How to Classify Workers in a Small Business

By: Kristy DeSmit | June 24, 2014

How to Classify Workers in a Small Business

As a small business owner, it’s your responsibility to properly classify your workers as either: employees or independent contractors.

Why classify?

Classifying workers is important for many reasons. Mainly, labeling workers correctly affects how you file and pay your taxes, and what benefits your workers receive. It also ensures that you are complying with employment laws.

Types of Workers

There are two types of workers to be familiar with: employees and independent contractors

Employee
An employee is someone who holds a position with a business, in which an employer has direct control over the work being done, the resources available, and how the work will be implemented.

Employees can be part time, full time, or temporary.

Independent Contractor
An independent contractor typically works for themselves and contracts their services to a business for a temporary period of time.

Taxes

How you categorize a worker can determine whether you pay taxes on an individual’s wage.

Employers are required to pay a portion of payroll taxes based on each employee’s income and withhold (deduct) a portion of their employee’s earnings from their pay check, including:

  • Federal and state income tax
  • Social security and health care benefits (Medicare)
  • Federal Insurance Contributions Act (FICA) tax, otherwise known as unemployment taxes
  • Other: stock purchase plans, meals, lodging, uniforms, union dues etc.

Employers must submit a Form W-2 to the IRS every year for each employee, as well as supply a copy to the employee. Employees are also given a pay stub (or wage statement) detailing the amount of taxes taken off their check.

Independent contractors pay their own income tax and do not get taxes withheld by an employer because they are self-employed. Instead, they may be eligible for deductions related to their contracting business.

Those who hire an independent contractor must provide a Form 1099-MISC (Miscellaneous Income report) to the freelancer if payment for their services exceeds a base amount.

Often, employers mislabel an employee as a contractor to avoid paying federal taxes on this type of worker. However, the risk associated with improper classification is great and consequences may involve liability for past withholdings, and liability for past workers compensation, such as medical or overtime expenses.

Employment Laws

Employers must follow several laws regarding their employees, including:

Fair Labors Standard Act (FLSA): This Act sets in place minimum wage and overtime rates for employees. Misclassification of an employee who is entitled to these rates can result in employer fines.

Workers Compensation: Workers’ Comp provides medical services to employees who are injured at work. Again, misclassification of employees as independent contractors can result in lawsuits related to lack of medical compensation or negligence.

Immigration Reform and Control Act (IRCA): This law states that employers must complete a Form I-9 to show that their employees are eligible to work in the United States.

If an employer fails to complete an I-9 for an employee because they were classified as an independent contractor, they can be in violation of this Act for failing to complete the paperwork. The consequences are even greater if the employee is not eligible to work in the United States.

Family and Medical Leave Act (FMLA): This Act governs an employee’s right to leave for family and medical issues, and become reinstated to their position upon return. Wrongfully labeling an employee as a contractor may omit this worker from potential leave, which directly violates their employment rights.

As you can see, employment laws protect employees. Neglecting to categorize a worker correctly may result in direct violations to these laws, and bring about potential financial and legal liabilities for your small business.

How do I classify workers?

Every employer must classify their employees according to standards set in place by the IRS and Department of Labor.

Classification Criteria

According to the IRS, there are three factors to determining whether your worker is an employee or independent contractor:

  • Behavioral control over employee
  • Financial control over employee
  • Relationship to worker
Behavioral Control

This factor involves the amount of control an employer has over their worker’s behavior.

Your worker is an Employee if…

  • You provide detailed instructions about what work should be done and how it is to be carried out, and the types of tools or equipment used.
  • You offer company specific-training to a worker.
  • You decide where and when an individual works.

Your worker is an Independent Contractor if…

  • There is little overview to the work itself other than your wishes for the outcome and timeline. For instance, a freelance web designer creating a website for you by a certain date.
  • They have more than one client who they are doing work for.
Financial Control

Financial control refers to how a worker is paid and your control over expenses.

Your worker is an Employee if…

  • You control their wage by regularly paying them a salary or hourly rate in the form of a pay check with details about taxes and benefits.
  • You reimburse them for company purchases, such as tools, equipment or supplies.

Your worker is an Independent Contractor if…

  • They invoice you for their services or you pay them after the work is complete (whether it’s an hourly or flat rate).
  • They incur a loss or gain, may have unreimbursed ongoing expenses and significant personal investment in their business.
Relationship to Worker

The relationship between the employer and worker can dictate whether the worker is categorized as an employee or independent contractor.

Your worker is an Employee if…

  • They have benefits, such as medical or dental employee benefits, vacation or sick pay, and pension plans.
  • You both signed an employment contract spelling out the terms of their employment.
  • You created their job description.
  • Their employment is continual (permanent), rather than on a per-project basis.
  • You have a sense of control over this worker’s output, and you may conduct regular employee reviews as part of an ongoing evaluation.

Your worker is an Independent Contractor if…

  • You don’t offer them employee benefits, such as sick pay, medical insurance or pension plans.
  • You signed an independent contractor agreement with terms about the service they are providing.
  • The nature of your business together is temporary or on a per-project basis.
  • You are not the only client of the contractor.
  • They hire their own employees to help with a project.

By combining all three factors into your assessment of your worker, you should be able to determine if they are an employee or independent contractor.

Once you have defined your worker, and they are classified as an employee, you must establish if they are exempt or non-exempt from the Fair Labor Standards Act.

Exempt:

Exempt workers are not included in the FLSA if they meet a minimum salary base and requirements regarding job responsibilities.

Exempt employees may include:

  • White collar workers (managers, administrative workers)

Non-Exempt:

These workers are covered by the FLSA, including minimum wage and overtime regulations. Employees may include, but are not limited to:

  • Clerical workers (temps)
  • Blue-collar workers (construction worker, miner, custodian)
  • Technicians
  • Laborers

To decide which distinction an employee falls under, refer to the Fair Labor Standards Act tests for salary level test, salary basis test, duties test, and more to help in further classifying the rights of your employees.

Also note that independent contractors can also be further classified as statutory employees or statutory nonemployees.

Properly defining a worker as an employee or independent contractor can save you from many risks involved with incorrect classification, such as penalties, fines, and severe liability if the mistake was intentional.

If you are still having trouble determining the particular status of an individual, consult an accountant to better distinguish the worker’s position before classifying them.

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Kristy DeSmit

Marketing Writer at LawDepot
Kristy is an avid blogger, Twitter enthusiast and company legalese interpreter.
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