If you have people working for your business, it’s important to classify them appropriately. Why? Because if you pay them on a 1099, as contractors, and it turns out they should’ve been paid on a W-2, your business can find itself in hot water.
What’s the difference between employees and contractors?
The way you classify your workers determines whether you pay employment tax and withhold other taxes from their pay. For employees, paid on a W-2, the business withholds income taxes and pays social security, medicare, and unemployment on all wages. For independent contractors, the business doesn’t withhold or pay any taxes—all pay goes directly to the contractor, who is responsible for paying the taxes.
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How do I know if my workers are employees or contractors?
The answer essentially comes down to the level of control the business has over the worker. Generally, businesses have more control over employees and less control over contractors. The IRS provides three categories of control to help you identify the appropriate classification:
1. Behavioral control: The business controls when and where the work is done, gives detailed instructions on how the work should be completed, provides training, and evaluates the details of work done by employees. Contractors make their own schedules, choose where and how to complete the work, and are generally evaluated on end results as opposed to details of how the work is done.
2. Financial control: The business has a significant investment in the equipment employees use to complete their work and covers necessary expenses. Independent contractors pay for their own equipment and business expenses and will typically have an opportunity for profit or loss. Independent contractors are also free to work for multiple businesses at one time.
3. Relationship: If the business provides benefits, those are available to employees and not contractors. The relationship between the business and employee is seen as indefinite, while a contractor may be hired for a fixed period or be performing services that aren’t key business activities.
The January 6, 2021, update to the Fair Labor Standards Act clarified the rules concerning employees vs. contractors, effective March 8, 2021. The new ruling provides more specifics related to the three tests described above, but the essence of the definitions remains the same.
Let’s look at some examples to see how those arrangements play out in real businesses.
Example 1: June is a graphic designer. She works remotely for a marketing firm, creating advertisements and graphics for client websites. The firm purchased her computer and all software licenses she needs to do her job; June pays for her own internet and phone. She signed a non-compete agreement that bars her from working for any other agencies.
Answer: June is an employee. Although she works remotely, she’s dedicated to the marketing firm and they pay for most of the tools and equipment she needs to do her job.
Example 2: Michael is a full-time student, and he also works for a logistics company doing last-mile deliveries. He uses his own vehicle, but the company reimburses him for mileage and provides liability insurance coverage. The company allows Michael to work around his class schedule, but he works the same hours every week. He receives two weeks of paid vacation each year.
Answer: Michael is an employee. Although he uses his own vehicle for work, the company pays his expenses via the mileage reimbursement and provides the benefit of vacation time. The set work schedule (although it’s flexible) is another indicator that Michael is an employee.
Example 3: Selena is a part-time pet sitter with a start-up that provides local pet care services. Each week, she logs into the app and selects from a list of jobs posted by clients. The company collects payment from clients and pays Selena the agreed-upon fee. Her fees increase as clients give her good ratings in the app.
Answer: Selena is a contractor. She sets her own schedule and workload, and she’s evaluated based on client satisfaction with her work. She’s also free to take on other work if she wishes to do so.
Classify your workers correctly from the start
If you’re starting a new business and unsure whether your workers should be contractors or employees, we can consult with you to help you make the right designation.
If you’ve incorrectly classified workers as contractors, the IRS can hold you liable for all employment taxes. For more on this topic, visit the IRS website.
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