How to Properly Classify Hires as Independent Contractors vs. Employees

Growing a successful small business often requires help, which means hiring someone to nurture and drive growth for your business. There are two different options for adding members to your team: adding employees or adding independent contractors.

It's important to know which worker is right for your business. That's because each designation carries different tax, labor regulation, and possible liability implications.  

What is an employee?

An employee is someone who agrees to provide labor in exchange for a set wage. The employer chooses where and when they work.

Historically, employee/employer relationships have been largely unregulated. Now, these relationships are regulated by government standards, including taxes, benefits, and workers' compensation. Those regulations can add up quickly, costing you more than what's printed on your employees' paychecks.

As such, you might want to hire employees in a less traditional sense. Hiring someone as an independent contractor reduces your liability, cuts costs, and allows you more hiring flexibility.

What is an independent contractor?

An independent contractor is any person who provides services without becoming an "official" employee.

Have you hired a carpenter to repair your home's floors? That carpenter is an independent contractor. Have you ever signed a legally binding agreement with a previous employer? A lawyer whom the business hired likely wrote that contract. As you can imagine, almost any profession can use independent contractors.

The contractor-employer relationship isn't as straightforward as you would think, however. Many such relationships have elements similar to standard employee-employer relationships, making it difficult for businesses to classify their relationships with workers.

What professions use independent contractors?

The IRS reports that the following often employ independent contractors:

● Law firms

● Medical offices

● Veterinary clinics

● Dentist offices

● Construction companies

● Freelance writing companies

● Public stenographer firms

● Auction houses

This is just a brief list of examples. Other organizations in other fields may also employ independent contractors.

Why is the difference between an employee or contractor important?

The most important difference between an employee and an independent contractor is tax obligations. Businesses with employees are required to withhold a percentage of workers' wages for federal income tax, Medicare taxes, and Federal Unemployment Tax.  

The employer then sends the amounts withheld to the IRS. If a business fails to collect and pay these taxes, it may be liable to pay the IRS for the amount it failed to collect, with other potential penalties and interest. These amounts can be significant.

You don't have to withhold taxes when paying independent contractors

If an employee is an independent contractor, then you, as a business, are exempt from withholding these amounts. However, you have to keep track of how much you pay independent contractors so the IRS can verify these facts come tax season.

However, there's a fine line between what constitutes an employee and what constitutes an independent contractor. If you wrongfully classify an employee as an independent contractor, this could carry harsh financial and legal penalties.

Employees have labor law protections

Standard employees are typically protected by labor regulations, governing factors such as:

● How long an employee can work in a day or a week

● Whether a business must pay overtime

● Whether minimum benefits are required

● Whether employees can organize or join labor unions

The relationship between a business and an independent contractor is not typically subject to these regulations. Again, suppose an employer mistakenly characterizes an employee as an independent contractor and fails to pay overtime to that employee. In that case, the business may end up being liable for those expenses.

Between the tax and other regulatory obligations, failing to correctly classify a worker as an employee is one mistake you never want to make. It could create a host of legal, financial, and ethical implications for your business.  

You could face serious penalties if you violate state or federal labor laws

You already have enough on your plate running a company, and the last thing you need is an investigation into your business practices. Failing to differentiate between employees and independent contractors could result in:

Financial penalties. The government might fine you if it finds you violated labor laws. The U.S. Department of Labor says that you could face a fine of $1,000 per violation for every labor law infraction.  

● Unexpected wage costs. The government might even order you to offer backpay, which reimburses employees for the time and benefits they did not previously receive. This can seriously cut into your profit margins and hurt your work relationships.

● Ceased operations. In serious cases, the state may shut down your business until you rectify certain issues. Even shutting down for a few days can devastate a small company, as this would require inspections, further investigation, and other complicated, time-consuming matters.

● Criminal penalties. Odds are, if you made a simple mistake, you're not going to face criminal consequences. However, you could face jail time if the government believes you purposefully committed tax fraud.

● Trouble finding workers. Word travels fast in the digital era, and workers may take their skillsets elsewhere if they suspect that they're being "cheated" out of certain benefits. This could significantly limit your abilities to locate and hire talent.  

Learning about the differences between workers is critical for your business.

These three things determine a worker's status

Per the IRS, the status of one's employment depends on:

● Behavioral aspects. Does their employer require daily updates? Do they have a chronological method in which the worker completes tasks?

● Financial aspects. Do workers get paid by the project or by the hour?

● The working relationship. Will the relationship continue even after the worker completes a project? Do they get benefits, like health insurance and workers' compensation benefits?

An overview of the IRS's 20-point checklist for classification

The IRS provides a 20-point checklist outlining the difference between employees and independent contractors. The list illustrates the amount of control businesses can exert over workers. The more control the company has, the more likely the worker is a standard employee.

When considering the list, no one item is definitive in determining whether a worker is an employee or an independent contractor. The list allows the employer to consider their situation and weigh the differences between the two designations.

The following conditions don't work 100 percent of the time, but they can help you determine who's an employee and who's an independent contractor:

● If you control most aspects of a worker's job, they're likely an employee.

● If you have limited control over a worker's job, they're probably an independent contractor.

The IRS 20-question checklist: employees vs. independent contractors

Depending on the business, some of the following may not apply. Perhaps, most importantly, when evaluating the criteria, you should consider the relationship between yourself and your worker.

Now, ask yourself the following:

Does the employee get instructions about the how, when, and where of their job?

The "where" and “when” is usually straightforward when talking about retail workers, for example. However, this can get confusing if you work in construction or don't have a standard brick-and-mortar business.

Regarding the "how," consider whether there are manuals or best practices that the business issues, even if there is no direct oversight. Compare this to an accountant, where the accountant might have standards or guidelines to adhere to but not guidelines issued by the company.

Bottom line: if the answer is "yes," more likely than not, your worker is an employee.

Does the individual receive training from your company?

This is usually straightforward. However, keep in mind that even third-party certifications provided by or required by the business might be considered training.

Again, a "yes" to this question indicates this worker is likely an employee.  

Does the success of your business ride on the worker's services?

Consider this hypothetical scenario to understand this question. You own an upscale restaurant.

You might hire a third-party worker to schedule bookings, make reservations, and provide customer service. You don't need this employee but having them makes things easier. They could be an independent contractor.

On the other hand, if you own a restaurant, you have a chef who prepares meals. Without this person, you don't have a restaurant. In this case, they're an employee.

Answering this question depends on the nature of your business and the services your workers perform.

Must the individual personally perform the contracted services?

This isn't as straightforward as you'd think. Consider hiring a lawyer for a real estate transaction. A paralegal will likely perform much of the work.

Compare that to most employees who, aside from management, are generally expected to perform tasks themselves. Another "yes" to this question weighs on the side of the worker being an employee.

Does the worker need "assistance" from other workers you've hired?

Think of this question through the lens of a construction project. If a business hired a plumber, an electrician, a supervisor, and some general laborers, the answer would be "yes." You need these individuals to collaborate on one specialized project.

On the other hand, if a business hired a contractor to complete one job unassisted, the answer is "no." The worker is self-reliant, and they do not need help from others to complete a task.

Does your business have an ongoing relationship with the worker?

The answer to this question largely depends on the nature of your business.

For instance, suppose you hire a freelance writer to provide content for your company's website. This writer will provide content for four weeks and then move on. So, this worker is likely an independent contractor.

Now, suppose you have another salaried writer who works indefinitely. This person is likely an employee because you have an ongoing, continuous relationship with them.

Does the worker work a set number of hours?

Keep in mind that even a flexible schedule can still include set hours. Think of an example like a coffee shop where a worker can request specific shifts. This is still a set number of hours.

However, contrast that with a plumber who comes and goes as they please until the project is complete. In that case, they don't work a set number of hours; payment depends more on the job itself.

Review your workers' schedules and mandated tasks before classifying them as employees or independent contractors.

Do you require the individual to work full-time at your company?

This is another factor that can be somewhat context dependent. Ask yourself: "Does this worker need to work full-time to complete their job?" Consider the nature of your business, the work required, and your worker's schedule to decide.

Does the worker perform work on company property?

This is also a context-sensitive question. For instance, if you own a catering business, you may have workers that render services off company property. However, they could still be employees. On the other hand, you might have someone performing onsite services who's an independent contractor.

Consider the following:

● Does your worker need to be onsite to perform specific job-related tasks?

● Does your employee "clock in" to work?

● Can the employee come and go as they please without notifying you or logging their hours?

● Does your employee report to a supervisor regularly?

Your answers to these questions may provide insight into your workers' status.

Must the worker follow a set sequence or routine to complete their job?

When considering this factor, the "set sequence or routine" should be thought of as one that's outlined by the business that hired the worker. If the worker can come and go as they please or complete tasks "their way," they're likely an independent contractor.

Must the individual give reports regarding their work?

Businesses hold employees and independent contractors to different standards. Employees usually log their hours, communicate regularly with supervisors, and give "reports" regarding their week's work.

Independent contractors do not. While they may ask for clarity or guidance about a task, they are not required to give updates or reports. If they provide you with updates on their terms, that's fine, but it does not constitute an employee-employer relationship.

Reports do not necessarily have to be formal, written statements. Informal verbal reports would suffice. If this is the case, then it would indicate the worker is more likely to be an employee.

Does the individual get paid by the hour or per project?  

Consider the following:

● If a worker is paid for completing particular tasks, this indicates an independent contractor relationship.

● If the worker completes timesheets or is paid a regular weekly or monthly salary, that is more indicative of an employee.

Does your company reimburse the individual for business/travel expenses?

When evaluating this factor, you should pay close attention to the contract between yourself and the worker. Consider the following:

● If the worker gets reimbursed for business trips, conferences, and off-site obligations, they're an employee.

● If the worker gets paid in a lump sum, they're an independent contractor.  

Think also about how the company would reimburse these expenses:

● Is the worker submitting receipts and then having these added to a paycheck? They might be an employee.

● Are these expenses being added to an invoice? The worker might be an independent contractor.

Do you supply the worker with necessary tools or materials?

This factor can be relatively straightforward if you consider a profession like a cook or a carpenter. For instance, is the cook using a kitchen provided by the business? Does the carpenter supply his own tools?

If you have to give the worker tools to do their job, they're likely an employee.

Have you invested in facilities used by the individual to perform services?

Ask yourself: without providing a specialized facility, could the worker still do their job? It doesn't have to be a huge office building; even supplying a mobile kitchen could qualify as investing in a facility.

Employees rely on their employers to provide the tools, facilities, and skills needed for their jobs, and independent contractors do not.

Is the individual free from suffering a loss on his work?

This question measures the risk the worker takes when providing services. If the worker is going to get paid regardless of their work's quality, then "yes." They're likely an employee. For example, if you own a storefront, the cashier gets paid regardless of whether ten customers or 100 customers come in.

On the other hand, if the worker could suffer a loss based on the quality of their work, they're likely independent contractors.

Does the individual only perform services for your company?

When evaluating this criterion, it's important to, again, consider the context. This question typically does not apply to part-time workers who have multiple jobs. Instead, it relates to whether a worker has multiple clients to whom they provide services.

Consider the following:

● You have a writer on staff who only produces content for your company. Your company owns all the work they produce.

● You have a freelance writer who produces content for you and other companies. Your company only owns the work they produce for you.

The first example is an employee; they work for your company and provide services for no one else. The second worker, however, is an independent contractor. They can choose their clients based on their skills and availability.

Does the individual limit the availability of his services to the general public?

This question asks whether the worker markets their services to the general public, meaning companies other than your own. Let's use the carpenter example again. If the carpenter has a public-facing shop or office, advertises publicly online, and is otherwise prepared to take on work from anyone, that would be a "yes" in answer to this question.

If the carpenter does not advertise and exclusively conducts business for your organization, that would indicate an employment relationship.

Do you have the right to discharge the individual?

Discharge, in this sense, means to end the relationship without cause, which can be difficult to evaluate based on the nature of labor laws and the worker's contract.

Let's say there was an agreement for a renovation. It might be tough to terminate that arrangement in the middle of the project since the worker would likely have incurred certain costs.

They would have already put in work and time that requires compensation, even though you're ending the arrangement early. Your contract might require you to give two weeks' notice or pay a cancellation fee.

On the other hand, some states have "at-will" labor laws that permit an employer to terminate a worker without notice, compensation, or reasoning. This could indicate an employee-employer relationship but may largely rest on the state's laws.

Think of your worker's commitment.

Think of the commitment between yourself and the worker. If your business can terminate a worker without notice or consideration of their income, the answer is "no." This would be more indicative of an employment relationship.

If the business could terminate the worker but must follow specific protocols (such as giving notice, offering compensation, etc.), that would be a "yes" to the above criteria. The worker is likely an independent contractor.

May the individual terminate his services at any time?

In most states, an employee has the right to terminate their services at any time. In contrast, an independent contractor must abide by the contract between himself and the employer. This may require giving notice or losing payment for certain services.

So:

● An employee can leave their job at any time.

● An independent contractor must fulfill their contract's obligations or risk losing money.

Some of these questions may not apply to your situation

A wide array of working relationships, projects, and legislation can affect the questions mentioned above. They might not even reflect the relationship between a worker and your business.

Keep in mind this is not a "majority rules" situation. Saying, 'Well, I got 17 "yeses' and three 'noes,' this worker is X," does not work. Focus on the questions that reflect your business's operations, work culture, and reimbursement.

It's critical to understand your workers' employment status

The above list doesn't just exist for tax purposes; it also ensures that your business adheres to state and federal labor laws. It can also help you decide whether a worker is entitled to workers' compensation benefits, retirement funds, overtime, or sick leave.

Different states have different employee definitions

In an April 2018 verdict, known as Dynamex Operations West, Inc. v. Superior Court of Los Angeles, the Supreme Court of California ruled that certain workers were not independent contractors for the purpose of California labor laws (as their employer had characterized them). They were, in fact, employees.

In doing so, the court outlined what separates an employee from an individual contractor in the state. Someone could be considered an independent contractor if:  

● "That the worker is free from the control and direction of the hirer in connection with the performance of the work, both under the contract for the performance of such work and in fact"

● "That the worker performs work that is outside the usual course of the hiring entity's business"

● "That the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity"

Consider the ABC Test

Legal jargon can be difficult to untangle. For that reason, many states employ something called the ABC Test. This allows employers to classify their workers based on various circumstances.

Consider the following:

● Point A means that the worker takes minimal direction from the business that hired them. They arrived at the job with a pre-existing skill set that allowed them to work without much guidance, training, or instruction.

● Point B is about the relationship between what the workers do and what the business does. It's most similar to question two, which was: "Does the individual receive training from your company?"

● Point C is about the tasks the worker performs. It asks whether your worker provides services to other companies in similar, related fields.

The ABC Test helps employers make the distinction between employees and independent contractors. Yet, as noted, not every state abides by this list, and not all factors may apply to your situation.

Smith.ai wants your company to succeed

Smith.ai provides resources to business owners who want to increase their conversion rates. We don't just offer insight into the difference between employees and independent contractors; we offer a suite of services designed to maximize your business's success.

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Connect with us today to explore your options

Smith.ai has something for everyone. Whether you need a virtual receptionist or a streamlined intake process, we're here to help. We offer all clients free, 30-minute consultations where they can explore their options. Additionally, we also have a 14-day money-back guarantee if you're not satisfied.

Request your consultation on calendy. Alternatively, you can email us at hello@smith.ai with any questions or concerns. You can also call us at (650) 727-6484.

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