Legal Pad: Classifying Employees and Independent Contractors

Whether employees or independent contractors, it’s a good idea to make sure your workers’ classifications befit their circumstances.

[Images: Getty Images][Images: Getty Images]As a business owner and employer, one of the most important decisions you must make is whether your staff will be comprised of primarily employees, independent contractors (ICs) or a combination of both. It’s important to properly classify a worker, because the penalties for failing to do so can be expensive and result in a lot of paperwork. In fact, misclassifying workers invites a lot of scrutiny from government agencies such as the IRS, the U.S. Department of Labor (DOL) and their state counterparts. Whether classifying a worker as an employee or IC, it’s best to get it right from the get-go. Let’s take a look at the pros and cons of each option, and the key role the government plays in your decision.

It’s tempting for spa owners to fill their staff with ICs instead of employees for numerous reasons:

  • The owner can avoid withholding and paying state and federal payroll taxes; ICs must pay their own withholding.
  • There’s no need to pay an employer’s share of Social Security and Medicare taxes.
  • Wages can be lower. It’s rare to hire ICs on a full-time basis or to pay them the same wage rate as that of employees.
  • With an IC-based staff, the spa owner isn’t obliged to pay for health care and retirement benefits, which often add 20 percent to 30 percent to an employee’s salary. There’s also no need to offer vacation, holiday or sick pay.
  • There is no required overtime pay for ICs.
  • There’s no need to file weekly or quarterly payroll tax forms, as ICs must file their own.
  • Workers’ compensation insurance and unemployment compensation taxes are avoided.

Given these costs, why should a spa owner ever consider hiring employees? Primarily because the IRS and DOL believe it’s a good idea. First, it benefits workers to be classified as employees rather than ICs: They may qualify for the above benefits and receive the protection of certain workplace laws, many of which may not apply to ICs. Employees also benefit by having a portion or all of their income taxes paid by the employer.

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Second, the government itself benefits from your hiring employees, because having payroll taxes withheld and paid to the government throughout the year generates cash flow for it and simplifies income tax collection.

It all sounds straightforward enough, but of course it isn’t. A 2009 report by the U.S. Government Accountability Office (GAO) found that there may be as many as 3.4 million workers improperly classified as ICs. In fact, improper worker classification by employers has cost the government billions of dollars in revenue. And that’s why you need to be clear on what you can and can’t do as an employer in determining your workers’ statuses.

The penalties for misclassifying employees are stiff. If you improperly classify an employee as an IC, you will pay the government $50 for each W-2 form that you failed to file. That may not sound like much, but say you failed to withhold income taxes for an employee, you must also pay a penalty of 1.5 percent of the employee’s wages, 40 percent of the FICA taxes that should have been withheld, and 100 percent of your share of FICA. There’s also a 0.5 percent penalty for unpaid tax liabilities per month up to 25 percent of the total tax liability.

In addition to these, there are also monetary penalties for the failure to file and withhold state payroll taxes, which can mount up quickly. Just to make sure no stone is left unturned, auditors can be sent to your business to perform detailed examinations of your payroll records and ledgers.

It’s still up to you to decide how to classify your workers. Before you opt for employee or IC for a particular individual, consider the degree of control you wish to have over that person in three major areas: behavioral, financial and type of working relationship.

employee-benefits

Behavioral Control

According to the IRS, a number of factors ultimately determine how much control you will have over your workers’ behavior.

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Type of instructions given. These instructions may include:

  • When and where to do the work
  • Which tools or equipment to use
  • Which workers to hire or to assist with the work
  • Where to purchase supplies and services
  • What work must be performed by a specified individual
  • What order or sequence to follow when performing the work

If the employer gives the worker most of these instructions, the employer is exercising a degree of control associated with a worker classified as an employee.

Conversely, if an individual worker can make all these decisions on their own, it mitigates in favor of the worker being classified as an IC.

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Degree of instruction. Simply put, the more detailed the instructions an employer gives a worker, the more control the employer exerts and the more likely the worker would be classified as an employee. An example would be a spa owner who asks a computer programmer to create software that would assist in inventory control. Most spa owners would not be capable of providing detailed instructions to a computer programmer. In this case, and based on this single criteria, the worker would most likely be classified as an IC. But be careful: A single criterion really never determines an employee or IC classification.

Evaluation systems. Using the computer programmer example above, we can see that how well the work is performed is of less concern to the spa owner than the overall achievement of the desired result, which is a functional program to track inventory. This primary concern with the end product is indicative of an IC classification.

Training. The more particular the employer is about having things done a certain way, the more detailed the training needs to be. This suggests an employee/employer relationship.

Financial Control

According to the IRS, financial control is the degree to which an employer has the right to control the economic factors surrounding a worker’s job. Financial control can be impacted by the following:

Significant investment. An employee isn’t usually significantly invested in an employer’s business, whereas an IC might be invested in their own business, as evidenced by use of their own tools and equipment.

Unreimbursed expenses. In most cases ICs bear their own expenses, whereas employees expect to be reimbursed for out-of-pocket expenses accrued for the employer’s benefit.

Opportunity for profit or loss. ICs take risks and experience the benefit or the detriment of profit or loss. Employees typically take no such risks and the business owner absorbs any potential profits or losses.

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Services available to the market. ICs are usually free to seek other work without limitation on the number of contracts into which they may enter. Employees would be expected not to work simultaneously for another employer, particularly one who could be considered a competitor.

Method of payment. ICs typically contract for a set or fixed fee for their services, while employees are generally paid hourly wages.

Working Relationship

The type of relationship between a worker and a business also helps to establish whether the worker is an employee or IC. The factors that determine a relationship are:

Written contracts. The existence of a written contract is often relied upon by employers. Some believe that they may specify the worker status in a contract. However, written contracts are frequently ignored by the IRS when determining a worker’s status, i.e., an agreement between a worker and a business cannot trump the legal analysis in determining the actual type of relationship.

Employee benefits. If a worker receives benefits that go above and beyond their monetary compensation, it suggests an employer/employee relationship.

Permanency of the relationship. If the relationship is ongoing rather than extends over the period of time in which a distinct task is performed, it again suggests an employer/employee relationship.

Services provided as key activity. If the services a worker provides are part of the core business activities, this suggests an employer/employee relationship. Contrast this with a task that may be needed but is somewhat ancillary to the business’ core purpose. (Again, recall the computer programmer, whose task wasn’t central to the delivery of spa services.)

Sometimes, the analysis doesn’t yield clear-cut results. For example, what if the factors are evenly split, half pointing to IC status and half pointing to employee status? In this case, it’s a good idea to let another set of eyes look at the issue as the business owner may not be objective enough to accurately apply the analysis to the given facts. In such instances, it’s best to consult an attorney or company specializing in human resource management.

–by Michael L. Antoline, JD

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