Employee vs. Contractor: Why Not Knowing the Difference Can Land Your Business in Hot Water

Make sure you fully understand the ramifications of mislabeling a worker when doing your taxes

Your business may see big benefits in hiring independent contractors for certain work. But it’s crucial to remember the difference between an employee and an independent contractor when reporting your taxes each year. Making a mistake in differentiating between the two can cost you penalties.

Some businesses mislabel regular employees as contractors on purpose to save on tax expenses, according to the National Conference of State Legislatures. But doing so has both legal and financial ramifications that just aren’t worth it.

Here’s how to tell the difference between a contractor and a regular employee: 

Independent contractors vs. employees: The basics

The IRS says that a person is an individual or independent contractor if whomever they work for has the right to “control or direct only the result of the work and not the means and methods of accomplishing the result.”

Basically, if you contract with an individual and generally outline the scope of work, yet you leave them freedom over how that final desired result is reached, their position is more of an independent contractor role. If a worker is an independent contractor, you as the employer usually don’t have to withhold federal taxes or pay taxes on payments to them.

A regular employee is generally someone who works for you who is performing services that you have the right to control. This means that their role is an integral part of the way the business operates, and there are guidelines that you provide them to govern how they get the job done.

Employers need to withhold income tax and pay Social Security and Medicare taxes on any payments to regular employees. Unemployment tax is also paid on anything paid to an employee.

How to make a determination

To figure out an employee’s level of independence or control, there are three categories to help you decide, as outlined by the IRS:

1. Behavioral control

Behavioral considerations include the following:

  • Do you have the right to direct how tasks are done?
  • Are instructions given to the worker when they’re hired? These instructions could relate to when work happens, where it will be done, what they’ll use to do the work, how to order tasks, etc.

The main consideration here is whether the worker’s tasks are fully determined by you, the employer. If everything is outlined and controlled, it’s likely that the worker is a regular employee.

2. Financial control

There are also financial considerations that need to be examined before you decide how to classify a worker. Questions to ask yourself include:

  • Does your business have the right to control financial and business aspects of a worker’s role? For instance, are expenses paid for by the company? The IRS says that an independent contractor is more likely to have unreimbursed expenses.
  • What kind of investment is a worker making to work for you? Independent contractors are more likely to have their own investments in either the space or the equipment with which they perform services.
  • Is the worker free to seek out other jobs? If so, they are likely independent and are often seeking new projects from different clients.
  • How is the worker paid? Regular employees are promised steady payments at an agreed-upon amount. On the other hand, an independent contractor is commonly paid a flat fee for a one-time service, though some are paid hourly.

3. Relationship of the parties

There are several factors to consider when determining whether a work relationship constitutes a regular employee-employer relationship. These factors include:

  • Whether or not benefits are provided, such as health insurance or vacation days.
  • Whether the work relationship is permanent or temporary. If you lead a worker to believe that the engagement will be for a longer or indefinite time period, this could be proof that the job was intended to be a regular employee relationship.
  • Whether a worker’s duties are crucial to the regular business and operations of the company. This means you’ll probably be controlling the details of the worker’s tasks.

What happens if you misclassify?

Some employers will purposefully misclassify a regular employee as an independent contractor to save on expenses. These expenses could be Social Security and Medicare taxes, mandatory overtime pay, benefits, workers’ compensation, and unemployment compensation tax.

But this is a big mistake that can cost you much more than those expenses.

If a mistake is discovered, whether an employee filed a complaint or it was found in a company audit, the Department of Labor (DOL) and the IRS will first determine whether the mistake was intentional or unintentional, and it could end up being a charge of fraud.

If a mistake was unintentional, the minimum penalties are to deal with the necessary reclassifying of payments as wages, including:

  • $50 for each wrong W-2 that was filed.
  • Income tax would not have been withheld, so penalties would be 1.5% of wages on top of 40% of Social Security and Medicare taxes, plus all of the FICA taxes that should have been paid on that income.
  • Another penalty of 0.5% of unpaid tax liability for each month, up to 25% of total tax liability. This is called a Failure to Pay Taxes penalty.

And these are just the fees that apply if a mistake was found to be unintentional. If the IRS finds intentional mistakes or suspects fraud, additional fines will be applied that can be quite high. Criminal penalties of $1,000 per misclassified employee could be imposed. Liability accusations may also arise.

It’s never worth making this mistake, even if unintentional. That’s why it’s crucial to understand these distinguishing elements.

It’s always a good idea to talk to a professional who can ensure you report everything correctly. Get in touch with Provident CPA & Business Advisors today to learn more about the services we can offer you.