Contractor vs. Employee Classification: What You Need to Know

In the business world, determining whether an individual is a contractor or an employee is a critical distinction. Not only does it impact your workforce structure, but it also carries significant implications for tax responsibilities and compliance with federal and state regulations.

Generally, an employee is generally considered anyone who performs services, if the business can control what will be done and how it will be done. The big thing here is that the business has the right to control the details of how and when the worker’s services are performed. On the other hand, independent contractors are individuals that work in an independent trade, profession, or business that offers their services to the public.

Why might a business misclassify someone?
Well, depending on if you hire an employee or contractor will change the way you pay them, and thus, their worker classification. This classification affects how they pay your federal income tax, social security and Medicare taxes, and how they file their tax return. The classification affects their eligibility for social security and Medicare benefits, employer provided benefits and their tax responsibilities.

The courts have considered many different factors that would decide if someone is an independent contractor or an employee, and they fall into three categories:

1. Behavioral control
2. Financial control
3. Relationship of parties

The courts have considered many facts in deciding whether a worker is an independent contractor or an employee. These relevant facts fall into three main categories: behavioral control; financial control; and relationship of the parties. In each case, it is very important to consider all the facts – no single fact provides the answer. Carefully review the following definitions.

No single part of this will answer the main question, but they all do play roles into determining the status.
Please note, that we are currently looking at how the IRS may deem an individual, not individual states, who have their own rules.

Behavioral Control

Behavioral control is one of the three fundamental categories that help differentiate between an employee and a contractor. Here’s a closer look:

• Employee Status: If you provide extensive instructions on how work is to be done, it indicates employee status. This can include specifying how, when, or where the work is to be performed, what tools or equipment to use, and even who to hire as assistants.
• Training and Procedures: If your business provides training and enforces specific procedures and methods, it implies that you want the work done in a particular way, reinforcing the idea of employee status.

Financial Control

Financial control is the second category that plays a significant role in determining worker classification:

• Expense Reimbursement: Contractors generally cover their own work-related expenses, whereas employees may have their expenses reimbursed by the employer.
• Investment in Tools and Equipment: Contractors often use their own tools and equipment, while employees rely on tools provided by the employer.
• Method of Payment: Contractors are typically compensated based on projects or tasks, whereas employees receive regular salaries or hourly wages.
• Work for Multiple Clients: Contractors often work for multiple clients simultaneously, while employees usually have an exclusive relationship with one employer.
• Long-Term Relationship: Employees often maintain long-term and ongoing relationships with their employers, while contractors are typically engaged for specific projects or a limited duration.
• Termination and Notice: Employees may have specific termination procedures and notice periods outlined in their employment contracts. Contractors may have termination clauses, but they often have more flexibility.

Relationship of Parties

An employee will generally have a written contract or employee type benefits, which may include benefits such as pension plan, insurance, vacation pay, etc.

It’s always important to have a written contractor or agreement that stipulates what is intended and to ensure that all parties are on the same page.

State Rules Vary: California’s Stricter Guidelines

It’s essential to note that worker classification rules can vary by state. California, for instance, is known for its particularly strict guidelines. In the Golden State, they use the “ABC test” to determine worker classification. This test places a higher burden on businesses trying to classify workers as contractors. It focuses on factors like control, independence, and whether the work is outside the usual course of the hiring entity’s business.

The ABC test looks at:

• the control that the company exerts on the worker
• whether the work is outside the company’s typical business
• whether the worker normally provides this type of work as an independent business

When does misclassification become an issue?

Penalties for misclassification typically come up if a worker complains or if there is an audit, that makes the state or IRS look into whether or not your contractors are indeed contractors.

If there are issues, you can incur penalties, fines, and legal consequences.

Correctly classifying workers as employees or contractors is not just a matter of semantics; it can have far-reaching financial and legal implications for your business. Ensure you are making informed decisions when hiring, protect your business, and ensure fairness for your workforce 🙂