Employee or Independent Contractor? The Wrong Decision Could Cost Your Business

Businesses may hire individuals as either independent contractors or employees, and the classification impacts how much the business pays in taxes, whether it needs to withhold taxes from its workers’ paychecks, and what tax documents the business is required to file. For example, if a business classifies a worker as an employee, it must withhold income tax, and a portion of the employee’s social security and Medicare taxes. Additionally, businesses are responsible for paying social security, Medicare, and unemployment taxes on its employee’s wages. Businesses must supply its employees with a W-2, Wage and Tax Statement, which shows the amount of taxes withheld from them. On the other hand, should a business classify a worker as an independent contractor, it is required to provide the independent contractor a Form 1099 to report what has been paid to the independent contractor. The independent contractor is then responsible for paying their own income tax and self-employment tax, and the business does not withhold taxes from payment.

 So how do you make this determination?

Courts have used many facts (and no one fact) when deciding whether to classify a worker as an independent contractor or an employee, so the decision is not always easy; however, relevant factors typically fall into three categories. The categories each business must consider is behavior control, financial control, and the relationship of the parties. Behavioral control looks at whether the business controls or has the right to control what the worker does and how they do their job. Financial control examines the business aspects of the worker’s job controlled by things like how the worker is paid, whether expenses are reimbursed, and who provides tools or supplies to do the work. Last, the type of relationship category considers whether there are any written contracts or any employee-type benefits offered to the worker (such as insurance, vacation pay, pensions etc.). Businesses must weigh all factors when determining how to properly classify a worker, and understand that there is no “magic equation.” Unsure? Contact a lawyer, or contact the IRS (and know that if you ask the IRS, it’ll take at least 6 months for the IRS to make a determination – which may not be conducive to your business or hiring goals).

 Get it wrong?

It’ll probably cost, a lot. There are both financial and legal consequences for misclassifying an employee. If you misclassify an employee as an independent contractor, you may face an audit from the IRS and/or state tax department. If it’s a wage issue, business may find themselves facing a class action lawsuit and individual lawsuits that they must defend in court. Upon a successful lawsuit by an employee, businesses may have to pay back-wages and overtime owed, and a variety of penalties may assessed along with the employee’s attorneys fees and costs. Non-complying businesses may also have to pay amounts that should have been withheld such as taxes, FICA, FUTA, benefit contributions or the value of lost benefits, in addition to penalties, interest or other damages and attorneys fees. Employees who get hurt on the job, and who have been misidentified as independent contractors, may also file a suit under negligence theories.

Misclassifying an employee can be potentially disastrous for a business, and classifying your workers correctly should be a place where you spend extra time and care in the operation of your business. If you’re unclear on the law, or how you classify your workers, you should contact legal counsel to assist you in making the determination.