How you classify your workers will make a major difference in the employment taxes you pay and your company’s obligations to the worker. While employees must be paid overtime and given employment-related benefits, independent contractors do not. Because there are significant penalties and fines for misclassifying employees, it’s a good idea to consult with an employment lawyer and exercise caution about how you’re classifying your workers.

What Is the Difference Between Independent Contractors and Employees? 

An independent contractor may be another business, person, or corporation that you hire to perform a service. When the independent contractor is an individual, they are considered self-employed. As such, they are responsible for their own employment taxes, health care, sick leave, and other employment benefits.

Employers have more obligations for an employee than an independent contractor, which is why some companies try to aggressively classify workers as independent contractors. However, this can lead to penalties, fines, and back taxes. To avoid unwanted surprises in the future, employers need to correctly classify workers when they hire them.

What Is an Employee?

The Fair Labor Standards Act (FLSA) includes specific rules about paying overtime and a minimum wage to your employees. All employees must receive FLSA protections. Additionally, there are many state, federal, and municipal laws that apply to employees. 

Someone is an employee if you have control over when and how they work. Traditionally, this is often someone who is scheduled to come into the office at a certain time each day. However, a remote worker can also be classified as an employee.

What Is an Independent Contractor?

The Internal Revenue Service (IRS) and the federal government have specific rules about what is considered an independent contractor. Often, state and federal regulations use common law rules about the employee’s level of control.

An independent contractor is considered self-employed. As a result, your tax and reporting obligations are less when hiring an independent contractor. While independent contractors may be lawyers or doctors, they could also be workers who perform tasks in the gig economy. If your company hires a janitorial service to clean each week, the individual or company running the service is generally considered an independent contractor.

When someone is an independent contractor, they have more control over their work. Often, they are given deadlines and specific project requirements. For instance, your company could hire a web designer to create a new website with a two-month deadline. 

An independent contractor pays self-employment taxes, so you are not obligated to pay any employment taxes for their services. You also don’t pay for their benefits, health insurance, worker’s compensation, or unemployment insurance.

How To Classify Independent Contractors: The IRS Versus the FLSA 

As a small business owner, it’s essential to classify your employees and independent contractors correctly. Among HR and payroll professionals, there is a saying that everyone is happy being an independent contractor until they aren’t. If an independent contractor becomes injured and can’t pay their bills, it won’t take long before their family members start urging them to talk to an employment lawyer or file a worker’s comp claim. 

Besides the financial implications, accurate classifications matter for your employee satisfaction and brand image. By treating workers and independent contractors fairly, you can save your company money and make it a better place to work for everyone. To determine how to classify your workers, start by considering FLSA and IRS rules about who is considered an independent contractor.

FLSA: How the Economic Reality Test Works

With the economic reality test, there are specific factors that are considered to determine if a worker is an employee or an independent contractor. If a worker is economically dependent on their employer, they are considered an employee. Individuals who are in business for themselves are classified as independent contractors. 

To determine if someone is an independent contractor under the FLSA, you must look at the following factors.

• Opportunity for Profit or Loss: This factor considers if the worker earns a profit or loss based on their own skills or not. For example, they may change their earning potential through negotiating a higher project fee, marketing their services, or buying additional materials.
• Permanence: The degree of permanence in the work situation is another factor to consider. If the employee is doing project-based or sporadic work, then they are likely an independent contractor. A consistent job without a fixed end date is likely an example of someone who is an employee.
• Investments: If the individual makes investments in the business to extend customer reach, market the company, or perform similar activities, they are likely an independent contractor. While employees may sometimes buy tools or attire for work, the scale of their investments isn’t on the same level.
• Control: An independent contractor will typically exercise control over the performance of the work, hiring, firing, and pay rates. If the employer has complete control, the worker would be considered an employee.
• Importance of the Work to the Employer’s Business: If a job is a critical aspect of the employer’s business, the worker is likely an employee. Meanwhile, someone who is contracted to perform janitorial duties or your company’s taxes is typically considered an independent contractor.
• Skill: An independent contractor often has a specialized skill set or ability, so someone who doesn’t have unique skills or who requires on-the-job training is generally classified as an employee. However, it’s important to remember that employees and independent contractors may both have specialized skills, so someone who has unique abilities could belong in either classification.

IRS: How Common Law Rules Work

The previous factors are used by the Department of Labor (DOL) to determine if your worker is an employee or an independent contractor. The IRS uses a different framework. If you are uncertain if your worker is an independent contractor or not, an employment lawyer or HR professional can help you evaluate the worker’s position and make a decision.

How the IRS Makes Its Determination

When the IRS decides if an individual is an employee or independent contractor, they consider the degree of control and independence involved. There are three main factors that determine the level of control and independence. 

• Financial: First, consider how the individual is paid. Do they have control over how they are paid or reimbursed? Who provides the supplies?
• Behavioral: Next, look at the degree of control the employee has over the work they do and how they perform that work.
• Relationship Type: Finally, consider if there are any written contracts or employee benefits. Is the employee’s tasks a key aspect of the company? Will the work be on an ongoing basis?

Let the IRS Decide: Form SS-8

If you are uncertain if your worker is an employee or an independent contractor, you don’t have to guess. You can also send Form SS-8 to the IRS and let them make the determination for you. It typically takes the IRS six months to process this form, so you should plan ahead. While the turnaround time may be too slow for individual workers, using Form SS-8 is effective if you have a number of workers who are in the same position and need an accurate classification.

What Are the Consequences of Misclassifying an Employee?

If you misclassify your company’s workers, it can lead to stiff consequences. Besides facing tax problems, you may have to deal with lawsuits, reputational damage, and penalties. 

• Tax Issues: If you haven’t been classifying your workers correctly, you can end up on the hook for back employment taxes.
• Legal Consequences: Under the FLSA and other laws, employers have certain obligations, such as providing breaks, paying a minimum wage, and paying overtime. If you haven’t been treating someone like an employee, you may have to pay penalties for your employment violations. Additionally, the government or the employee can file a lawsuit if they have been misclassified.
• Impact on Your Employee Brand: You don’t want your company to be in the headlines for the wrong reasons. If your company is audited by the DOL or IRS because of an employment misclassification, it can impact your organization’s reputation and bottom line.

Learn More About Employee Classifications

While using independent contractors can save you money on employment taxes, you don’t want to risk facing an audit or stiff penalties. By ensuring you are classifying your workers appropriately, you can prevent legal consequences and make sure you’re fulfilling your obligations as an employer.

To learn more about how Asure can assist with your employee classifications, reach out to our team of small business HR and payroll experts today.