Employee vs. Contractor: What Employers Need to Know

When hiring help for your business, do you know the difference between an employee versus an independent contractor? It's essential to understand the distinction, as how you classify workers can have a big impact on your business.

Here's a breakdown of the key differences between employees and contractors, so you can make the best decision for your company.

Employees vs. Independent Contractors

Contractors and employees work for a company, but how the company handles its paperwork and taxes differs.

Companies have much more responsibility with an employer-employee relationship versus an independent contractor relationship, including withholding taxes and filing special paperwork.

So what's the difference between an employee and an independent contractor?

Employee status

Employees are on the company's payroll. They receive either a salary or hourly pay and may also receive employee benefits, such as health insurance, stock options, paid time off, and retirement accounts. Employers handle an employee's tax liabilities, withholding federal and state taxes from their pay.

At tax time, employees receive a Form W-2 showing their wages paid, federal income tax withholding, and other taxes withheld.

Independent contractor status

Contractors work independently, not under the supervision of a direct boss, and with more flexibility. In exchange, contractors don't receive a salary or employment benefits like a pension plan or health, disability, or unemployment insurance. They get paid the agreed-upon amount for work performed. Employment taxes are not withheld from a contractor's pay, and contractors are responsible for paying the taxes themselves.

Independent contractors receive a 1099-NEC that shows their yearly earnings, but the company that hires them doesn't have to withhold income or federal employment taxes. Independent contractors are generally required to handle their own taxes.

Risks When You Misclassify Employees as Contractors

Misclassifying an employee as a contractor carries high penalties. If the misclassification was an intentional effort to save money on unemployment insurance benefits, workers' compensation insurance, and payroll taxes or skirt federal and state laws, the employer may have to pay all the unpaid taxes. Employers may also face fines and penalties. Those penalties depend on the number of employees misclassified.

If the employee was eligible for specific employee-type benefits they missed out on by being classified as a contractor, the employer might have to provide them with back pay and the benefits they didn't get.

In extreme cases, there may be legal or criminal consequences. For example, employees misclassified as independent contractors who lost a lot of money in benefits or earnings may sue the company.

Tests to Determine Worker Status

It can be confusing to determine the status of someone working for your company, primarily if they work from home and purchase their own equipment and supplies. So here are three tests to help you correctly classify them.

Department of Labor

The Department of Labor doesn't have a specific test to measure if a worker is an employee or independent contractor. Instead, it focuses on how much control the employee has and how much commitment is required.

 The DOL looks at the following:

·         Are the services provided an integral part of the business's operations?

·         Does the worker have to invest money in equipment or supplies?

·         Where is the work done?

·         Is there a formal work agreement?

·         Does the employee choose their hours?

·         Is there direct supervision?

·         Can the person work for other companies?

For example, if workers are required to work certain hours and prohibited from working for anyone else, they are employees. On the other hand, if the person works their own hours and can work for more than one company, the worker is an independent contractor.

Internal Revenue Service Test

The IRS cares about classifying workers because of the tax liabilities. Employers withhold Social Security taxes and Medicare taxes from money paid to employees and pay the employer's share of payroll and unemployment taxes. Independent contractors handle their own income and self-employment taxes.

The IRS looks at a few factors when deciding whether a worker is an employee or independent contractor.

Behavioral control

Does the company have complete control over the worker's tasks, hours, and obligations?

Financial control

Does the company handle all aspects of buying equipment, covering business expenses, and paying the worker?

Business relationship

Does the company provide the worker with any benefits, or is there a written contract? A contract alone isn't enough to ensure a worker's employment status, but it's useful when combined with other factors mentioned above.

If you answer 'yes' to most of these questions, the worker is an employee in the eyes of the IRS.

Bringing on new help is a good sign that your business is growing; however, it's one of the most important decisions you'll make for your company. If you aren't sure if you're hiring employees or independent contractors, schedule a call with Slate to avoid the risk of legal and financial consequences.