How do you determine if a worker is an employee or an independent contractor?

Key concepts to avoid misclassification of employment status and business relationships

Whether a small business owner or a leader in a large corporation, it is critical that you understand the working relationships you maintain within your business structure. Employer-employee relationships can dictate how business is done, and the role, dynamic, responsibilities, and worker status that is agreed upon. Employee status is an important part of compliance, including federal law and state laws, and maintaining clarity for tax purposes. Worker classification impacts the information reported to governments and what payroll taxes and tax forms (Form 1099-MISC, 1099-NEC, or W-2) are provided to the worker.

Some examples of various worker designations can include full-time employees, part-time employees, exempt employees, non-exempt employees, independent contractors, gig workers, and subcontractors. This article will focus on understanding the differences between employees and independent contractors so that business owners can properly classify their workers and comply with labor law.

Defining an employee

What is an employee

An employee can be defined as a worker who provides services for an organization at the direction of company leadership. Employees are considered within an organizational structure or as a member of the team. Employees are often delegated tasks and processes that are supervised or managed by individuals in the leadership team at the business. As a general understanding, employers can control what work is completed by the employee and how the work is completed.

Employee factors

Factors to consider that might designate someone as an employee of a company are specific to the working relationship and how the employee does their work. Some of the most important factors that suggest a person is an employee are as follows:

• The employee has a set schedule, specific to times and days of the week that they are available.
• The employer has a higher degree of control regarding projects assigned, the completion of projects, and overseeing general employee performance.
• Customers are part of the business domain (not belonging to the employee).
• Employees receive a salary or consistent wage (possibly minimum wage) for the work they produce.
• Employees often receive benefits, including health insurance, and have income tax withholding taken care of by their employer.

How employees are paid and how the pay is reported

Payroll is an important part of the determination process for classifying employees properly. Generally, you withhold and pay income taxes, social security taxes, Medicare taxes, unemployment tax wages, and unemployment insurance. Pay stubs track income paid out and tax data for the employee and employer to track regularly.

Employees also receive a W-2 tax form that showcases the employee’s earnings throughout the year and is part of the tax reporting process for the business. W-2 forms even include the word “employee” to emphasize the employment status present within the worker relationship. It is worth noting that there are additional classifications within employees; there can be non-exempt or exempt employees. According to the Fair Labor Standards Act (FLSA), non-exempt employees must be paid overtime and are beneficiaries of FLSA protections. Exempt employees do not get paid overtime, must make a minimum of $684 per week, and have less oversight with hour laws in place.

Defining an independent contractor

What is an independent contractor

Independent contractors are individual entities or business owners who offer their services to the public, including other businesses. Independent contractors have their own independent company and provide services through contracts and requests of other entities. Using their tools and setting their schedule with their hours, independent contractors have a lot more control over how they get their work done. Unlike employees, there tends to be less permanency with independent contractors, usually paid for specific projects or for a designated time period.

Independent contractor factors

There are specific factors to consider that might designate someone as an independent contractor. Some of the most important characteristics that suggest a person is an independent contractor are as follows:

• The employer authorizes a contract for a specific scope of work and with parameters of focus.
• The employer may agree to pay invoices that include business expenses, especially since contractors don’t have the same in-house benefits as employees (access to printers, for example).
• The employer has less financial control over the worker, especially in managing tax payments or maintaining more extensive payroll documents. Still, pay data is kept to comply with the Internal Revenue Service (IRS).

How independent contractors are paid and how the pay is reported

Independent contractors are paid either hourly or via an established project rate. Payments are tracked and reported through 1099 forms, including 1099-MISC or 1099-NEC. Generally, businesses do not have to withhold or pay any taxes on payments for these workers. Instead, independent contractor status workers will pay self-employment taxes.

Using the Common Law Test

The Common Law Test is a guide issued by the IRS to help businesses classify their workers accurately, especially looking at levels of control and the general work structure of different employee types. There are three primary categories that the IRS recommends considering when evaluating the worker status of your team:

• Behavioral: This category looks at how much control the company has over the work of the worker. When there is a significant investment from the employer into how the work is completed (requiring certain training, for example), there may be a reason to consider that that worker is an employee. The more control in place around employee behavior, the more likely the worker is an employee.
• Financial Control: Considerations in this category include the structure around how the employee is paid, whether expenses are reimbursed, the provision of materials/office space, and tax reporting and involvement. Employers have more financial control over their workers, whereas independent contractors often manage their own taxpayer situation and circumstances.
• Type of Relationship: Looking at the relationship between the job description and expectations or contracts is helpful in defining the working relationship. Any signs of benefits suggest that an employee-employer relationship is in place. If the worker signs on to the company with a contract for a set period of time and doesn’t have benefits, there may be substantial evidence of a contractor relationship.

Impact of misclassification

If your business does not classify your workers correctly, there can be major tax implications, including additional taxes, fines, and penalties. For example, if your business classifies a worker as an independent contractor without reason, your company would later have to back pay employment taxes. This can be costly and can cost your company more in the long run if you have to permanently change how you are classifying your employees. It’s important to do right the first time to avoid these types of costs and business structure changes.

Depending on your state, if you knowingly make a classification error, specifically classifying workers as independent contractors to avoid paying workers’ compensation insurance or other wages, your action could be considered fraudulent. From the employee side of things, this could make your business liable for a lawsuit for misrepresentation by the employer. In such legal actions, employees often retroactively seek unpaid wages or benefits that they were not provided with during their working relationship.

Final considerations

How you decide to classify your worker is something that many government agencies will have access to review for the sake of business compliance. As discussed, the IRS maintains recommendations on classification can be completed in the first place. In addition to the IRS, other possible reviewing agencies include your state unemployment compensation agency, your state workers’ compensation agency, your state tax department, and the U.S. Department of Labor.

The role of many of these reviewing agencies is to ensure business compliance. However, the IRS is explicit in wanting to help companies classify correctly, thus their introduction of the Common Law Test. If you have ongoing questions about classification processes, you can certainly consider reaching out to the IRS for additional consultation.

Next steps

Are you ready to understand the right IRS forms to provide to your workers? Are you looking to avoid the problem of misclassified workers? Are you ready to make sure you have the proper written contracts and relationship agreements in place with the workers at your business?

Heartland is ready to help.

Heartland helps nearly 1,000,000 entrepreneurs make and move money, manage employees and engage customers with human-centered technology solutions that allow them to rise above the daily grind and lead their businesses into a brighter future. Learn more at heartland.us