Employee vs. Independent Contractor: The Dangers of Misclassification

In today’s business world, it’s imperative that you do everything in your power to protect the rights of your employees and independent contractors. Businesses that fail to classify their employees correctly are often hit with severe implications. By reading this eBook, you should give yourself and your business the ability to correctly classify your current employees and ensure that any new onboarded employees are classified correctly as well.

It’s not just your most important assets that are at stake—it’s your very business as well. With that said, let’s get into our main topic of discussion.

A Closer Look at an Independent Contractor

As a business owner, you’re certainly familiar with the term, “independent contractor.” In your mind, an independent contractor is simply a non-employee whom you contract with to perform work on your behalf, or to provide services to your company. But what does it really mean to work with an independent contractor? In this chapter, we’re going to break down the classification in terms of their status as a non-employee, their responsibilities as a non-employee, and the fundamental differences between an employee and an independent contractor. All this information is absolutely critical for a business owner to understand, because when working with an independent contractor, it’ll be up to you to ensure that you’re doing things correctly.

What Is an Independent Contractor?

The IRS has a strict definition of an independent contractor. The organization says, “People such as doctors, dentists, veterinarians, lawyers, accountants, contractors, subcontractors, public stenographers, or auctioneers who are in an independent trade, business, or profession in which they offer their services to the general public are generally independent contractors. However, whether these people are independent contractors or employees depends on the facts in each case.”

From there, they go on to say that an individual can be considered an independent contractor if the “payer”— aka, employer —has “the right to control or direct the result of the work and not what will be done and how it will be done.” This is where things get interesting. Apparently, the IRS holds that a payer or employer— your business —could hire an independent contractor to provide a service, say something like web design. While you can hold the contractor accountable for the final product, you do not have a say in how they reach that final product.

The IRS then explains what they wouldn’t consider to be an independent contractor. They say, “You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done).” This essentially means that the employer holds the legal right to control every single aspect of how a service is completed or offered.

The clearest line of distinction within the IRS’s definition of an independent contractor comes down to a simple sentence: “If an employer-employee relationship exists (regardless of what the relationship is called), you are not an independent contractor and your earnings are generally not subject to self-employment tax.”

So, at face value, the difference between an independent contractor and an employee comes down to self-employment tax, and the contractor having the legal right to dictate how a service is performed. But is that all it comes down to?

The IRS Differentiates Between Independent Contractors and Employees

Because the distinctions between independent contractors and employees seem murky, the IRS tried to make it easier for businesses to distinguish between the two classifications. Now, let’s take a look at the differences between independent contractors and employees as defined by the IRS.

1.   Employment Laws

The first thing we’ll discuss is the difference between the laws regulating employment for employees and independent contractors. According to the IRS, employees are covered and protected by federal labor laws and state employment laws. Independent contractors, on the other hand, are not covered by these laws, and have the choice to contract out their skills, services, and trades as they wish, which would negate the need for their protection under the law.

2.  Hiring

This is an interesting one, because it can sometimes go both ways. After all, independent contractors are often hired in a similar manner. They’re interviewed, onboarded, and hired to perform their service. However, the IRS likes to make a clear distinction between the hiring practices of employees and independent contractors by suggesting that employees complete applications prior to hiring, while independent contractors do not. Again, this is a bit murky.

However, it becomes clearer after the application process. For business employees, the business is required to record and file the personal information of the employee. For instance, their citizenship status, their marital status, their date of birth, and their work history will all be filed away. On the end of an independent contractor, all they’re required to do is sign a Statement of Work contract, with no need to disclose personal information.

3. Taxation

In the way of taxation, employees and independent contractors are treated quite differently. For example, employers are required to withhold federal and state tax, which is typically reflected in an employee’s weekly or bi-weekly paycheck. In addition, employees are required to provide all their tax information upon their hiring, including their name and address, their social security number, and their tax filing status/exemptions through a W-4 form.

Independent contactors are not required to withhold taxes on their pay because they’re typically paid on a per-job basis. This means that they’re subjected to something called self-employment tax. Along with that, they’re still required to pay social security tax, Medicare tax, and FICA tax, but this is something that they’ll do on their own either through estimated tax payments made to the IRS quarterly, or at the end of the year when they file before the April 15th Tax Day deadline. In addition, independent contractors are not required to fill out a W-4 form. Instead, they complete a document called a W-9 form. These forms require independent contractors to provide their name, address, and their Taxpayer Identification Number.

4. Business Reporting Requirements

As a business owner, you’re required to report the amount of money that you pay out in payroll every year as part of your annual tax filing requirements. As with employees, you’re also required to report payments made to independent contractors. For your typical employees, you send out something called a W-2 form each year, which reports all the money paid to individual employees throughout that specific tax year. For your independent contractors, you’re required to send out a 1099 form, which outlines all payments made in excess of $600 in that given tax year. However, these reporting requirements are only reserved for the IRS. Employers with salaried employees, on the other hand, must also submit reports for state and federal unemployment insurance to show that their employees are protected through unemployment laws.

5. Payments and Contracts

This is something that we touched on earlier, but let’s allow the IRS to give us some more clarification in terms of just how payments to employees and independent contractors are structured. First and foremost, you already know that your employees are hired based on some sort of wage—whether it be a salaried wage where they earn an annual income, or an hourly wage where they earn based on the number of hours worked during a given pay period, typically between one and two weeks’ time.

With an independent contractor, there is a bit more flexibility in terms of financial compensation. For example, a contract can be written where you’re required to pay an independent contractor for a total amount, regardless of the length of time, the scope of the work, expenses, etc.

This is a simple form of payment because you can define the terms up front, and know that no matter what happens, they won’t change without a formal amendment to the contract. On the other hand, you can also pay your independent contractors by the hour, by the day, by the week, or by the specific job or service being completed. You can also dictate exactly when you want to complete the payment. You can offer payment beforehand, or you can wait until the job is completed. As long as the terms are clearly defined and stated in the work contract, this would be considered acceptable.

6. Invoicing and Payment Periods

With an employee, pay periods must remain constant, predictable, and unchanged as guided by both state and federal laws. The IRS says, “An employee pay period must remain the same unless formally changed. Federal and state laws require that an employee be paid on the normal pay date or earlier if the paycheck is not negotiable on the normal pay date, which can occur on holidays.”

In terms of an independent contractor, things are a little bit different.

Independent contractors are responsible for submitting an invoice to the payer or employer. Until the payer or employer receives this invoice, they are not required to pay for the services. Your Accounts Payable department shall pay the invoice when received and would be subjected to the terms of that invoice, in addition to the contract or Statement of Work, which also indicates when payment should be completed.

What Does It All Mean for Your Business?

The differences between employees and independent contractors are important to consider because they could dictate the ways in which your organization functions as a whole. For example, let’s say you operate a high-end real estate firm. You have several salaried administrative employees, and you staff a team of realtors, brokers, and listing agents, all of which receive a salary, along with commission for sales.

All the employees listed above would be considered payroll employees. This means that you’d be required to withhold tax in their paychecks, and it means that you’re responsible for ensuring that their rights as employees are protected under state and federal law. And given their classification as full- time or part-time employees, you’re also responsible for ensuring that their benefits are taken care of.

On the other hand, in order for your realtors, brokers, and agents to market your listings and properties, you’re most likely going to need high-quality photographs, immersive videos, and interactive graphics to show potential buyers. It might not seem entirely cost-effective to outright staff your own marketing team, complete with professional photographers, videographers, and graphic designers, so perhaps it would make more sense to hire independent contractors.

In this case, you could hire an independent real estate photographer, who can also create the types of videos that you’re looking for. Here, you'd be able to negotiate a fair rate. This could be based on the amount of hours worked, the number of listings completed, the number of photographs submitted. It could also be a general fee that would cover all expenses related to providing your firm with a collection of photographs, a video walk-through, and a PDF document that you can use for marketing a property all-in-one package.

This will help you save costs on payroll and benefits, while also allowing you to simply pay an independent contractor to give you exactly what you need, leaving the pathway to completion up to them. Essentially, you’re enlisting the help of a tradesman or an expert to complete work on behalf of your firm.

As you can see, this type of relationship offers a benefit both for your business and for the independent contractor.

What are the Benefits of an Independent Contractor?

Let’s continue with the example described above. From the independent contractor’s view, they’ve just brought on a new client. More than likely, they’re making a living by maintaining relationships with several clients at any given time. Perhaps on the days where they’re not photographing a home for your firm, they’re out doing a fashion shoot for a clothing company. Having the ability to independently represent themselves allows them to develop a vast portfolio and pursue a wide range of job opportunities, which can help them expand their expertise in their trade and offer more refined services later in their career.

If you had simply hired a photographer and added them to your payroll, they’d be restricted to only focusing on one aspect of photography: real estate. By working with an independent contractor, you’re not only cutting costs, but you’re giving a professional the chance to see what else is out there.

It’s a win-win situation. And with that in mind, it should be clear at this point that there are benefits to hiring employees and independent contractors. But how exactly can you decide which is right for your business and your unique organizational needs? In the next chapter, we’ll talk about how you can make the choice.

How to Decide Between an Independent Contractor and an Employee

As it relates to your business, how can you decide between hiring an independent contractor and an employee? Well, thankfully, the IRS has some recommendations that we can look at. Remember, choosing the right classification is going to be the key difference maker between following the law and complying with regulations—or finding yourself involved in an employment litigation case.

The IRS offers businesses some help in deciding by breaking it all down into 3 distinct categories: Behavioral Control, Financial Control, and Relationships. This discussion should add a bit more context to your decision-making process.

Let’s start with Behavioral Control.

1. Behavioral Control

Regarding behavioral control, the IRS says, “A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.” This means that an employer can not only determine the scope of the work for an employee, but it can also determine the ways in which the scope of work is completed by that particular employee. The IRS lists the categories of behavioral control as follows:

• “Type of instructions given, such as when and where to work.” In addition, they specify the type of tools that can be used, where to purchase supplies, and how to receive the instructions required to complete a task.
• “Degree of instruction. More detailed instructions may indicate that the worker is an employee.” This means that employees typically receive guided instructions on how to complete a task. Independent contractors, on the other hand, merely complete the task as they see fit, because they are considered a tradesman or an expert.
• “Using evaluation systems to measure the details of how work is done, points to an employee.” Typically, employees and independent contractors are evaluated differently. While a worker might be evaluated on their process, an independent contractor is more likely to be evaluated by the end result and the experience.
• “Training a worker on how to do the job—or periodic or ongoing training about procedures and methods—is strong evidence that the worker is an employee.” Typically, independent contractors have their own set of methods, processes, or approaches, which they’re given the discretion to use to complete a project

As you can see, the behavioral differences between employees and independent contractors are quite clear. And depending on the amount of behavioral control you’d like your workers to have, you should be able to make the decision between hiring an employee or an independent contractor.

2. Financial Control

Do you want your business to maintain direction or control over the financial and business aspects of your work? This one comes down to the expenditures of hiring a worker, including the costs of equipment, services, etc. The IRS recommends taking the following points into consideration:

• Do you want to make a significant investment in equipment that a worker might use with another client?
• How do you feel about unreimbursed expenses? Independent contractors might want to include a percentage of this in their final invoice.
• Are you prepared to profit or accept a loss over hiring a worker as an independent contractor or an employee?
• Are you looking for long-term help, or are you fine working with an independent contractor who is free to seek out other opportunities in the market?
• Would you rather pay an employee weekly, bi-weekly, or monthly, or agree to a specified flat rate with an independent contractor?

These are important points to consider because they could directly impact your bottom line. Depending on the level that your employee or independent contractor is at, you could set yourself up for some significant cost savings, or some significant expense increases simply from paying them for their services.

3. Relationships

Lastly, let’s tackle the concept of employer-employee and employer- contractor relationships. When it comes to hiring an employee or an independent contractor, you can automatically assume a different type of relationship from case to case. In other words, what type of interactions do you want to have with your new worker? Do you want to see this person every day in your office? Do you want to know what they’re working on and be able to lend your input wherever necessary to ensure that their work is completed in a way that aligns with your business goals? Perhaps you merely need a task accomplished, and it doesn’t matter how it gets accomplished? Let’s break down these relationships as described by the IRS.

• Do you want to enter into written contracts with an employer designed to describe this relationship in plain, simple, and clear terms?
• How do you want to deal with benefits? Are you willing to provide your full-time or part-time employee with healthcare benefits, retirement benefits, paid time off, etc.? Or are you fine paying a little more out of pocket to hire an independent contractor whose benefits you’re not responsible for?
• Do you want a permanent relationship with this individual, or are you prepared to potentially lose their services to another competitor?
• Are the services that you’re seeking essential to your business? In other words, if they’re necessary to help ensure continuity of your operations, then it might be worth it to consider hiring this individual as a full-time employee.

Defining the relationship that you wish to have with your new employee is a crucial step in determining just how you want to proceed in classifying them. In fact, this last category directly plays into the business impact of hiring employees and independent contractors. And that’s exactly what we’re going to get into in the next chapter.

The Business Impact

When it comes down to it, the major business impact that comes along with hiring an employee or an independent contractor for your business deals with payments and relationships. Sure, we mentioned behavioral control as one of the major categories that businesses should consider when making the decision between an employee and an independent contractor, but that’s a small percentage of the impact. It really boils down to how much you’re willing to pay, and how much of a relationship you’re willing to have. But this isn’t to say that it doesn’t vary from case to case.

Remember, all businesses are different, and oftentimes, independent contractors end up maintaining long-standing and productive relationships with a selection of clients. It doesn’t necessarily mean that hiring an independent contractor results in some sort of awkward, cold relationship, and hiring an employee results in bringing your workforce together as a loving family. It simply means that the fundamental differences between payments and relationships make the largest impact on a business.

Withholding Taxes

As a business, you’re responsible for withholding federal income tax, social security tax, Medicaid tax, and unemployment tax on all wages paid to your employees. This essentially means that you pay a portion of these taxes each and every year to the federal government, while also withholding some of that money from your employees’ paychecks every pay period.

When it comes to independent contractors, you’re not responsible for withholding any of the above, or paying taxes for your payments to independent contractors. While you might be subjected to a higher flat rate, hourly rate, or fee since these contractors are offering their services on the competitive open market, you do strategically position your business to save a bit more when it comes to taxes.

Plain and simple, this is often a defining factor for business owners when making the key distinction between an employee and an independent contractor. In some cases, the savings could be quite substantial, and you can still build powerful and positive relationships with these contractors, ultimately resulting in a long-term partnership that remains outside the bounds of an employee classification.

Relationships

While it’s important to remember that your employees are protected by federal and state laws, your independent contractors aren’t privy to the same protections. This makes your relationship with independent contractors a bit more flexible in terms of how you proceed in purchasing their services or enlisting their assistance on a given project.

This is important to consider, because should the independent contractor not meet your expectations in terms of the quality of work performed, you can sever ties with them after submitting payment. From there, you’d be free to explore a new relationship with another independent contractor. On the other hand, employees are protected, and you wouldn’t exactly have the ability to fire an employee for performing subpar work a handful of times over the course of a few years.

What This Means for You

As you can see, there are always going to be a few key areas of concern that business owners need to consider when deciding whether to hire an employee or an independent contractor for their business. At the end of the day, that decision will leave an impact on your business, either financially or in terms of production. Use the information provided in this chapter to better understand the potential impact of your decision so that you can move forward to making the right choice for your business.

In our next chapter, we’re going to talk about the implications of misclassifying your employees as independent contractors and your independent contractors as employees. In some cases, these implications could potentially be catastrophic.

The Implications Of Misclassification

More than 50 years ago, the Supreme Court presided over a dispute between newspaper boys and newspaper publishers. At the time, there was concern over the classification of newspaper boys in terms of their employment. Newspaper boys argued that they should be classified as employees of a publisher, so that they would have the ability to form a union and receive protections. This landmark case helped to set the stage in the highest court in the nation as to how the law can help businesses determine the difference between employees and independent contractors.

And thanks to this landmark case, businesses now face clear implications for misclassifying their workers. This article by Mondaq.com says, “Few problems in the law have given greater variety of application and conflict in results than the cases arising in the border between what is clearly an employer-employee relationship, and what is clearly one of independent entrepreneurial dealing.” This was part of the Supreme Court’s report, and even today, there are still some grey areas.

In an effort to clear the air, the IRS has attempted to develop a clear set of financial implications that businesses are faced with should they misclassify their employees.

The Consequences

The IRS says, “Classifying an employee as an independent contractor with no reasonable basis for doing so makes employers liable for employment taxes. Certain employers that can provide a reasonable basis for not treating a worker as an employee may have the opportunity to avoid paying employment taxes.” Again, there is a clear fine in the form of employment taxes, but there is a grey area because some businesses might be able to avoid this penalty. In addition, businesses also have the opportunity to reclassify their employees if they suspect that they have incorrectly classified them to begin with. However, only eligible businesses can qualify for this program. This program, called the Voluntary Classification Settlement Program, was designed to help businesses correct misclassifications without forcing them to pay those employment tax penalties.

For Independent Contractors

For independent contractors who have reason to believe that they should be reclassified as employees, they have a way to challenge their classification with the employer and report this challenge to the IRS for consideration. In these cases, an independent contractor would fill out and submit Form 8919.

What It All Means for Your Business

Your choices are clear. Either you want a seamless relationship with your employees and a seamless experience with your independent contractors, or you want to open yourself up for a headache of tax payments and potential legal issues.

Following the rules, laws, and regulations can really be the key difference maker in terms of how you go about staffing your business. There are financial implications that come along with misclassifying your employees, and there are personal relationships at stake with independent contractors who feel as though they’ve been cheated by you. While we can’t point you in one way or another, all we can do is recommend that you understand these implications and do everything in your power as a business owner to avoid them.

Conclusion

As a business owner, you should now have a better understanding of the differences between employees and independent contractors on a fundamental level. You know how the IRS defines these classifications and have a better understanding of how these classifications impact your relationships with your workers.

You’ve also seen the ways in which hiring employees and independent contractors can impact your business, both in terms of expenses and profit. And you’ve learned about the legal implications that come from misclassifying your workers as employees or independent contractors.

With this information, it’s time for you to trust your decision-making process, knowing that as long as you try to navigate the grey areas gracefully, you should be able to avoid any potential misclassifications.

Thank you for reading, and we hope this eBook has helped to make you a better business owner!