What You Need to Know to Avoid Making a Costly Hiring Mistake

You’re probably familiar with the terms “Employee” and “Independent Contractor.” But what do they mean and do they apply to you as a small business?

Playing by the (IRS) Rules

The IRS has created guidelines to help businesses classify the different types of workers they may hire to help them. These guidelines determine what taxes are paid and by whom (the worker or the employer) and that all benefits due to the worker are made available to them. The guidelines apply to all employers, whether you’re a solopreneur hiring your first team member or a large business operation with hundreds of thousands of employees.

It’s vital that you understand the differences between these two main types of workers (Employees and Independent Contractors) so you can correctly choose the right workers for your business. The IRS expects business owners to know and understand these guidelines. Failure to follow them can lead to hefty fines, penalties, and other unwanted consequences.

Do You Need an Employee or an Independent Contractor?

Every business operates differently and the type of worker you need (and should legally hire) will be based upon the position you're hiring for and the work that person will be asked to do.

The biggest factor to help you determine whether you need to hire an Employee or an Independent Contractor is something called “Degree of Control.” This simply means how much say your company will have over the individual you plan to hire, including:

• What work they’ll be doing,

• How they’ll be doing the work,

• What tools they’ll be using, and

• When they’ll be doing the work.

IRS Common Law Rules for Employees vs. Independent Contractors

The IRS has outlined some common law rules to help guide businesses in classifying their workers properly. There are three main categories: Behavioral, Financial, and Type of Relationship. The following questions in each category will help you determine the degree of control you will need to have over your worker, and ultimately, which type of worker you should hire:

Behavioral

• Will the company control how the work is being done?

• Will the company control when the work is being done?

Financial

• Will the company control how the worker will be paid?

• Will the company reimburse expenses to the worker?

• Will the company provide training or tools for the worker to do his/her job?

Type of Relationship

• Is the work being performed essential or core to the business?

• Will the relationship be ongoing or long-term?

• Will the worker receive any benefits (vacation pay, insurance, etc.)?

Answering “yes” to any of the above questions won’t automatically mean that your worker needs to be classified as an Employee, but it should definitely give you pause and lead you to take a much closer look.

Unfortunately, determining worker status isn’t as easy as answering a few questions.

There’s no magic formula or system that you can plug your answers into that shoots out a clear-cut answer for you. There are even cases where a worker might be classified as a contractor for one company or position, but might need to be classified as an employee for another.

I know, it can get pretty confusing.

Your best bet is to get a professional to help you determine which type of worker you should hire for your business so you can avoid hiring the wrong type of worker. This is something we help our clients with all the time and we’d love to help you, too!

Can I get in trouble for treating an Independent Contractor as an Employee?

The short answer: Yes. Big time!

The longer answer: Treating an Independent Contractor as an Employee is what the IRS refers to as a “misclassification of worker.” It’s a fancy phrase that simply means you mixed things up.

Now, you might have made an honest mistake. But the government isn’t big on excuses. As a small business owner, you’re responsible for knowing and following the rules of hiring and properly classifying your workers.

That’s just how it works.

Why is misclassifying workers such a big deal?

Over the years, a lot of businesses (both large and small) have hired Independent Contractors (instead of Employees) in order to avoid paying taxes, insurance, and other obligations that come along with hiring employees.

When you treat your Independent Contractor like an Employee (i.e. controlling when they work, how they perform the work, providing them with tools and training, etc.), then the government views that as an Employee/Employer relationship.

Why is this bad? Because when you misclassify an Employee as an Independent Contractor, they may be denied access to critical benefits and protections under federal law.

Why do employers misclassify workers?

In many cases, employers misclassify workers to avoid certain costs associated with hiring employees, including:

• Minimum wage and overtime laws

• Employer’s share of Social Security and Medicare taxes

• Employee benefits, such as vacation, sick pay, and holidays

• Unemployment Insurance and Benefits

• Workers’ Compensation Insurance

• Civil Rights and Discrimination protections

• And various other protections under Federal, State, and Local laws

These can definitely add up! But if you are in the business of doing business, these are the rules of the game that you must follow in order to comply with Federal, State, and Local laws.

What are the consequences of misclassifying workers?

Let’s start with a question I know might be on people’s minds: “Yeah, but…how would I get caught?”

Here are a few ways you might get caught misclassifying a worker:

• A worker who believes they’ve been misclassified files a complaint with the Department of Labor (DOL).

• A worker who has been classified as an Independent Contractor files for Unemployment Benefits or gets hurt while working for you and files a Workers’ Compensation claim.

• Random audits performed by the DOL or IRS, which covers all Independent Contractors and Employees you’ve hired for roughly a three-year period.

Federal agencies are teaming up and cracking down on businesses that misclassify their workers. By misclassifying your workers, you could be subject to a variety of penalties and fines, and other consequences, none of which I want for you to deal with.

Let’s say the audit finds that the misclassification was unintentional, at best you’ll still be required to pay back pay, back taxes, and penalties for failing to file W2s and failing to pay taxes. 

However, if the misclassification is found to be intentional, you would be required to pay all of the above, plus you could face even more severe penalties and fines, including criminal penalties and jail time.

Final Thoughts

Whether a worker should be classified as an Employee or an Independent Contractor is determined by the nature of the working relationship.

Just because you issue someone a 1099 (or they themselves state that they are an Independent Contractor) does not mean that they’re an Independent Contractor. It truly depends on the work they’re doing in your business and how much control you have over their work.

Authored by Ashley Cox, PHR, SHRM-CP