employee or an Independent Contractor?
When defining the term independent contractor, the key work to consider is independent. The independent contractor is their own discrete business entity. This is in-contrast to company employees, who are not an independent business, but rather workers within a company that operate as a part of that business.
This distinction seems intuitive enough, however, there is substantial grey area. Consider an independent contractor that works 36 hours per week for the same small business three months of the year. Are they a seasonal employee or a contractor?
In certain situations, the line between employee and contractor can get incredibly fine. This is important, as it’s the responsibility of the hiring company to determine an accurate and consistent classification for each new hire. Here are a few tips from the IRS for making this important determination:
- - Does the company have the right of control over what the worker does?
- - Does the company administer the financial and business aspects of the worker’s job?
- - Does the company provide ‘typical’ benefits to the worker (ie. personal time-off, 401k plans, pensions, health or dental insurance)?
- - Does the company provide equipment or tools for the worker?
The first point here (the right of control) is of particular importance. State and federal agencies, such as the IRS, normally rely on the “right of control” test to determine whether a worker is an employee or independent contractor. Can the company control what the worker works on, as well as when they work and how they perform their job? Or, on the other hand, is the company’s input limited to accepting or rejecting the final results?
This test is grossly ambiguous, and tends to disintegrate when you consider more experienced, trusted, and independent employees that—despite their status as an employee—tend not to be told how to do their job. Nonetheless, this is the main IRS assessment when determining the status of a worker.
States are also interested in the distinction between employees and contractors, as it has implications in workers compensation and unemployment insurance laws. They too tend to use the right of control test, but also focus on the financial relationship between company and worker. This is called the economic realities test, and it considers the degree that the worker is economically dependent upon the business (assuming that independent contractors tend to be more financially independent than company employees).
The Consequences of Misclassification
So, we’ve seen that there is no bona fide test for government officials to determine the classification of a new worker, but why do they care to begin with? The IRS and other State revenue agencies are incredibly involved in the employee/contractor distinction because it has major legal implications in terms of worker rights, compensation, and—most importantly—taxation.
In short, when a new worker is classified as an employee, the company is required to withhold income taxes, social security, Medicare, and other state dues from their paycheck. Conversely, when the new hire is an independent contractor, these taxes generally aren’t withheld. In other words, federal and state taxation only applies to the employee-business working relationship. However, hiring an independent contractor is more akin to a business-to-business relationship, thus these taxes largely don’t apply.
From a company’s perspective, this means that it’s notably less expensive to hire an independent contractor than a full- or part-time company employee. As one may imagine, many owners choose to intentionally misclassify employees as contractors to protect their financial bottom line—albeit illegally. Although this is undoubtedly unlawful, it’s particularly difficult for officials to detect and prevent. The labor department estimates that over a quarter of all U.S. companies misclassify workers, costing the government billions of dollars each year.
At the very least, the legal consequences of misclassification will include payment of back-taxes. The ramifications only increase when the misclassification is done intentionally, and repeat-offenders will incur substantial financial penalties or even jail-time.
Remember, the ‘employee/contractor’ classification has legal implications on two levels: the State and the Federal. So when a company is penalized for misclassification—either intentionally or by-accident—the disciplinary actions are two-fold.
For business owners, your best bet is an accurate and fair classification immediately following a new hire. Because the correct determination can be tricky, an attorney with experience in business or employment law can be of great assistance.