When employers engage a new worker, one of the first questions that pops up is how should this worker be classified – is the worker an employee or an independent contractor?
There can be more than meets the eye at first sight here. This may be a complex inquiry as various sets of rules and criteria apply in this area. The rules may vary from state to state and from one area to another – state and federal taxation, workers’ compensation, employer’s agency liability, and others. In some contexts, there may be less clarity and more grey areas may surface. Nevertheless, business savvy employers would aim for certainty and would follow best practices.
Why the labels?
Employer, employee, independent contractor, business partner, agent? Are these mere labels or meaningful distinctions? Each classification comes with its own sets of legal and financial consequences and implications.
Some employers believe the tax form issued to the worker for the prior year defines the relationship. “My worker is an employee because I issue her a Form W-2.” or “He is a 1099 contractor because I give him a 1099 in January.”
Rather, it is the reverse. The nature of the relationship determines the proper classification and the tax form that should be issued: a Form W-2 or Form 1099.
Why does it matter?
Certain laws exist – on the state and federal levels – to protect employees. Many laws apply to require employers to take certain actions for their employees. These same laws usually do not apply to workers hired as independent contractors.
Employers are required to pay:
- half of the employee’s federal Medicare and Social Security (payroll taxes),
- state-mandated minimum disability coverage;
- employees all of their earned wages or state labor departments may interfere to require employers to pay, and
- toward workers’ compensation insurance funds to compensate employees who get hurt on the job.
Many employers choose to provide employment benefits that independent contractors are otherwise not entitled to receive: paid sick days, paid vacation, paid holidays, and paid health and other insurance premiums.
Federal and state discrimination laws apply to protect employees from unfair treatment. Independent contractors fend for themselves and are not afforded the same level of protection.
On the other hand, independent contractors have the freedom to set their pay terms and negotiate their compensation on a project by project basis, to choose their clients, to set their work schedules, to deduct business expenses from their total compensation, and to make their own arrangements for the payment of taxes.
Who is an employee?
Unlike an independent contractor, an employee is directed and works under the employer’s control. In essence, the employer controls how the work will be done. That is the key distinction although it has a lot more depth to it.
In general terms, the employer typically specifies the work days and work hours, the location where the work will be performed, what work will be completed, how this work will be performed, and what compensation the employee will receive and how it will be paid. The employer typically prescribes policy and dictates practices and the manner of accomplishing tasks under the employer’s supervision. The employer may also provide equipment, office space, tools, materials, and other resources for getting the job done.
Who is an independent contractor?
Conversely, an independent contractor is totally independent and free from an employer’s control. An independent contractor takes on a new project on the contractor’s own terms and agrees to deliver a specific result. An independent contractor decides independently how the work should be done so long as the result is achieved. Independent contractor set their own hourly rates, bring their own tools, drive their own vehicles, set their own schedules, pay their own benefits, do not rely on tax withholdings, and make their tax filings entirely independently.
While there are many other factors we study and analyze to determine the proper classification, these are some of the distinctions among many others that help distinguish an independent contractor from an employee. On occasion, that distinction may be fuzzy and unclear. That is when governmental authority and courts typically come in. Even then, one court may disagree with another based on identical or virtually identical facts.
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That is why, understanding the risks and being proactive about minimizing them as much as possible is critical in this area of the law.
Our firm offers assistance with the following worker classification services:
- Handling disputes involving independent contractor vs. employee worker status
- Advice on structuring worker classification arrangements
- Advice on IRS Voluntary Classification Settlement Program (VCSP) applications
The IRS VCSP program allows businesses to voluntarily reclassify workers as employees for future tax periods for employment tax purposes.
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Petrova Law is a boutique business law firm focused exclusively on tax and business law matters. The firm assists businesses with tax strategy, IRS representation, sales and purchases of businesses (M&A), and general corporate law from startup launch through growth and maturation to exit and succession.
For more information, call us today at (336) 310-1210, email us, or contact us online.