What Businesses Need to Know About Classifying Employees and Contractors

If your small business hires new employees or independent contractors, chances are you might worry about incorrectly misclassifying a worker and facing legal consequences. Not knowing the difference between employees and contractors can affect your business in a major way. Here's what you need to know.

1. Know the difference between employees and contractors

While this may seem straightforward enough, the lines blur when contractors begin to assume more duties in the workplace. According to the IRS, employees are classified as individuals who work for one employer. These employees are given training and perform duties as dictated by others.

Independent contractors fall under a wider range of job titles including freelancers and self-employed. They are hired to do a specific job and are paid for it. Unlike employees who received benefits and legal protections, contractors do not receive the same type of coverage. They are responsible for their own expenses including paying taxes, federal taxes on FICA and income, Social Security, and unemployment taxes to name a few.  Contractors typically work with more than one client and use their own tools (like laptops) while setting their own hours. By hiring contractors, small businesses enjoy benefits that include savings on labor expenses, hiring flexibility, and reduced liability.

2. After determining contractor vs. employee, assign the right forms

To determine if a worker is an employee or a contractor, look at three common law rules: behavioral (does the business control how the worker does their job?), financial (pay, expense reimbursement, etc.), and type of relationship (is there a contract and do they receive benefits?). Look at the entire relationship that the worker has with your company to make the decision.

Once you’ve made the determination, assign the right forms to individuals based on their specific classifications. For newly hired contractors, this means having them complete a Form W-9 (Request for Taxpayer Identification Number and Certification). Form W-9 asks for their federal tax classification along with their TIN (Taxpayer Identification Number). Meanwhile, new employees must complete Form W-4 (Employee’s Withholding Allowance Certificate).

3. Help, I’m a contractor who was declared an employee! What should I do?

Contractors who feel like they have been misclassified by an employer must file Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding). Once the form has been filed by either the business or worker, the IRS will review it to determine the worker’s status.

According to the SBA, businesses that misclassify contractors as employees could be required to pay back taxes for federal and state income taxes, and also have to pay for misclassified workers’ compensation, unemployment, Social Security, and Medicare. In addition, they would have to provide employee benefits including health insurance and reimburse contractors for wages—like overtime and minimum wage—under the Fair Labor Standards Act.

4. Help, I accidentally misclassified a worker! What should I do?

Mistakes happen. For small businesses that accidentally misclassify workers, the last thing they want is to have the worker believe it was intentional. Luckily, the IRS provides relief provisions for businesses with a reasonable basis claim. To qualify, businesses must file required federal information returns on a basis consistent with the worker. According to the IRS, a reasonable basis claim needs to show one of the following:

• You reasonably relied on a Federal taxes court case or ruling the IRS issued to you.
• Your business was audited by the IRS during a time when similar workers were treated as contractors.
• Your industry treats similar workers as contractors.
• You relied on another reasonable basis, i.e., advice from a lawyer that knew facts about your business.

Keep in mind that determination on these claims, for businesses and workers alike, takes time to process. Since time is of the essence during tax season, consider filing Form 8952, an application for the Voluntary Classification Settlement Program (VCSP). This program gives eligible taxpayers the opportunity to reclassify workers as employees for tax purposes with some relief from federal employment taxes.