Let’s say you hire a freelance graphic designer to create your logo. Their work is fantastic, and you give them so many additional projects they eventually decide to work exclusively for your company.
Is this graphic designer still a contractor?
The answer might be no. If you control the workday, the designer has now become an employee of your company, and it’s critical to treat them as such. The government strictly regulates employee and independent contractor classifications, and making a mistake could have serious consequences.
Here’s what you need to know.
Employees vs. Independent Contractors
First, let’s explain the fundamental differences between employees and independent contractors.
Employees
Employees work under the company’s direct control and supervision. They typically have ongoing responsibilities and must follow company policies, schedules, and procedures. They also might receive employee benefits like pension plans and paid time off.
If you hire employees, your business is responsible for withholding taxes from their paychecks.
Independent Contractors
Independent contractors are self-employed and work on a project-by-project basis. They control how, when, and where the work is done.
If you hire an independent contractor, they’ll pay their own taxes. Your business will simply send a 1099 form at the end of the year.
What the Government Says
Both the IRS and the Department of Labor (DOL) have guidelines regarding employee classification.
IRS
The IRS considers three factors to determine worker status:
- Behavioral Control: Does the employer control how the worker performs their tasks?
- Financial Control: Can the worker incur a profit or loss? Are they financially invested, i.e., by purchasing their own equipment?
- Relationship Type: Is the work being performed essential to the business?
Department of Labor (DOL)
The DOL focuses on the economic realities of the worker’s role.
- Is there an opportunity to profit based on the worker’s skill?
- Does the worker invest in equipment or use company supplies?
- Has a permanent working relationship been established?
- Does the employer control many aspects of the workday?
- Is the work integral to the business?
- Does the worker have specialized skills? Or were they trained by the employer?
State Rules
The federal government isn’t the only authority you have to listen to. Many states have their own rules about worker classifications.
Risks of Misclassification
So, what happens if you mistakenly classify an employee as an independent contractor? The consequences can be pretty severe. Your business might be subject to:
Fines and back taxes
If the IRS or DOL determines you’ve misclassified a worker, you’ll be required to pay back taxes and penalties for each employee. This includes 100% of the unpaid FICA taxes you should have contributed, 40% of the taxes owed by the employee, and a $50 or more fine for every unfiled W2.
Back Pay
Being an employee generally provides more money for workers. If you’ve misclassified your employees as contractors, you could owe back pay in overtime or other wages.
Potential Legal Issues
Misclassification could trigger lawsuits from disgruntled employees and the government, leading to expensive legal fees and a potential loss of brand reputation.
Steps to Ensure Compliance
Preventing misclassification is an ongoing project, as roles can shift over time. The following steps will help your business stay compliant:
1. Conduct an Internal Audit
Regularly review your current contractors and their roles within your company. Watch for signs like exerting control over the contractor’s work.
2. Consult Legal and Tax Advisors
Engage with legal and tax advisors to understand the nuances. Classification can be tricky, and experts know how to avoid the pitfalls.
3. Use Clear Contracts
Draft clear, concise contracts that explicitly outline the nature of the relationship. Ambiguity could cause trouble later.
Final Thoughts
Misclassifying employees as independent contractors can disrupt your business goals. By understanding the differences between the two classifications and implementing proactive measures, you can limit the risk and protect your cash flow while avoiding reputational damage.
CPA firms like Kondler & Associates offer specialized knowledge and guidance that help keep you compliant. If you need further assistance navigating the complexities of worker classification, consider partnering with our team. You can set up a free consultation today.
