For startup founders, expanding your team is an exciting part of your business journey, but how do you know if you should be classifying new members as independent contractors or employees?
It’s important to stay on the right side of the law and avoid severe penalties that could jeopardize your business. Misclassifying, even unintentionally, can disrupt your operations and result in costly legal troubles.
In this blog, we’ll discuss considerations for hiring an independent contractor or an employee, and the tax obligations, legal liabilities, and benefits of each so you can make informed hiring decisions.
Employee Versus Independent Contractor: What Are the Legal Differences?
Worker Classification Definitions
An employee is someone who is hired by a company to perform certain tasks under the employer’s direction and control. In other words, the employer maintains the rights to how specific services are performed.
An independent contractor is a worker who provides a service to a business or individual, and maintains their own right to control how the work will be executed. These workers are technically self-employed.
A freelance worker or freelancer is a subset of the independent contractor, but one who typically works on smaller projects while invoicing on a per-job basis.
What Degree of Control Over the Work is Needed?
A major classification consideration is the degree of control exercised by the employer. Determining the level of control your startup requires will inform which type of employee best suits your needs.
Employee: The employer sets compensation rates and schedules and supervises the performance of the work. The employer also has the right to limit the worker’s ability to perform work for others.
Independent Contractor: The employer compensates the worker based on the worker’s set rates. The worker also dictates their own schedule, maintains the right to work for multiple clients, and is not directly supervised by the employer.
What Are the Differences between Employee and Independent Contractor Compensation and Taxation?
Several critical differences exist regarding the worker’s compensation and tax payment structure between employees and independent contractors.
Employees should complete Form W-4 at the commencement of the working relationship. Employers are required to deposit and report federal income taxes. They are also required to withhold Social Security and Medicare taxes, as well as pay the employer share of these taxes. In addition, many employers are required to pay federal and state unemployment taxes. Employee compensation must meet requirements from the Fair Labor Standards Act which outlines wages, hours, record keeping, and more.
An independent contractor should complete Form W-9 to inform the employer of their Taxpayer Identification Number and Certification. Reporting is completed through Form 1099-NEC. Employers are not responsible for withholding taxes for contractors. Rather, the worker is responsible for paying appropriate Self Employment Taxes in addition to applicable federal and state taxes upon filing. Independent contractors do not necessarily require minimum wage, overtime pay, or other protections.
Are There Any Easy Ways to Determine Proper Classification?
There are multiple factors involved in determining proper employment classification. The Department of Labor’s Economic Realities Test outlines various factors that help employers determine whether the worker is an employee or a self-employed independent contractor. Further, for California-based employers, employees, and independent contractors, California’s Labor & Workforce Development Agency offers an ABC Test to help clarify employers versus independent contractors.
If classification is not clear, the Internal Revenue Service can determine the classification on behalf of the employer or worker by completing Form SS-8.
What Risks or Penalties Exist for Misclassification?
Misclassification of workers can cause major problems for employers. Incorrect classification is more than getting payroll wrong. It can lead to serious violations of tax compliance, labor laws, and employee rights. Backpayments can span up to three years — not only on wages, but also insurance programs such as paid leave. Fines and interest are also likely to be applicable.
While the IRS offers some relief provisions, careful and consistent filing of federal information returns is mandatory. The Voluntary Classification Settlement Program may permit taxpayers to reclassify workers as employees for tax purposes as long as certain eligibility requirements are met.
Across multiple workers, these penalties can quickly multiply to total large sums and cause further implications for business owners. Ensuring proper employment classification is critical to startup leadership to maintain best practices as well as business reputation.
How Do I Avoid Worker Misclassification Risks?
Clear outlines of work expectations and aligned compensation should be detailed in writing, for both long-term employees and temporary contractors performing small tasks. In New York, employers hiring independent contractors for even small amounts of work – anything valued above $800 in a tax year – are required to hold a written legal agreement according to the Freelance Isn’t Free Act.
HJF Law is here to ensure your contracts are transparent and in compliance with state and federal guidelines. Visit hjflaw.com/contact or call (917) 267-8184 for more information and to schedule your free consultation today.