After a few years of flying solo, you’ve finally decided that you have the need and budget for your first hire. This is a huge and welcomed milestone for most business owners. Before you start drafting a job description and posting an application on Indeed or LinkedIn, you really need to take a moment to determine whether this new hire will be working as an employee or independent contractor. In the legal world, this issue is known as “employment classification”; OR, when you get wrong, “employment misclassification.”
Why the Distinction Between Workers?
In legal and HR circles, there have been countless discussions and debates over misclassification issues because it’s so easy for businesses to misclassify a worker as an independent contractor when they should be considered an employee. In addition, there is a strong temptation to misclassify workers because employers are not required to withhold employment taxes as mandated by law. Moreover, employers usually do not provide health and retirement benefits to independent contractors.
So, what does your tax obligation look like when comparing an employee beside an independent contractor?
Paperwork: W-4 and I-9 Forms (at the beginning of employment); W-2 statements (during the tax season).
– Depending on your business structure, you’ll file a number of returns throughout the year.
– Internally, you may even need HR documents, policies, forms and orientation protocols to properly on-board your new hires.
– Withhold federal, state, and local income taxes from your employees’ paychecks, and pay the company’s half of those taxes as required by the Federal Insurance Contributions Act (FICA).
– Pay the full amount of your estimated unemployment insurance taxes as required by the Federal Unemployment Tax Act (FUTA) and any state unemployment insurance tax laws.
– Depending on the number of employees you hire, you may even have to pay workers’ compensation insurance
Paperwork: In most cases, the only paperwork you’ll be completing is a 1099-MISC form and 1096 summary during the tax season.
Taxes: Normally, a business is not required to withhold taxes or pay taxes on wages paid to an independent contractor.
At first glance, it may appear that you want to classify all workers as independent contractors to increase company savings. However, there are drawbacks. As you’ll see below, you generally cannot direct or closely monitor how an independent contractor performs their job. You typically cannot prevent them from moonlighting or seeking other business opportunities. In addition, if they get hurt on the job, they may be able to sue you to pay for their medical expenses. Workers’ compensation insurance would have covered a traditional employee’s on-the-job injuries. Therefore, solely hiring independent contractors is not the ultimate solution to hiring the right professional.
The Test — Employer or Independent Contractor?
Making the correct distinction between workers is crucial because the Georgia Department of Labor and IRS can impose steep penalties on businesses that do not properly withhold taxes and unemployment insurance premiums for workers who are considered employees as defined by law. Therefore, you want to get this distinction right the first go-around.
So, how do you know when you’re hiring the right professional for the job? The general rule is that a worker is considered an independent contractor if the business owner (“payer”) does not have the right to control how the work will be performed and what will be done to accomplish the work. Instead, the business owner only controls the results he/she expects to receive at the end of the work or project.
The IRS and Georgia Department of Labor use a number of factors to determine whether a worker has been classified properly. However, these factors fall under 3 categories that have been developed by the courts over time. All of these categories relate to the element of “control.”
1. Behavioral Control.
With traditional employees, a business owner has the right to tell them where to be, when to be there, whether to wear a uniform, what tools to use, what supplies to purchase, and the budget for those supplies. Employers also typically give their employees instructions or training on how to perform tasks. Unlike an employee, independent contractors typically use their own methods, tools and procedures to accomplish a job.
However, just because you provide instructions to a worker or direct certain aspects of their performance does not automatically make them an employee. The IRS will look to the degree of control you exercise in these areas to make a classification determination.
2. Financial Control.
This category focuses on the financial and business aspects of the work. For example, the IRS will consider whether the business is making a significant investment in the tools or equipment the worker uses to perform the job; whether costs are reimbursed (in most cases, you wouldn’t reimburse an independent contractor’s expenses); whether the worker is free to take on other projects with multiple businesses simultaneously; and the workers payment arrangement (e.g., flat fee vs. hourly wage).
3. Relationship of the Parties.
Here, the IRS is looking for facts that speak to how the business and worker perceive their relationship or interaction with one another. For example, is there a written contractor that describes the nature of the parties’ relationship; is the worker receiving employee-like benefits (health insurance, vacation days, paid or unpaid sick leave or a retirement plan); and is the relationship permanent or for a specific project or time period?
With each of these three categories, one factor will not outweigh the other in determining whether a worker has been misclassified. Misclassification issues are determined on a case-by-case bases; therefore, all factors under each category will be considered as a whole.
Companies know that, under most circumstances, they will save a significant amount of money outsourcing their work to contractors as opposed to hiring in-house personnel. They know it, and so does the IRS. In some cases, there are legitimate reasons to hire a contractor over an employee, but avoid the temptation to automatically label every worker as an “independent contractor” just to reap the tax benefits. Misclassifying workers can amount to a hefty price tag. The last thing an otherwise successful business wants is to pay IRS penalties and fines worth years of unpaid employment taxes.
Avoid misclassification issues by getting it right the first time. When in doubt, ask and rely on a professional to help you sort out employment classification issues. Our legal team at Brim Law, LLC is here to help!
Your thoughts: What do you think — would the IRS consider your new hire or the person you’re thinking about hiring an employee or independent contractor?
This article is intended to provide you with general information; it does not constitute any type of legal advice. For recommendations related to your specific matter, we encourage you to review our Practice Areas page for additional information and then contact us to discuss your company’s legal needs.