Independent Contractor vs. Employee: Knowing the Difference

Many business leaders are unfamiliar with the ways that they can hire people to perform work. Here, we’ll share some information to give you a baseline understanding of common issues related to employment, engagement, and the classification of a worker as an employee or independent contractor. 

Who will you hire?

Let’s begin with the most basic element of bringing on a new worker.  Whenever you need help with something (labor) that’s beyond what you and your current team can complete, you have a few options. Throughout this post we’ll use an example of a business owner that needs help with their Marketing work.  

Independent Contractors

First, you can engage an independent contractor to assist with that work.  An independent contractor can either be an individual (e.g. a Marketing Consultant) 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.

Part-time and Full-time Employees

The second option, if you have enough work that you need help with (or if you want to have more control over how the work is carried out) is that you can hire an employee, either on a part-time or full-time basis.  Using our earlier example, you may want to hire a part-time Marketing Coordinator or a full-time Manager for that work.  Employees are W-2 employees, a “full timer” or a “part timer”.  The term W-2 refers to the yearly summary form that employers issue their employees. The W-2 breaks down wages, taxes, withholdings, and deductions. Often times, payroll companies will assist with the generation and distribution of a W-2.

Employee Misclassification

One major issue that business leaders should know when deciding on whether to hire an independent contractor versus an employee is misclassification. Many businesses wrongly categorize 1099s as W-2s, and vice versa.  Some do it by accident, and some do it knowingly. They may think they’re being clever and saving money or time.  Either way, we call this error “employee misclassification”. And while it is rampant and widespread throughout the U.S., it keeps all sorts of investigators, auditors, government workers, and lawyers employed and well fed. 

Regardless of what you have in terms of intentions, it can also set you up for massive penalties and fines.  Even dealing with inquiries related to misclassification can be a huge distraction. It can embarrass and damage your company, its directors and officers, investors, donors, and even your employees and customers.  It’s also important to note that the government will not hesitate to throw the book at you if they suspect you of misclassifying your workers – either intentionally or unintentionally. 

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. Many businesses focus on the IRS control test. This looks at various categories of evidence to assess the degree of independence or control over the work.  While people commonly cite this test, there are also other government agencies, including the NLRB and the DOL, that have their own independent contractor tests.

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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