Classifying workers: a taxing situation
The fuss over employee classification comes down to taxes.
If a staff member is classified as an employee, you need to withhold, deposit, report, and pay employment taxes, withhold and pay Social security and Medicare Taxes, and pay unemployment tax on wages paid. The IRS also requires that you file special paperwork for employees.
If a worker is classified as an independent contractor, you aren’t required to do as much legwork. Independent contractors arrange and pay their own income tax quarterly, aren’t given any benefits, and aren’t eligible for things like unemployment insurance.
Not withholding taxes and benefits (or incorrectly withholding them) doesn’t just put an undue burden on employees and contractors. If you “misclassify” a worker and don’t correctly withhold or pay the required amounts, the IRS may flag your business and come after any money owed.
So what’s the difference between an employee and an independent contractor?
Employees get paid a regular wage, have taxes withheld from those wages, and they have their work and schedule dictated by the employer. Independent contractors are the reverse. They tend to get paid for projects, they worry about their own taxes, and work when and where they want.
The difference boils down to control: if the employer is dictating all the terms and doing so consistently over time, the person is probably an employee.
The three IRS tests
But as the IRS explains, there is no “magic” single factor that makes the worker an employee or an independent contractor.
Instead, the IRS encourages companies to assess the relationship they have with their workers holistically, based on three broad criteria: behavioral control, financial control, and type of relationship.
If you’re not 100% sure whether your workers should be classified as employees or contractors, think of these as three “tests” you can apply to your relationship:
1. Behavioral control
The degree to which you exercise control over your workers’ time, work life, and tools affects how they’re classified by the IRS.
If you train the worker, direct their tasks, set specific hours, and dictate how the work should be completed, the IRS is more likely to classify them as an employee.
On the other hand, if the worker sets their own hours and decides how and when to get the job done, that could mean they’re an independent contractor.
If you’re planning on hiring an independent contractor and want to make sure there’s no confusion about how they’re classified, just remember that only the result of their work will be under your control. If you want to be able to dictate the way that the work is carried out, you might want to consider hiring an employee instead.
2. Financial control
If the worker is paid a salary or guaranteed a regular company wage, they’re probably classified as an employee. If the worker is paid a flat fee per job or project, they’re more likely to be classified as an independent contractor.
Independent contractors usually also have what the IRS calls a “significant investment” in their business—whether it be equipment, training and licensing—and aren’t reimbursed for expenses like fuel, tools, and office supplies.
Unlike employees, independent contractors are also usually allowed to carry out work for other businesses, and can incur a profit or loss, just like any other small business.
3. Type of relationship
The type of relationship you have with the workers you hire also affects how they’re classified.
If a worker provides you with services directly related to your business’ core work, that makes it more likely that the IRS will see them as an employee. If you grant someone benefits (like sick days and health insurance) that also makes it more likely for them to be an employee.
What the IRS calls the “permanency” of your relationship also factors in. Independent contractors are usually brought on for the short term, to carry out a set amount of work. If you bring someone on board for the long term and expect them to work for you indefinitely, they’re probably an employee.
Let’s say you run a coffee shop and you pay a graphic designer a lump sum to create new menus and business cards for your cafe over a specific period of time. In this case you are most likely hiring an independent contractor.
On the other hand, if you hire a barista 20 hours a week and pay them an hourly wage to pull espressos in your coffee shop, you’re almost certainly hiring an employee.
Should you file a 1099, a W-9, or a W-2?
As a business owner, you need to file different tax forms depending on whether you hire an employee or an independent contractor.
You need to arrange a Form W-9 and file Form 1099-MISC for each independent contractor you pay $600 to or more during the tax year.
For each of your employees, you’ll need to file a Form W-2, as well as withhold and pay certain taxes and benefits.
Why do employers misclassify, and how can they prevent it?
Sometimes employers misclassify employees as independent contractors in order to skip out on paying the taxes and benefits that employees normally get.
But it’s not just big, faceless corporations that misclassify workers. Small businesses sometimes do it too. But it’s usually less nefarious, and often comes down to genuinely not knowing if someone fits into the employee or contractor mould.
The best way to prevent misclassification is to be proactive and acquaint yourself with the IRS’s definitions. If in doubt, ask a tax professional (like a CPA).
Also remember that misclassifying employees as contractors carries a much higher penalty than misclassifying the other way around. If both options are on the table and you have the budget for it, it’s always safer from a classification standpoint to simply hire an employee.
Heads up: this article is only relevant for U.S. businesses.
Misclassifying an employee as an independent contractor—intentionally, or otherwise—might save your company time and money in the short term. But make no mistake: the IRS won’t stand for businesses under-paying their taxes, and they’re quick to penalize businesses who misclassify workers—intentionally, or otherwise!
What happens if I misclassify an employee or independent contractor?
Just because someone works remotely, signs an independent contractor agreement, pays for their own office supplies and receives a 1099 form doesn’t necessarily mean they’re an independent contractor.
According to the U.S. Department of Labor, “employers may not misclassify an employee for any reason, even if the employee agrees.”
When the IRS finds a business misclassifying employees as independent contractors, it will usually order the business to pay back-taxes as well as penalties for income taxes, Social Security, Medicare, and unemployment taxes. Depending on the position, the employer may also need to provide the newly designated employee with their rightful benefits.
Independent contracting and “gig” labour are getting more popular, and employer-employee relationships are getting murkier. As the IRS and Department of Labor crack down on misclassification, it literally pays to get the distinction between employees and independent contractors right!