While employees themselves have many different classifications, the most notable being overtime-exempt versus non-exempt, before you can even begin to think about such things you need to ensure that they are in fact, employees.
This article will walk you through how to classify employees as independent contractors so that you can maintain compliance appropriately.
Employee or Independent Contractor: Why Is it Significant?
As an employer, it is your job to withhold and pay income taxes, social security taxes, medicare taxes, and unemployment tax on wages paid to your employees.
The key word there is "employees". As such, it is important to understand "who is an employee", and "who is an independent contractor?", so that you can ensure payroll taxes are collected and handled properly.
Improperly collecting and filing payroll taxes and deductions can land your business in a lot of trouble.
Am I an Independent Contractor or an Employee?
In order to determine whether or not a worker is an independent contractor or an employee, you must analyze the relationship between the employer and the worker.
The IRS has a list of rules that pertain to determining that relationship.
Employee or Independent Contractor Checklist
The U.S. Department of Labor recently published a final rule for classifying workers as independent contractors or employees. The final rule acts like a checklist of sorts.
To determine whether workers are employees or independent contractors, employers must take into account six factors equally to determine if a worker is in business for themselves as a matter of economic reality.
Here are summaries on each of the six factors:
Opportunity for Profit or For Loss Depending on Managerial Skill
When a worker lacks the opportunity for a profit or loss, it indicates that the worker is an employee.
Some things to consider when making the above determination include:
- Whether the worker determines or can meaningfully negotiate the charge or pay for the work provided
- Whether the worker accepts or declines jobs or chooses the order and/ or time in which the jobs are performed
- Whether the worker engages in marketing, advertising, or other efforts to expand their business or secure more work
- Whether the worker makes decisions to hire others, purchase materials and equipment, and/ or rent space
Investments by the Worker and the Potential Employer
This next factor looks at whether any investments by a worker is capital or entrepreneurial in nature.
In other words, expenses incurred by a worker for job-related tasks, such as tools, equipment, and labor, do not signify capital or entrepreneurial investment and thus imply employee status.
When expenses / investments incurred are in fact capital and entrepreneurial in nature, this could indicate independent contractor status. The department considers expenses / investments as capital and entrepreneurial in nature if they “generally support an independent business and serve a business-like function”.
Degree of Permanence of the Work Relationship
This is likely one of the easier factors to look at, and it revolves around the degree of permanence of the work relationship.
An exclusive, indefinite duration, or continuous work relationship, could indicate that the worker is an employee.
A relationship that is definite in duration, project-based, or sporadic based on the worker being in business for themselves, could indicate that the worker is in fact an independent contractor. It is worth noting that independent contractors may still have regularly occurring fixed periods of work, which is why it is important to consider all factors under the new rule.
Nature and Degree of Control
The next factor looks at the nature and degree of control that the potential employer holds in regard to key aspects, economic aspects, and performance of the work.
Key aspects to consider include:
- Setting schedules
- Supervision and restrictions
- Control over price rates for goods or services
- Selecting projects
- Affecting the worker’s ability to work for others
- The use of technological means to monitor work performance
- Controlling workloads
When the potential employer establishes work schedules, oversees the work, and administers any necessary disciplinary actions, this could suggest that the worker is an employee.
Because this is arguably the toughest factor to asses, the IRS has developed three common law rules to help employers evaluate the above-mentioned factors.
The IRS common law rules cover the following:
- Behavioral Control
- Financial Control
- Relationship Type
Extent to Which the Work Performed Is an Integral Part of the Potential Employer’s Business
This factor looks at whether or not a worker performs tasks that are an integral part of the potential employer’s business. If tasks are considered integral, this could indicate that the worker is an employee.
The department classifies tasks as integral if the task is critical or necessary to the potential employer's business.
Skill and Initiative
The final factor evaluates whether or not the worker performs specialized skills and whether those specialized skills contribute to business-like initiatives.
If a worker brings specialized skills to the work relationship, that could indicate an independent contractor.
In comparison, if a worker does not bring any specialized skills and is reliant on training from the employer to perform the given work, this could indicate an employee.
Is it Better to Hire an Independent Contractor or Employee?
The answer to this question ultimately depends on your business and your needs.
Independent contractors are a popular choice for organizations that are just starting out and can't necessarily afford to hire employees for all their needs. They are also a popular choice when there is a need to hire someone to work independently on a short-term assignment.
Additionally independent contractors:
- Don't require training or onboarding
- Are not entitled to employee benefits
- Handle their income taxes, social security taxes, medicare taxes, and unemployment taxes on their own
- Are responsible for their own career development
On the other hand, hiring employees can help secure long-term relationships while creating a sense of continuity within your talent base. Hiring employees can help facilitate ongoing contributions to your business, while also avoiding employee misclassification risks.
Get Help with Classifying Employees vs. Independent Contractors
It is crucial that employers understand the distinction between employees and independent contractors so that they can avoid any unnecessary payroll mistakes, fines, lawsuits, or damages.
If you are struggling with making these classifications, you may want to consider reaching out to a human resource consulting company.
Reach out to us today and get the support you need, or take a look at our webinar recording that breaks down everything you need to know about independent contractor classification.
