Employee or Contractor? What Employers Need to Know

We’ve seen many reasons why companies and organizations use independent contractors instead of hiring employees. However, distinct conditions must be met to consider someone an independent contractor; failure to do so can lead to significant costs, fines and other ramifications. So it’s important to make sure you classify your team correctly.

What’s the Difference?

The U.S. Department of Labor (DOL), the Internal Revenue Service (IRS) and the National Labor Relations Board each have their own rules. However, the basic “common law” standard defined in the Fair Labor Standards Act of 1948 focuses on whether the employer is “legally responsible for the acts or omissions of” the worker.

The IRS considers three areas of examination:

• Behavioral control – Who possesses the right to direct or control how the worker performs tasks?
• Financial control – Who possesses the right to direct business aspects of the arrangement, such as reimbursement terms?
• Relationship – How do both parties perceive the relationship, whether the worker receives employment benefits, the terms of termination, etc.?

Independent contractors typically set their own hours, scope and other aspects of their work and can serve other businesses besides yours. They generally don’t receive employment benefits such as paid time off or insurance coverage, and your company doesn’t have to withhold income, social security taxes and Medicare taxes or pay unemployment wages. They’re self employed and are generally subject to self-employment tax.

Employees are typically subject to more rules about their daily work and given the protection and benefits of employment. While they’re more expensive to hire and retain, they may be longer-term, more engaged team members due to the benefits of being an employee. They’re also more likely to build relationships with your customers, which in turn helps customer growth and retention.

Why Do Employers Bring on Independent Contractors?

They might have an occasional or temporary need for a worker with a particular skill set. Perhaps they need to handle increased business but aren’t quite ready to permanently grow their staff. Or they could be hesitant to commit resources to employees when available capital is uncertain.

The lower cost of hiring and retaining independent contractors is of particular benefit for nonprofits and small companies, where funding is often an issue. During periods when more help is needed, these entities don’t typically have as much cash or resources to pay for employee benefits (like health insurance) and payroll taxes. Independent contractors provide a more feasible workforce solution.

How Can This Become an Issue?

Sometimes employees are classified as independent contractors because it’s cheaper or involves less paperwork. It could also happen because the employer simply isn’t aware of the classification requirements.

However, when you provide an independent contractor all the resources needed and/or pay by the hour — even with the best of intentions — it’s called employee misclassification. Not only does this deny workers their proper protections, it can also result in steep penalties and damage to your company. If the IRS determines that employee misclassification has occurred, the agency could come after your company for income tax, social security tax or Medicare tax owed on amounts paid.

An Additional Concern: The Liability Angle

Some companies hire contractors because they assume it will protect them from lawsuits regarding the conduct or performance of that person (since he or she is not an actual employee). However, this is not always true.

In liability cases, one test for validity is the customer’s perception about the worker’s employment. Let’s say an independent contractor you hired performs work that results in a lawsuit filed by the customer. If you haven’t made it clear at every stage of the customer relationship that this person is not an employee of your business, that customer — and the law — might see the worker as an employee. And if your liability insurance policy covers the work of an independent contractor, the plaintiff’s lawyers could look use it as a source of funding if the plaintiff wins.

Are You Misclassifying Workers?

The Wage and Hour division of the DOL is working with the IRS and several states to ensure proper employee classification. To determine whether your company is compliant, you can start by asking yourself a few questions:

• Does my business pay for the worker’s resources (computer equipment, office supplies, etc.)?
• Do I have specific instructions on how tasks are to be performed?
• Is he or she required to work full-time hours for my business?
• Do I pay based on time increments (such as hours or days) instead of for deliverables?
• Does my company pay for business/travel expenses (e.g., visiting a client or attending a conference)?
• Does my company require they not perform similar work for another business?

A “yes” to any of these questions could indicate that a self-employed worker should be classified as an employee.

How Do I Avoid Misclassifying My Workers?

You can take several steps to demonstrate that a worker is an independent contractor.

Use a written contract that details all aspects of the work agreement.

A formal document detailing the work arrangement puts you and an independent contractor on the same page. Among other things, the contract should:

• Set pricing for work performed or deliverables (pricing should be for results, not hours)
• State that they can perform the same work for other companies
• Indicate that the independent contractor decides how his/her work is performed and is not subject to your approval
• Stipulate that they must have own liability insurance (you should also check your own insurance policy to understand how contractors are covered)

Limit resources used by independent contractors.

Make sure resources typically used by employees are not available to the contractor. For example, a self-employed contractor should not have a company email address, display your logo or use any business-owned materials like computers, letterhead or appointment cards. They must also bill separately for services rendered.

Educate your management and employees.

Make the difference clear to everyone at your company and ensure they’re using the correct terminology for each person. Even casual references can be misunderstood by customers or used in court to suggest an employer-employee relationship.

Consult an employment attorney.

Legal professionals can supply the correct wording for signs/forms and advise you on how to make this distinction clear to all involved.

As HR consultants, we understand that sometimes an independent contractor is the best way to go. Just make sure you’re doing so without violating DOL and IRS requirements. Having an independent contractor agreement may not provide protection to your organization if the other factors suggest employee status. We can help you navigate these requirements so you stay compliant when filling your personnel needs.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.