Employers Beware: Contractor vs. Employee Classification

freelance-contractor-300x200Businesses can enter into various types of employment relationships with their workers. Employees may be treated as full-time hires with a complement of benefits, part-time workers with limited benefits or independent contractors with no other benefits than the wages they were contracted to receive. The type of relationship typically depends on the needs of the business.

How Employment Benefits Vary

The most common types of employment contracts are traditional full-time workers and independent contractor arrangements. The employer defines work hours and workplace regulations for full-time employees, and even part-timers. Wages and other benefits as reported in the online payroll system should conform to prevailing federal and state labor laws, such as minimum wage, overtime compensation and an OSHA-compliant workplace. Employees receive a W-2 indicating their earnings, benefits and tax withheld, which would have been indicated in the online payroll system.

For a W-2 employee, you as the employer would be providing a fixed pay structure and a benefits package that would include employer contributions to payroll taxes and full or partial subsidies for health insurance premiums. Mandatory benefits include unemployment compensation and disability benefits.

In contrast, independent contractors on your online payroll system are entitled to the wages that are set forth in the employment contract and not much else. However, as their client-employer, you have little control over their work process or work hours as long as they meet the standards for the pre-defined work output. No taxes are withheld for independent contractors, and their wages will be reported on a 1099-MISC. Contractors are responsible for making estimated tax payments on their income.

Misclassification of Employees and Independent Contractors

Hiring workers under an independent contractor agreement has many advantages, including significant savings on employee benefits. As contractors, you can end their contract at will, which works well for short-term or special projects.

However, the IRS has specific guidelines for when an employee is regarded as an independent contractor with a 1099-MISC or a traditional W-2 employee.

The guidelines have been condensed into three factors:

1. Behavioral Control – As the employer, do you control the workers’ schedule and work process? Do you direct their methodology through training and similar efforts?

2. Financial Control – How much influence do you have over the employees’ business finances? Do you have a substantial investment in their work? How much of their expenses are reimbursed? Independent contractors should provide their own equipment and supplies.

3. Employer-employee Relationship – How do the parties involved perceive their relationship? How is this reflected on employment contracts and other documents?

The U.S. Department of Labor oversees the enforcement of employee classification guidelines. Payment of back wages and overtime compensation on top of hefty penalties may be imposed if employers are found to have misclassified employees as independent contractors for the purpose of evading unemployment compensation and other employee benefits.

How Automated Payroll Management can Help

Payroll processing becomes more complicated with various types of employee contracts on the rolls. With an online payroll system outsourced to a professional outfit, you will have access to our expertise in payroll and benefits administration. While the decision to treat an employee as a W-2 or 1099-MISC worker is between employee and employer, payroll experts can point out the misclassification red flags.