Classifying employees vs independent contractors can be tricky.
But, there is no need to fret because this post will go over everything you need to know to avoid a dreaded misclassification.
Employees and independent contractors owe different responsibilities and each has different rights and obligations when dealing with your business. Employees and independent contractors have different tax obligations in relation to your business. It is critical to appropriately classify to understand how it affects big or small businesses.
Even large companies can misclassify the type of work completed. For example, in 2015 Uber was fined for misclassifying drivers as independent contractors. But, since then, Proposition 22 allows for app-based companies to classify drivers as independent contractors.
What is Proposition 22?
Proposition 22 was a 2020 Californian ballot initiative which allowed workers of app-based transport and delivery companies as independent contractors rather than employees. This means all kinds of delivery drivers are not entitled to mandated benefits from their host company.
However, Proposition 22 entitled drivers to:
- 120 percent of the local minimum wage for each hour a driver spends driving.
- $0.30/mile for expenses for each mile driven with passengers or en route.
- Health insurance for individuals who average more than 15 hours per week driving.
- medical costs and some lost income for individuals hurt while driving or waiting.
- Protection and policies regarding workplace discrimination and sexual harassment.
However, in mid 2021, the California Superior Court invalidated Proposition 22 on the basis that it is unconstitutional and unenforceable. While it claims to protect workers, it prevents them from bargaining collectively or as a union and merely protects the economic interests of the network companies.
It is expected that these app based companies will appeal this decision and ask for stay while the decision is pending. Practically speaking, Proposition 22 will remain in effect until the appeal process is completed and there is a final decision.
What’s the difference Between an Independent Contractor vs Employee?
Generally speaking, an employee is a person who agrees to provide labor for a company and thus becomes part of the company. All employees must have an employment agreement that sets out the expectations and responsibilities. The specific terms of their employment contract will establish their roles and duties.
An independent contractor is a person who agrees to do work for a company usually to fulfill a specific task but is not part of the company. Often they are an alternative to hiring an employee. This allows each contractor agreement to fit the parties’ purposes rather than be broad or unclear.
Essentially, an independent contractor works for themselves. This is because they are specialists at what they do and contract their services to whoever is in need. As a result, they have a lot more freedom to dictate their working conditions.
The Key Differences
|Hours of work||Set hours||Up to the Contractor and terms of business contract|
|Leave and Benefits||Full-time employees are also offered more protection under the Fair Labor Standards Act and benefits like severance, workers compensation, reimbursements, medicare, employee benefits, unemployment insurance and anti-discrimination protection.||The independent contractor is not entitled to leave whilst completing their project.|
|Pay||Regular wage||Paid per project|
|Tax||Tax is deducted directly from the employer as payroll tax.||The independent contractor is considered self-employed in the eyes of the IRS.|
Helpful tests you can use
While there is no set test to determine an independent contractor vs employee, the IRS and the U.S. Department of Labor have set some criteria to help make determining the nature of the business relationship easier.
California Assembly Bill 5 (AB 5), as amended, requires courts to apply an “ABC test” when determining whether a worker is an employee for purposes of the California Labor Code and the California Wage Orders.
The following three categories are highly important to consider when trying to make sure you are within the confines of U.S. labor laws. Under the ABC test, a person is an employee and not an independent contractor unless the employer can demonstrate that:
A. Degree of Control
As an employer running your own business, the degree of financial control and behavioral control over what your workers do gives an indication into their classification. Key considerations when determining a worker’s status include:
- Tasks to be completed
Thus a contractor is someone who is free from the control and direction of the hiring entity in the performance of the work, both under the contract for the performance of the work and in fact.
B. Working Relationship
When looking to determine what sort of business relationship is occurring, the type of services that a worker provides is significant. If the person performs work that is outside the usual course of the hiring entity’s business, then a contractor can be determined. Independent contractors are brought in for short term or specific projects and have a set amount of work to complete usually within the confines of a written contract or independent contractor agreement.
On the other hand, if the work is directly related to the core of your business then the IRS will likely classify the worker as an employee. If a worker has benefits this would substantiate a claim that they are an employee.
C. Independent Trade
If the person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed then a contractor can be determined
Exceptions to the ABC test
Several occupations and contracting relationships are exempted from the ABC test.
Some exemptions include:
- Business-to-business contracting relationships (that satisfy certain requirements).
- Contracts between a referral agency and a service provider, where a referral agency is defined as a business that connects clients with service providers that offer services. Examples of this include, graphic design, photography, consulting and sport coaching.
- Contracts for professional services. This can include marketing, fine art, HR, and travel agent services.
- Occupations in the fields of marketing, promotion, or distribution of sound recordings or musical compositions.
Still can’t figure out classifications?
If you still can’t figure out if someone is an independent contractor or employee, you can always file a Form SS-8 which allows you to request a determination of the status of a worker for purposes of federal employment taxes and income tax withholding.
Filing Tax Forms
As a business when you employ an independent contractor or employee you will need to complete the appropriate tax forms to consider the different types of workers.
Should you file a 1099 and W-9?
For an independent contractor a 1099-MISC form is required as well as a Form W-9 to determine income tax and self-employment tax. Independent contractors can also be referred to as 1099 employees under the tax regulations.
Should you file a W-2?
For employees, the business will need to file a Form W2 for each and every one of their employees.
What happens if you misclassify?
While the test outlined above should give you a good indication of how a worker fits into your business, misclassifying workers can happen. So it’s important to understand the consequences of a misclassification.
If the IRS determines that there is a misclassification, it will order your business to pay back-taxes as well as substantial penalties which range from $5,000 to $15,000 per violation.
Similarly, the California Labor Code requires an employer that is found to have willfully misclassified a worker as independent contractor to post a public notice for one year on a website or at a worksite that outlines that the employer has changed its business practices to avoid committing further violations.
Contractor vs Employee: Effects on business operations?
How you decide between classifying an independent contractor vs employee is all about your control over them as a business and how they affect operations.
Overall, employees are more beneficial for a company in the long run. This is because they provide for stability, increased productivity and are invested in the company. It is important that the company does well so that they may receive further benefits and grow in their career.
Contractors, on the other hand, do provide more flexibility, however, they are more complex to administer from the employer’s perspective. A contractor is very useful if you have one specific task you would like done and employing a specialist would be too expensive for the business.
Deciding whether to classify an independent contractor or employee can be an important decision for your business.
The decision to hire an employee or a contractor must be weighed according to the costs and benefits outlined in this article. Whether you have a contractor or an employee working for you, just make sure you appropriately classify them so you can protect yourself from unnecessary legal issues.
While this post sets you up to classify an independent contractor vs employee on your own. Lawpath is more than willing to assist you in any of your classification needs to bulletproof your business operations.