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Independent Contractor vs. Employee: Knowing the Difference

Many business leaders are unfamiliar with the two main ways that they can hire people to perform work for their company. This post will give you a baseline understanding of common issues related to employment and when to classify a worker as an employee versus an independent contractor. 

Who will you hire?

Let’s start with the idea of bringing on a new worker to support what you’re doing.  Whenever you need help with something (e.g. work) that’s beyond what you and/or your current team can complete, you have a few options. Throughout this post we’ll use an example of a business leader that needs help with their Marketing work. So picture yourself up to your eyeballs in Marketing work and saying to yourself “I need someone to help me do all of these things.”  

You then get a knock on your (electronic) door and it’s your best friend’s neighbor, Billy. This person tells you that they have a degree in Marketing and some free time throughout the week. All of our problems are solved. Or are they?

Independent Contractors

The easiest option is to engage this person as an independent contractor to assist with your Marketing efforts.  An independent contractor can either be an individual (e.g. a Marketing Consultant like Billy) or a business (e.g. a Marketing Agency).  Your independent contractor can be physically close to you (like seated in the desk next to you) or located halfway across the globe.  Wherever they are located, you’re asking them to assist you with specific work and to produce specific deliverables independently, and not as an employee of the company. Independent contractors are often referred to as “contractors” or “1099” workers. “1099” refers to the Form 1099 that you’re required to provide to them each year for tax purposes. You may hear independent contractors based outside the US referred to as “W-8s“. W-8 references the IRS form that they must complete and return to you at the outset of the engagement. In the case with Billy, consider whether he can operate entirely independently. Can you say “Go get me more marketing leads” and he does the work? If so, he may qualify as an independent contractor. However, if Billy needs to be managed (or as the IRS likes to say, “Controlled”) then you may be treating him as an employee. Often times, Independent Contractors can turn into Employees, and knowing when and how to do this is important – from both a management standpoint and a paperwork standpoint. Billy the Independent Contractor gets bonus points if he’s helping a bunch of companies out with their marketing, if he has his own website, and if his goal is to build the next big Marketing company.

Part-time and Full-time Employees

So it turns out that Billy is doing a great job helping out with Marketing. You like the work that he’s doing and he wants to do even more for the company. This doesn’t automatically trigger “employment” for Billy. “Control” is still an important element of the relationship. Let’s say that Billy now needs an email address to do his job, and the company is using Marketing tools that Billy needs training and access to, and you ask Billy to be more consistent with his schedule. Now we’re starting to veer into “Employee” territory. Once we’re starting to treat Billy as an employee, we should hire him as one. This involves providing him with paperwork that’s a little different than just an independent contractor agreement. If Billy is working on a part-time basis, we can provide him with a schedule and have him track his time using our time system (no more invoices from Billy!). And when we pay Billy, we’re now required to withhold federal and state income taxes on his behalf, and split Social Security and Medicare with him (and pay his unemployment insurance). There are also a host of other compliance related items associated with hiring Billy, mostly required by Federal, State, and Local employment-related laws. And at the end of each year you’re required to provide Billy a Form W2 detailing his compensation and withholdings so Billy can pay his taxes.

Employee Misclassification

One major issue that you should know when deciding on whether to hire an independent contractor versus an employee is misclassification. Many businesses wrongly categorize independent contractors as employees, and vice versa.  Some do this by accident or willful ignorance, and some misclassify their workers knowingly. They may think they’re being clever, saving money, or don’t have the expertise to employ someone. Either way, this error is called “employee misclassification.” And while misclassification is widespread throughout the U.S., it keeps all sorts of investigators, auditors, government workers, and lawyers employed and well fed.  Regardless of what your intentions are, misclassification set you up for massive penalties and fines.  Even dealing with inquiries related to misclassification can be a distraction.

Knowing the Difference

When classifying workers, a key difference between employees and contractors is the degree of control that the employer exercises over how the work is performed. Some states (and the IRS) use the Common Law test and others use the ABC test (or an a, based on the state that the contractor is based in. California also has the Borello Test. Most agencies default to a worker being an employee unless it can be proved otherwise. This is one of the most important things that you should be aware of when Billy winds up on your doorstep. Instead telling Billy to come work for you and that you’ll cut him a check for $500 per month, first figure out why Billy would NOT be considered an employee of your company.

Additionally, some states look at misclassification through their own lens, either by having their own state-specific laws (e.g. California’s AB 5) related directly to misclassification or laws related to workers compensation and unemployment that function similarly.  For example, California AB 5 went into effect on January 1, 2020 and implemented the ABC test in California.  The test lays out three requirements in order for a worker to be classified as a contractor. They are: 1) Contractors are free from control and direction by the hiring company; 2) they perform work outside the usual course of business of the hiring entity; and 3) are independently established in that trade, occupation, or business. 

Penalties and Other Risks

We could spend this entire blog post detailing the types of penalties and fines associated with employee misclassification.  Aside from basic penalties and fines for failing to abide by the law itself, you could also be subject to penalties and fines for non-payment of social security, Medicare, and income tax. And trying to skirt employee thresholds by misclassifying creates yet another area of penalty risk. For example, the ADA applies to companies with 15 or more employees. But what happens if you have 6 employees and 10 incorrectly misclassified independent contractors? Beyond federal repercussions, if state agencies believe that you are deliberately shortchanging them on unemployment taxes and workers compensation premiums, you’ll face an additional area of scrutiny. 

Workers’ Comp & Violations

Aside from government penalties and fines, businesses that misclassify their workers could also face risks directly from the worker. If a workplace injury happens, and the company doesn’t pay worker’s compensation premiums for the employee, there could be trouble. The injured employee could take legal action against the company for not providing worker’s compensation coverage (as required by most states). If your workers are, in fact, employees, and you have not been completing I-9s for them (demonstrating their authorization to lawfully work in the United States), you could be subject to criminal charges related to employing workers illegally. You could also face myriad wage-and-hour violations for underpayment of wages, non-payment of wages, non-payment of overtime, and failure to provide employees with mandated leave. 

Some business owners believe the cost of compliance outweighs the potential risk of fines. This mindset overlooks the potentially enormous costs of undergoing an investigation from a government agency. That’s including legal costs, time, lost productivity, the distraction to you and your team, and the disruption to outside relationships.  Imagine closing a large round of funding or receiving a large donation, gaining positive press or buzz, and then having to deal with former workers coming after you alleging that they were misclassified. 

What can you do for your business?

If you have workers, this is a great opportunity to work with an employment attorney and/or an HR professional. You should determine how to document and treat your workers so that you correctly classify and engage them. At Suitless, we help our clients build great teams, all with an eye toward compliance. Reach out here to learn more about how Suitless can simplify your workday. 

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