Employee or Independent Contractor?

I’m hiring; should they be classified as an employee or a contractor?

I get this question all the time from my business clients.  How do I classify this new worker?  Are they an employee or a contractor?  Do I give them a W-2 or a 1099?  Isn’t having them as an employee more costly?  It’s become a hot topic over the last several years, especially here in California after the last election when Proposition 22 came into play.  It’s very important to understand the difference between the two because any misclassification can lead to back taxes, penalties and even legal disputes.

Let’s first start with the definitions: 

An employee is on a company’s payroll and receives wages and benefits in exchange for providing services, following the organization’s guidelines and remaining loyal to that company.  Generally, the business can control what work and the details of how the work will be done, including which hours of the day the employee works.  An employee usually only works for one company and is therefore subject to the rules and obligations of that particular company. The majority of employees are at will.

An independent contractor is an independent worker who has independence and flexibility, carries on a trade or business, and is usually a sole proprietor.  Examples include, but are not limited to accountants, architects, lawyers, realtors, subcontractors, etc. A contractor has the choice to work for one as up to as many organizations as they want at the moment.

Hiring a contract worker rather than a full-time employee potentially could be a money saver — you won't have to pay for a contractor's health insurance, 401(k)s, vacation time etc. However, this option comes with restrictions and potential risks.

Before you decide which type of worker to use for a given role, it is critical to understand the differences between contractors and employees and potential consequences for misclassifying workers. 

An independent contractor or freelancer is a self-employed individual who operates independently on a contract basis. A contractor is not an employee; they run their own entity, such as a sole proprietorship or limited liability company and are contracted out by other businesses to work on particular projects or assignments. Their contract relationships can be short- or long-term.

There are many differences between a contractor and an employee, payment, taxation and benefits.  One of the biggest differences between contractors and employees is the way they are paid and taxed. An employee is on a business's payroll, so the company pays the employee and withholds the applicable taxes. An employer often pays for employee benefits as well. These can include required employment benefits, like health insurance, and other optional benefits, such as retirement plans, health reimbursement accounts, health savings accounts, paid vacation, etc.

A contractor is paid an agreed-upon amount for their services, but your company would not withhold or pay any of their taxes (in most cases). A contractor is responsible for paying their own taxes, including federal & state income tax and self-employment tax. The contractor also pays for and obtains their own benefits, including health insurance, etc.

Another major difference between a contractor and an employee relates to their level of independence.

Employees are hired to perform specific work at the direction of the employer. Independent contractors, on the other hand, are typically given a job or project to work on without the company controlling when and how they do it.

The processes also differ greatly between contractors and employees. Contractors are likely to focus on a specific project, they are often given only the information that's critical for completing that task. Full-time employees, in contrast, require lengthy onboarding procedures to understand their daily work duties, the company culture and overall goals the employer has set for them.

The IRS looks at certain factors to see if a worker should be classified as an independent contractor or an employee of a company. Here is a list of questions that can help you determine how to classify a worker:

·         When, where and how is the work done? Is the work performed at the employer's place of business, or is the work done remotely? Does the employer set the hours, or can the independent contractor work whenever they want? Does the employer provide the tools, or does the independent contractor use their own equipment?  What is the behavioral control that the company has?

·         Is the employee required to complete company training?

·         Is the worker doing full-time or even part-time continual work, or are they doing temporary work on projects that have specific end points?

·         Is the worker paid hourly, weekly or monthly? Or do they get paid based on percentage of completion or once an entire project is complete?  What financial control does the company have?

·         Does the company pay for travel? For employees, travel costs are usually covered by the company. Independent contractors, however, pay their own travel costs.

·         Are there any written contracts?  What are the details of those contracts?

The consequences for misclassification vary depending on whether the misclassification is deemed intentional.

Typically, a company will be required to pay back taxes, as well as fines and penalties that can be based on the number of IRS Form W-2s that the company failed to file because of the misclassification and a percentage of wages in which the company failed to withhold the proper taxes.  These can be very costly and sometimes unanticipated costs can be detrimental to a company.  It is best practice to try and avoid these as much as possible.

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