There are clear guidelines on classifying workers that affect your bottom line
Independent contractors and employees are a lot to manage as a small business. Small business owners know one of the largest costs of doing business is people costs. Not just the cost of labor, but the cost of workers’ compensation, payroll expenses, and payroll taxes. Is there any way to reduce some of these expenses without cutting employees? Can you just make them an independent contractor instead?
Some business owners think they can circumvent the system by putting employees on as 1099 independent contractors. Unfortunately, according to the new tax form, just because an employee classifies as an independent contractor doesn’t mean they qualify.
What are the tax differences of an independent contractor versus an employee?
A business owner is responsible for withholding employee income taxes, as well as paying into Social Security, Medicare, and unemployment tax. But businesses generally do not pay any tax on 1099 contractor hires; the contractors are responsible to pay their own self-employment tax.
Can you hire seasonal help and pay them as 1099 independent contractors, or is it better to hire them as W-2 employees? To better understand this, we need to look at the employment relationship, not the financial benefits to one or both parties.
The IRS breaks these relationships down into three distinct categories: behavioral control, financial control, and relationship.
Below are 10 simple yes/no questions you can ask yourself with regard to an independent contractor.
- Do they have the right to work elsewhere? Simply put, an independent contractor is allowed to work for several people at the same time. If you as an employer deem this as a conflict of interest, then this is a good indication of employee status.
- Do they set their own work hours? When someone is a true independent contractor, you have no say as to when the contractor can work, the number of hours worked, when they take breaks, etc. If the expectation is that the contractor has set working hours, they are most likely an employee.
- Can they delegate work? An independent contractor has the right to outsource to anyone they want to accomplish the job you hired them to do. Similarly, they have the right to hire or fire anyone under them to complete the tasks at hand. Any restriction on this is an indication of employee status.
- How do you pay them? Independent contractors are paid by the project or job at hand, not by the hour, week, or month. These contractors should be invoicing you for the jobs or tasks they complete and detailing those charges. If you pay them an hourly rate for standard set hours, they fall under the employee status.
- Do you provide tools? Are they skilled enough for the job? Independent contractors should provide the tools and be skilled to do the job. If you provide them with the training or tools, this is an employee-employer relationship.
- Does the relationship have a set beginning and end date? Independent contractors are hired for a specific period with a set end date. Ongoing work with no set jobs or tasks is likely for an employee to fulfill. If you hire an independent contractor for ongoing work, clearly define each job or task.
- Are they in business for themselves? An independent contractor is a business owner whom you are hiring (sometimes doing business in their own name). But if you are hiring them as a person, not as a business, they are most likely an employee.
- Does the hire have a chance of a profit or a loss? As is in any business, an independent contractor can either profit or suffer a loss when working with clients. If a contractor has not calculated correctly or needs to take time to fix errors in their work, this could potentially eat into their profits, but would not affect you as the client. If you suffer the loss or profit and there is no cost to them, they’re likely going to be classified as an employee.
- Do you have the right to discharge without cause? If contractual obligations are being met, the right to discharge an independent contractor is not allowed. The contract might include an exit clause, which is allowable if you are adhering to the contract. But to terminate without cause is potential grounds for breaking a contract.
- Did you agree to a contract or was there a bid proposal? Independent contractors generally bid for work or offer a proposal. Accepted proposals for any projects or tasks result in a contract between the parties with a set beginning and end date. No contract is usually an indication of employee status.
What if I cannot answer “yes” to all of these?
If you cannot answer yes to all these questions, then your independent contractor is most likely an employee or should be classified as such to avoid any possible issues with the IRS. What could those issues be? You could be subject to paying back taxes for unemployment, your portion of the employee’s Social Security tax, and Medicare. This could get quite costly, depending on how long this person has worked for you as a misclassified independent contractor
Other things to keep in mind when classifying a worker as an independent employee or not
In addition to potential tax implications, uninsured subcontractors and employees under your Workers’ Compensation insurance have coverage. Therefore, if independent contractors cannot provide proof of their own insurance, you must cover them and their job duties under your insurance. This is a prudent step in protecting yourself and your organization from a possible worker-related injury. Without this coverage, you could be subject to paying for these injuries out of pocket, including covering lost wages and the cost of litigation that could arise from having an unsafe working environment.
The bottom line for an independent contractor or employee
When in doubt, ask your business accountant or tax professional about classifying your independent contractors or employees. You can still cover subcontractors on your Workers’ Compensation if they cannot provide you with a copy of their certificate of insurance. We have an excellent blog on How To Properly Collect Certificates of Insurance.
We provide Workers Compensation insurance quotes for most small businesses but we must also write the other coverages such as General Liability, Property, and Auto. If you are interested in a quote for small business insurance, please contact us.