Independent Contractor or Employee? Factors and Consequences

 In Legal, Payroll

Most small businesses require the services of more than one person to operate effectively. Even sole proprietors may need support from a virtual assistant, a webmaster, an accountant, or an attorney to help the business thrive. However, in some cases, a business owner may seek outside services on an ongoing basis, from these or other professionals, to reach its optimal level of performance. In cases where a person is providing services on a frequent basis, it is important to consider whether that worker is an employee or an independent contractor.

What is an Employee vs. an Independent Contractor?

An employee is a worker who performs services for a person or business, and the person or business hiring the employee can control the work that will be done and how it will be done on a detailed level. An independent contractor is someone involved in a trade, business, or profession who offers their services to the general public.

In the simplest of situations where a person provides only one-time or occasional services, it can be easy to determine which worker classification applies. But in other cases, it may require more analysis to make the correct determination. This analysis will depend on the facts and circumstances of each case.

Why Does Worker Classification Matter?

The question of worker classification, whether a worker is an employee or independent contractor, affects both parties in the transaction and the government as well. The business paying the worker is impacted by financial obligations, tax compliance, and legal obligations based on the classification. The worker performing the services is entitled to certain legal protections and employment benefits if he or she is classified as an employee and has different obligations to the person or business that hires him depending on the classification. The government is impacted by whether it is entitled to collect certain taxes and impose compliance requirements on the business.

From what I’ve seen in my career as a practitioner, most small businesses tend to prefer classifying workers as independent contractors. The reasoning is that the small business would rather not add someone to payroll, which subjects the business to payroll compliance obligations and requires them to pay several different taxes on the employee’s behalf. The employee classification may also require that employer to offer or provide certain health or fringe benefits to the employee based upon existing policies the business has implemented and/or under state or federal law. Additionally, in some states, worker’s compensation insurance is required for employees as well, and other premiums such as liability insurance can be impacted by the number and type of employees on staff. The impacts are even greater if the worker lives in another state.  Hiring a remote worker who lives in another state and is classified as an employee can affect the business’s sales tax and income tax filing obligations and add additional compliance responsibilities, since having an employee within a state generally creates “nexus” in that state. But if the worker you hire is misclassified as an independent contractor, when under the eyes of the law they should really be an employee, the consequences can be steep for the business owner.

Some of the consequences to a small business that may result from misclassifying workers include:

  • Fines and penalties from federal and state government agencies for violating employment law
  • Judgments from employee lawsuits that require the payment of back wages, overtime, and benefits
  • Unemployment insurance rate increases
  • Worker’s compensation violations
  • Income tax and/or sales tax assessments for years in which that worker provided services (along with accumulated penalties and interest)

What Facts and Circumstances Are Considered in Worker Classification?

As mentioned above, the most important determination in worker classification is control. A worker is an employee if the business hiring her can control what will be done and how it will be done. The degree of control that the business has over the worker is determined by three categories:

  1. Behavioral Control– how much control does the business have over what the worker does and how the worker does his job? Can the business set work hours, location, require specific equipment and software? Is the worker required to work exclusively for this business? The higher the level of control that the business has suggests the worker may be an employee.
  2. Financial Control– are the business aspects of the worker’s job controlled by the payer? Considerations in this category are what method is used to pay the worker and how frequently, who determines the frequency and occurrence of payment, are invoices provided by the worker to the payer prior to payment, and who provides the tools and supplies related to the job.
  3. Type of Relationship– what is the extent of the relationship between the parties? Considerations are the frequency with which work is performed (i.e. one-time, daily, weekly, monthly, or yearly), whether work is expected over a short duration or an indefinite ongoing period, whether the work being performed is an integral aspect of the business (i.e. a lawyer performing services for a law firm) or an incidental aspect of the business (i.e. a lawyer performing services for an architectural firm), whether there is a contract between the parties denoting their understanding of the relationship as an employment or independent contractor relationship, and whether any employment-type benefits are being offered to the worker. Also what annual forms were filed by the employer at the end of the year in reporting the worker’s wages- a Form W-2, a Form 1099, or none of the above?

How Does the Government Find Out About Misclassified Employees?

Many small business owners that knowingly misclassify employees as independent contractors do so because they believe that it would be difficult for the government to find out about the misclassification. However, some of the ways that the government finds out about misclassified employees are:

  • The employee submits an unemployment claim with respect to the work performed for that business.
  • The employee reports the employer to the state or federal government through a hotline designated for that purpose.
  • The employee makes a legal claim with respect to wages, benefits, overtime, discrimination, or another labor-related issue.
  • A competing business discovers through a hiring process of one of the contractors currently or formerly working for the business that workers are suspected to be misclassified and notifies the government
  • The IRS or a state department of revenue conducts an audit for a different reason (i.e. for income tax or sales tax purposes) and discovers this issue in the course of the audit process.
  • The business in question voluntarily notifies the government of the misclassification and requests relief directly with the government agency.

When the government agency becomes aware of a potential employee misclassification issue, the respective agency will then send out a letter to the business notifying the business owner of an examination of the issue. The notice will request the business owner’s definition of the relationship, relevant documents, and potentially request interviews with the business owner, other employees, and applicable witnesses who may have knowledge of the facts and circumstances of the relationship. Audits for worker misclassification can be quite invasive, and it is generally in the government agency’s best interest for the worker to be classified as an employee, as it can result in a large windfall of revenue for the government. If you encounter a worker classification audit as a business owner, I would highly recommend hiring a representative during the process to assist you with your case.

If you have questions on whether some of your workers might be misclassified or have received an audit notice from a state or federal agency with respect to potential worker misclassification, feel free to contact me and my firm would be happy to assist you!


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