For most businesses, it’s clear who you need to hire. A gym needs fitness instructors. A restaurant needs cooks. A salon needs hair stylists. But what’s not always clear is how you should categorize those people. Should they be employees or independent contractors?
Companies across the U.S. are struggling to answer this question. For example, are Uber drivers independent contractors or employees? While Uber has historically defined them as “partners” (i.e., contractors), several recent lawsuits have argued the opposite. And one worker sued GrubHub for back wages, overtime, and expense reimbursement, insisting that he was an employee, not a contractor.
And in the growing gig economy, the question will only become more common. In 2017, 36 percent of the U.S. workforce were freelancers. If the trend continues, more than half the population will work as independent contractors or freelancers within just 10 years.
But it doesn’t only come down to your (or your employees’) preference. There are laws that help determine whether workers should be classified as independent contractors or employees, and if you do it wrong — intentionally or not — there can be hefty penalties. Beyond fines and back taxes, you could face criminal penalties, up to $1,000 per misclassified worker and one year in prison.
To keep your business on track for success — and to avoid fines and penalties — make sure you understand how to choose the right classification. Here’s where to start.
The Basics: Employee vs. Independent Contractor
How you classify your workforce is about more than whether you hand employees a W-2 or a 1099. It will determine if you’re responsible for withholding taxes and providing benefits, as well as how much control you have over how and when the individual completes his or her work.
In general, if you hire an independent contractor, you can only control the result of the work — not how or when it will be done. For example, a salon may hire hair stylists as independent contractors. That means the salon has control over the end result (e.g. completing a haircut or color service), but can’t specify the products the stylist uses, what the stylist wears to work, or if that stylist chooses to also work at another salon. The benefit, of course, is that as an independent contractor, the stylist is considered self-employed, so the salon doesn’t have to withhold taxes or provide benefits.
If you hire employees, on the other hand, you do have control over how and when the work is completed. You can require restaurant employees, for example, to wear a certain uniform, show up at a specific time, and prepare food using particular ingredients and processes. Employers who hire employees are responsible for withholding taxes for those individuals.
There’s Still More to Consider
OK, you may understand the basics of the two designations — but is your evaluation accurate? Once you start looking at specific elements — like if you reimburse expenses for the worker, require him to attend meetings, or prohibit him from working for another employer — the line between employee and contractor can blur.
To help you think through the classifications in a more detailed way, the IRS developed three categories of questions to consider:
1. Behavioral: To what extent can your company control how an individual does his or her work? For example, can you require the worker to stick to a set schedule? Can you specify the processes he or she should follow to complete the work? When you evaluate the worker, do you critique how the work is performed, rather than just the result of the work? These all point to the designation of employee, rather than a contractor.
2. Financial: Can you control financial aspects of the worker’s job? For example, does the worker have to buy his or her own equipment, without submitting anything for reimbursement? Can the worker make his or her services available to other (potentially competing) companies, in addition to your business? These elements typically point to a contractor, rather than an employee.
3. Type of relationship: How do you — and your workers — perceive your relationship? Do you provide benefits, like a retirement account? Do you assume that the individual will work for you for an indefinite period of time, rather than a set, limited timeframe? These may point to an employer-employee relationship.
Even given these categories, there are no hard and fast rules. For example, while independent contractors generally don’t receive benefits from an employer, a lack of benefits doesn’t necessarily mean the worker is an independent contractor. The key is to look at the individual holistically in regard to the definitions and the three IRS categories.
If you are still struggling, don’t panic. You can fill out form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding), and the IRS will review the circumstances and determine the worker’s status for you.
The Costs of Misidentification
If you classify an employee as an independent contractor — meaning you aren’t withholding taxes as you should be — you will be liable for employment taxes for that individual, as well as an additional penalty up to 25% of the total tax liability. Plus, if the IRS suspects intentional fraud or misconduct, it can issue additional fines.
For businesses that want to reclassify workers as employees, the IRS provides an option that will lead to benefits in future tax periods. The Voluntary Classification Settlement Program (VCPS) will reclassify workers and grant relief from federal employment taxes to employers that treat their workers as employees. Businesses must meet certain eligibility requirements to qualify for the program.
Still struggling with worker classification or other issues that impact your taxes? Bookkeeping Express can help. We can take the pain out of taxes, accounting, and payroll — just get in touch.