Understanding the difference between an employee and independent contractor.
If your business or organization uses independent contractors to fulfill some of the necessary roles within the business, it is vital to ensure that they are correctly classified as such. Misclassification occurs when a person who works for your business is wrongly classed as an independent contractor, when in fact they should be categorized and treated as an employee. While there are numerous benefits to having independent contractors rather than employees, these benefits by design lead to the wrongly-classified employee in question losing out on some of their basic employee rights.
Being caught for misclassifying those who should be on the payroll as independent contractors, even inadvertently, can lead to a range of penalties, including court orders for the payment of back wages, fines, and of course, the additional expense of costly litigation to defend yourself.
Employees vs. Independent Contractors
The difference between an employee and an independent contractor is difficult to define at times, but that doesn't obsolve you from the responsibility to classify an invidiual correctly. Below is a rough explanation of the differences between the two:
Who is an employee? (W-2)
An employee is a person who works for your business as a payrolled individual. An employee’s general working patterns and process will be controlled by their boss; who would, for instance, dictate working hours, where to work, what to do and how to do it, as well as providing all of the necessary tools and equipment.
If your staff are paid a set rate per hour worked, they should almost certainly be classified as employees. Additionally, employees can expect that the company will take care of work-related expenses, including the provision of tools and equipment. Employees receive a standard W-2 pay slip, and taxes and other costs are deducted by the employer at source before the employee receives their wages.
Who is an independent contractor? (1099- Misc.)
To be correctly classified as an independent contractor, the person in question must maintain a degree of freedom in terms of their working practices, models and autonomy. Generally, the relationship with the employer in this case will follow a pattern of the employer telling the contractor what is required in any given task and potentially, how they want it to be performed. The contractor in turn determines their working patterns and how they reach the end result.
An independent contractor makes annual 1099-Misc. declarations to the IRS. They are responsible for paying their own social security taxes and health insurance, while for employees, the cost of these things is split between the employee and the company. Additionally, independent contractors are not eligible for employment benefits, such as coverage under the Workers Compensation Act regarding workplace injuries and accidents at work, and they are also ineligible for other basic employee rights. These may include, but are not limited to the right to a minimum wage, overtime and holiday pay, and access to the basic framework designed to protect employees from harassment and discrimination.
Financial Control vs. Behavioral Control
In order to correctly determine the status of a person as either an employee or an independent contractor, it is first important to understand the basic elements of the relationship between the company and person in question, and vitally, who holds the power of veto when it comes to both financial control and behavioral control. These factors in combination are used as the benchmark for correct employee classification, and understanding how financial control and behavioral control are measured and determined is critical.
Some of the factors that can be used as a litmus test to ascertain financial control include:
- Whether or not the worker takes care of their own business expenses for later reimbursement, or whether the company covers such costs directly. Contractors generally invoice for business expenses after first covering the cost themselves, while employees generally have such expenses covered by the company in the first instance.
- Who owns the tools and equipment required to fulfil the job; independent contractors generally provide their own tools and equipment, and are responsible for maintaining or replacing them. Employees on the other hand work almost exclusively with equipment and provisions supplied and maintained by the employer.
- The leeway to either profit from or make a loss on a project generally indicates an independent contractor, while an employee can expect a set wage and no responsibility for the ultimate income or shortfall caused by their work.
- A true independent contractor rarely works exclusively and long term for one company or business; whether or not they exercise the right to do so, an independent contractor can and may work for other organizations either alongside of or as an alternative to one company’s project.
Behavioral control relates to the employer’s input into their worker’s working practice itself; such as dictating working hours, tasks to be performed, and how they should be performed. If all of these elements are dictated by the employer, this indicates the high probability of a employer/employee relationship. If, on the other hand, the company or employer simply sets a task or project (and potentially a deadline) and the worker has the freedom to dictate their working patterns and methods and to some extent, the procedure followed, this indicates an independent contractor.
The Risks Involved in Misclassifying Employees
The IRS and DOL have cracked down heavily over the last few years when it comes to misclassification of employees, something that has reached the public awareness thanks to high-profile cases such as the April 2016 settlement by the Uber ride share company in the states of California and Massachusetts.
This means that as more and more workers and litigators are becoming aware of the full remit of misclassification laws and the correction of long-running mistakes in worker classification, more cases are arising each year. The DOL is also taking such cases very seriously, and will investigate the potential incidences of misclassification aggressively, in conjunction with the IRS.
If your company is caught with misclassified employees, the penalties can be large, including but not limited to:
- Mandates for back payment of wages, which can potentially run into the millions of dollars.
- Compensation payments to affected workers.
- The cost of litigation and legal representation for a potentially complex and long-running dispute.
- Loss of reputation and goodwill if such cases come to the attention of the media and wider public.
- The potential losses your business may incur due to misclassification are not small change either-yet another up-and-coming ride share service (Lyft) recently had their request to settle a worker misclassification case for $12.5 million rejected out of hand, with the judge stating that such a settlement would leave drivers “short changed.”
Best Practices for Determining Employee Classification Status
In order to avoid a potential misclassification lawsuit and ensure that all of your workers are correctly classified in terms of their employment status, it is important to maintain a protocol in terms of determining status and maintaining best practice. Ultimately, if a worker is borderline or you cannot definitively define them to one status or the other, it is advisable to play it safe and classify the person as an employee. You can also request the IRS to determine the status of a worker using information that you provide via IRS form SS-8 and further investigation into said worker’s specific situation.
If you are uncertain about employee classification or you feel your business may be at risk, we recommend you seek legal counsel from your preferred attorney right away. A reliable business law attorney can answer your questions and provide proper guidance on how to handle your specific situation.