Tips for Classifying Independent Contractor vs. Employee?

what's an independent contractor
Independent Contractor vs. Employee?

The rules surrounding whether a worker is an employee or independent contractor are certainly complex. Yet when a company misclassifies an employee as an independent contractor, it doesn't properly withhold and pay payroll taxes … a costly oversight the IRS is cracking down on.

Most notably, classifying employees incorrectly as independent contractors to cut costs carries a financial risk that could result in devastating penalties.

Get it wrong and your business could incur:

  • Back taxes (Social Security, Medicare, unemployment) plus penalties
  • Back wages including overtime pay
  • Back premiums for workers' comp insurance
  • Possible employee lawsuits

There is also the possibility of criminal penalties and imprisonment.

What's more, the risk of getting caught has never been higher due to a federal and state crackdown. The Department of Labor (DOL) has hired thousands of federal investigators to "detect and deter" businesses from misclassifying workers. Increased enforcement means employers need to be on "high alert" with the classification rules.

On a state level, if employers misclassify workers to avoid paying unemployment taxes, the DOL will also be contacted to investigate federal tax evasion. This combined effort has resulted in the collection of millions in back wages.

With the IRS taking a closer look at companies' skirting the rules, it's never been more important to get the classification right.

The IRS uses Common Law Rules to determine worker status, grouped under three areas: behavioral, financial and type of relationship. Generally speaking, the more control you have over the worker – and the person's contributions to the business – the more likely the worker is an employee.

The following pointers don't cover every item on the IRS list, but they'll help steer you in the right direction.

Workers are most likely independent contractors if they:
Use their own equipment (laptop, phone, tools) to perform the job
Work on a temporary basis and are paid "per project"
Service other clients, often at the same time (look for an individual business license)
Work at an offsite location (occasional meetings at your business location are OK; working onsite for days and months at a time are not)
Have flexibility to set their own hours and schedule


On the other hand, you should classify workers employees if they:
Are paid by the week or month
Obtain training and detailed direction from your business
Work full time on a regular basis
Perform most of their job tasks on the premises
Can be fired at any time (rather than falling under contractual terms)
Provide services that are an essential part of your day-to-day operations

Let's say you run an electrical service company. Though it would be reasonable to work with a contract designer to develop your website, it would raise a red flag if you hired an electrician and labeled the individual an independent contractor. Or what if you're a legal firm paying an attorney as an independent contractor for at least 35 hours of time each week? Again, this would arouse suspicion, because the individual should be considered an employee and get proper benefits.

Keep in mind, these factors are only basic guidelines, and not every factor will apply in every situation. Plus, certain states may apply their own tests.

Because the rules surrounding worker classification are complicated, you may want to consult a tax professional for specific direction.

Note: Beginning with calendar year 2020, the IRS will be using form 1099-NEC for reporting independent contractor earnings. For additional information on the 1099-NEC form, please see the IRS site.

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