Independent contractor or employee?
The Department of Labor (DOL) is cracking down on businesses that either purposely or unintentionally misclassify their workers. And the IRS is one step behind, ready to levy tax penalties and additional fines on those who do. Misclassification can also result in liability for unemployment taxes, violation of workers’ compensation laws and a host of other issues.
All the intricate details of what you need to know for proper worker classification can be found in the 2016 Employer’s Supplemental Tax Guide, published by the IRS.
Common mistakes when classifying
The IRS guide is thorough, but also long, complex and often confusing.
So, to help you out, we’ve outlined five common employee classification mistakes. And we’ll also provide some pointers on how to avoid them in your business.
Mistake 1: Not considering all aspects of the work relationship
A key factor in determining whether a worker is an employee or contractor is the amount of control over the details of the work performed. To determine the independence and amount of control over the worker in question, the IRS considers these three main categories:
1. Behavioral: Degree of company control over what the worker does and how he or she does it
2. Financial: The extent to which the business (payer) controls the business aspects of the worker’s job
3. Type of relationship: This is determined by reviewing such details of the worker-business relationship including contracts, benefits, duration and type of work performed
Not so much once you consider the fact that a yes for many categories and a no for one, or the other way around, could completely change your worker’s classification.
To properly classify your workers, you must consider all aspects of the worker-company relationship.
For example, upon discovering a plumbing issue in their main facility, Waffle World restaurant hires Bill Jones, a local plumber to unclog their drains.
Bill’s work is completely different than Waffle World’s core business. In addition, Waffle World has little control over the behavioral aspects of his job (i.e., what he does and how he does it) and he owns and pays for his own equipment.
But this isn’t a one-time job for Bill. Waffle World decides to hire Bill to return once a month to flush the company’s drains. It pays him $600 per month for this service.
If Waffle World considered all these factors, Bill would likely be classified as an independent contractor. But if it only considered his recurring employment and monthly wage, he would be wrongly classified as an employee.
Mistake 2: Going solely by written contracts
The nature of the work relationship between you and your employee determines how he or she is classified, not what is stated within a written contract.
For example, Waffle World hires Jane Smith as a batter mixer on its production line. It gives her specific instructions on how to mix the waffle batter, what time work starts and ends, and also equips her with a mixing bowl, mixer and uniform.
All details above point to Jane’s likely classification as an employee.
If she and Waffle World have a written contract between them that states she is an independent contractor and is personally responsible for paying her self-employment tax, it will not be recognized by the IRS when evaluating her worker status. This is true even if the agreement is drafted by an attorney, signed and notarized.
Some employers believe that a signed contract that defines a worker’s classification supersedes all other considerations. This is not the case.
IRS standards classify workers solely on the nature of their work relationship.
Mistake 3: Improperly defining a significant investment
The IRS defines a “significant investment” in job training and equipment by the worker as representative of an independent contractor.
However, both employees and independent contractors may invest to some degree in the tools and materials they use for their jobs. The difference in classification depends upon the size of the investment and factors such as whether or not the company offers reimbursement to the worker.
This can cause confusion because there’s no exact numerical determination for “significant investment.”
For example, Waffle World provides Jane with a uniform and tools for her mixing job. She may prefer to wear a hat and gloves while mixing, but these items are not provided by Waffle World because they are not necessary for Jane to perform role. Nonetheless, Jane decides to purchase a hat and gloves with her own money. These purchases would not likely be deemed a “significant investment”. And even if Waffle World reimbursed Jane, it would probably still be accurate to classify her as an employee.
On the other hand, Bill’s “significant investment” in his plumbing tools, service vehicle, etc., indicate that he would likely be classified as an independent contractor. And in this case, Waffle World is not required to reimburse Bill for anything other than the work he does for the company.
You must use your best judgment and consider all factors of the investment, and most significantly, the entire work relationship, before making a final classification.
Mistake 4: Similar payment methods
Typically, if a worker is paid a regular wage for a determined period of time (even with commissions or production incentives to supplement), he or she would more likely be considered an employee.
Independent contractors are typically paid a flat fee for a job.
However, confusion lies in situations where independent contractors may be paid hourly.
For example, Jane, the production line batter mixer, is paid $500 per 40 hour workweek.
Bill, the plumber, is paid one $600 lump sum after he completes the job of unclogging Waffle World’s drains. In this example, Jane’s method of pay indicates she may likely be classified as an employee, while Bill’s indicates he may be an independent contractor.
Now, let’s say Bill comes by Waffle World once a month and is paid $50 per hour for the time he spends flushing out the drains.
Although he is paid an hourly fee versus a single lump sum, the other aspects of Bill’s work relationship still probably indicate his classification as an independent contractor.
Mistake 5: Viewing benefits as a determining factor
Employees are usually provided or offered benefits from employers that include things like sick days, pension plans, health insurance, etc. Independent contractors are not offered these.
But just because your worker is or is not offered benefits doesn’t mean you have classified him or her correctly. The consideration of benefits is less a leading indicator as it is an after-classification requirement. Some employers mistakenly believe they have the choice (or offer the employee the choice) of having benefits and treating the worker as an employee, or not offering benefits but paying a higher rate and treating the worker as a contractor. While this practice is not uncommon, it is very difficult to defend.
Continuing on the examples above, because all signs point to Jane’s likely classification as an employee, Waffle World may be required by law to allow her to participate in in its benefits plan(s).
Because Bill would likely be classified as an independent contractor, Waffle World is not obligated to allow him to participate in the same benefits plans.
Depending on its total number of full-time employees, if Waffle World decided not to offer benefits to any of them, the company could be further penalized for lack of compliance with the Affordable Care Act (ACA).
Summing it up
When evaluating whether your worker should be considered an employee or independent contractor, be sure to watch out for these easily overlooked errors:
- You must consider all factors of the business-worker relationship. No single factor is enough for a concrete classification of either employee or independent contractor.
- The DOL and IRS consider how business is conducted between the company and worker to determine the accuracy of employee classifications, not what is stated within a written contract.
- A worker’s significant, unreimbursed investment in his or her own tools and training is a good indicator that he or she is an independent contractor. Employees rarely invest in items that are required for their jobs and are usually reimbursed for their expenses.
- Employees are typically paid a regular wage or salary for an indefinite relationship length, while independent contractors are more often given a lump sum payment for a one-time job, regardless of the amount of time it takes. Independent contractors may be paid hourly in some cases, but that fact alone will not affect their classification if all other aspects of the work relationship remain unchanged.
- Benefits are offered as a result of classification as an employee. Therefore, they are not a reliable indicator of whether or not worker classification is accurate.
Why it matters
Companies sometimes purposely treat employees as independent contractors to avoid obligations such as paying for employment benefits and taxes. It is also not uncommon for both the company and the worker to want the worker to be treated as a contractor (such as when the worker has benefits through a spouse and does not need them). On some occasions, genuine mistakes are made.
If the DOL or IRS finds an over-abundance of independent contractors working for your business, they are more likely to perform an audit, requiring you to take valuable time away from your business to cooperate with their processes. While some leniency may be given if an honest mistake has been made, possible penalties still include fines, paying back taxes and wages for the misclassified employee, and additional penalties.
To learn more about steering clear of other common HR errors, download our guide: 7 Most Frequent HR Mistakes and How to Avoid Them.