CONTRACTOR OR EMPLOYEE? UNDERSTANDING THE DIFFERENCE WHEN HIRING.
A big challenge for new & experienced entrepreneurs is understanding the nuances of building a team while complying legally. In this post we will break down the questions you should ask yourself when you’re hiring a new team member to decide if they should be classified as an employee or an independent contractor.
We promise, we’ll keep it as simple as possible!
Why is worker classification important?
The short answer is the IRS. The IRS cares how a business classifies a worker because this directly impacts how that person/entity is paid and taxed.
Independent Contractors are responsible for independently paying tax on the money your business pays them. They are separate from your business and therefore your business does not need to withhold & contribute to payroll taxes on their behalf.
Employees on the other hand are very closely linked to your company and come with greater responsibility for your business. When you hire someone as a W-2 employee, your business is responsible for withholding and remitting your employee’s payroll taxes in addition to paying a portion as the employer.
Word to the Wise: If you hire a W-2 employee remember to include payroll taxes when you calculate what your company will pay for that role. This is their salary or hourly pay plus the employer portion of Social Security Tax (6.2% paid by employer), Medicare Tax (1.45% paid by employer), Federal Unemployment (6% on the first $7,000 in wages per employee), and State Unemployment (varies by state). People often forget to include payroll taxes when running numbers and these definitely add up.
We also highly recommend using a payroll service that will withhold and remit payroll taxes on your business’ behalf. Gusto is our favorite - we promise their service is worth the money!
Deciding how to classify a worker.
How a worker is classified really comes down to the relationship between the worker & business. Consider these three categories when deciding on a new role.
1. Behavioral Control - a worker is an employee when a business has the right to directly control their work. This includes things like: when and where work is done, the level of instruction given by the company to the worker, and training provided.
2. Financial Control - a worker is an employee when a business has the right to direct or control the financial & business aspects of their job. An independent contractor is generally free to seek out business opportunities beyond your company and would supply their own tools/materials to complete work instead of relying on you to buy the equipment. Employees are generally guaranteed a wage while independent contractors are paid by the job or hourly for their work.
3. Relationship of the Parties - as with most relationships, what each party perceives of their interaction is important. Just like in dating, the “what are we conversation” will soon be asked! For this reason, having a written contract in place that spells out your relationship with a worker is recommended. If you will be offering benefits (insurance, vacation or sick pay, etc) these typically point to an employer-employee relationship. If the services the worker provides are key to your regular business, this also suggests an employee classification.
Consequences of Misclassifying a Worker.
We don’t mean to put the fear in your eyes but do want to make it clear that if the IRS audits your business and finds that you’ve classified workers as independent contractors who should have been employees, your business will be liable for employment taxes on their pay.
So use the resources above to get clear on how you should classify a worker from the beginning to avoid dealing with this issue years later. It’s definitely less painful than going back through your records while the IRS watches and potentially owing back taxes on what was overlooked.
Here is a link to IRS Form SS-8. You can use this if you’d like help from the IRS to determine whether a hire should be classified as an employee or independent contractor.
The information in this post is meant for educational purposes and we recommend consulting with a lawyer if you have questions on whether you’re on the right track with hiring decisions.