Classifying a worker as an employee or independent contractor holds significant ramifications in determining tax withholdings, employer tax contributions, benefits, and repercussions for misclassification.
Employers are responsible for withholding federal income tax, social security tax, Medicare tax, and state income tax for all employees. Additionally, employers must pay their share of social security and Medicare taxes as well as pay unemployment premiums based on the employee’s wages. Furthermore, employees are entitled to protections granted by the Fair Labor Standards Act (FLSA) such as established minimum wage and overtime pay. Employees can also take advantage of benefits offered by individual companies such as medical insurance, retirement accounts, or paid vacation to name a few.
As mentioned earlier, there can be some steep penalties for misclassifying an employee as an independent contractor. Take the above paragraph for instance; try to imagine the accumulation of those back taxes for each employee misclassified. Now consider paying an interest rate on top of those tax payments owed, along with other penalty fines. Misclassified employees can also claim back benefits such as health insurance, overtime, and/or severance pay; conceptualizing these costs may start to feel financially suffocating. However, there are legal implications that you must consider as well such as lawsuits, criminal charges, and the possibility of an IRS audit.
There are many common misconceptions regarding the classification of employees as independent contractors. A collection of state reports indicates that 10 to 30 percent of all independent contractors have been mistakenly misclassified, which translates to several million employees being misclassified nationally (NELP, 2020). The classification of a worker as an independent contractor is not contingent on a shared agreement or signed contract. Instead, the IRS determines if a worker qualifies as an independent contractor based off a general criterion.
An independent contractor is in business for him/herself—self-employed; they don’t work exclusively for a company and manage their own expenses with the aim to make a profit. It’s important to look at the relationship between the employer and worker; the common law test infers that independent contractors set their own hours, dictate how they work, and provide their own equipment. Contrarily, employees comply with instructions, work exclusively for the employer, and are provided equipment and training.
An example to consider is one that involves a landscape professional. Imagine the grass in your lawn hasn’t been growing this season, so you decide to hire a landscaper to restore the health of your yard. After a few monthly visits, your lawn is healthy, and your grass is growing again. Take a moment to consider the landscaper; this person wasn’t exclusively working on your yard, and most likely was attending to the yards and gardens of many other individuals. In fact, once your grass was restored, they moved on to the next job. That person is an independent contractor; they did a job, you paid them for that job, and then they moved on. Perhaps you may consider this example in the future when attempting to classify a worker and ask yourself: “Is this worker the landscaper or an employee?”
National Employment Law Project (NELP), Policy Brief: Independent Contractor Misclassification Imposes Huge Costs on Workers and Federal and State Treasuries, Oct 2020, at 2, available at https://s27147.pcdn.co/wp-content/uploads/Independent-Contractor-Misclassification-Imposes-Huge-Costs-Workers-Federal-State-Treasuries-Update-October-2020.pdf