Business owners looking to hire must first learn how to properly classify workers. In this article, we will discuss why it is important to classify correctly, how to minimize the risk of misclassification, and the differences between employees and independent contractors. After reading, you should have a good understanding of how to properly classify workers.

Who Cares How I Classify Workers?

Employment taxes comprise approximately 70% of federal tax revenue for the IRS, and they consider the misclassification of employees as a form of tax evasion. Federal and state regulatory bodies recognize the tax gap created when employers misclassify workers, so they actively look for companies that misclassify employees as contractors.

It is unwise for business owners to misclassify workers as contractors to avoid taxes, paperwork, or benefits. Large companies such as Uber, FedEx, and Amazon have garnered the most headlines for misclassifying workers. However, you must consider that small businesses comprise 99.9% of all U.S. businesses, and if discovered, you can be required to pay back taxes, interest, fines, and penalties.

Failing to classify workers correctly can have a significant and lasting negative impact on your business.

penalties for worker misclassification can be severe.
The CPA Journal

CONTRACTOR

How to Minimize Risk When You Classify Workers

Know – Ignorance is not a sufficient legal defense. First, you must gain a clear understanding of the difference between an employee and an independent contractor
Discuss – Leverage the resources around you. Talk with your business advisor, attorney, and CPA about the proper way for you to classify workers
Document – Properly document your relationship with workers. Following best practices when hiring employees or contractors will help support the nature of the relationship.
Review – Worker classification is not set in stone. Both laws and relationships change over time, so you should periodically review your relationship with workers.

An employee is subject to the employer’s control as to what work must be done and exactly how it must be completed. The employer often provides training, tools, and a place of work for the employee. More on hiring employees can be found here.

An independent contractor, on the other hand, is in control of how the work will be completed and typically provides their own training, tools, and workspace. Independent contractors are usually hired to complete a specific task or project with a definite end date, and they are not considered part of your regular workforce. More on hiring independent contractors can be found here.

EMPLOYEES

The Difference Between Employees and Contractors

There is not a single factor that determines how you should classify workers. Under the law, you must examine all evidence of the degree of control and independence in the relationship between the worker and the business.

Common Law Test

The Internal Revenue Service (IRS) and Texas Workforce Commission (TWC) use various forms of the common law test. The IRS now organizes facts providing evidence of the relationship between the business and workers into three broad categories:

Behavioral Control:

The extent to which the business has the right to direct & control how the worker performs the work. Factors to consider include:

Whether there are specific work hours or locations where work must be done
Whether the business dictates tools, equipment, or vendors that must be used
Whether the worker is directed who to hire to assist with the work
Whether the worker is required to follow a set order or sequence of tasks
Whether there are written instructions detailing how to do the job
The degree of supervision exercised by the business over the worker
Whether the worker is evaluated on how the work is performed
Whether the business provides training on how to do the job

Financial Control:

The extent to which the worker has financial control over the performance of the work. Factors to consider include:

Whether worker incurs unreimbursed expenses
Whether the worker has the opportunity to make a profit or a loss
Whether the worker is free to seek work elsewhere
Whether the worker is guaranteed a regular wage

Type of Relationship:

The extent to which there are written contracts or agreements in place. Factors to consider include:

Written contracts are important to document the relationship, but not sufficient alone to determine a worker’s status
Whether the worker has been granted employee benefits
Whether the relationship is expected to continue indefinitely
Whether the worker provides core business services to customers

The primary method is to consider every piece of information in a case that helps to decide the extent to which the taxpayer does or does not retain the right to control the worker.
The CPA Journal

Economic Realities Test

Under the Fair Labor Standards Act (FLSA), an employee is a person who follows the usual path of an employee and is dependent on the business which he or she serves, as tested by “economic reality.”

Employers should think carefully about entering into IC relationships that last long-term or indefinitely.
The CPA Journal

Summary

After examining all of these factors, you should have a clear understanding of how to properly classify workers. If you want to dig deeper, there is a list of resources at the end of the article.

However, if you are still unsure, it is best to err on the side of caution and treat the worker as an employee. And if you are not prepared to hire employees directly, consider alternatives such as temporary agencies or Professional Employer Organizations (PEOs).

This post was intended to provide general information only and is not tax or legal advice.

Sources

Whether this is a problem you are currently facing or just something that has been weighing on your mind, feel free to contact me via phone or email so we can discuss your situation, goals, and solutions.

I built my first career in management consulting and have spent the last 20+ years using my passion and skills in community and economic development. For the past nine years, I have advised hundreds of start-ups and small businesses.

How to Classify Workers: Employee or Independent Contractor?

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