As an entrepreneur, it is always an exciting moment when your business has succeeded to the point that you need to hire help and can afford the additional expense. However, if your business is thriving, you may feel that you simply do not have the time to deal with the complexities of preparing and administering payroll. You might feel that it is much simpler to engage a self-employed independent contractor. Unfortunately, your new assistant may not qualify as an independent contractor and is actually your employee. There can be serious financial consequences if you treat an employee as a contractor. The answers to a series of questions can help you decide whether you have chosen the correct classification.
Tests for Determining Whether You Have Hired an Employee or an Independent Contractor
The Internal Revenue Service and the Department of Labor both take a dim view of categorizing employees as contractors. Each agency has the power to levy fines and/or require retroactive payments of payroll taxes as well as any back wages that may be due the employee for overtime, minimum wage violations or other practices that are contrary to the Fair Labor Standards Act. Neither agency has one universal test to determine whether the individual is your employee or an independent contractor. Instead, they typically examine your overall relationship with the individual by determining answers to all or most of the following questions.
1. Did the employer have to train the worker? Independent contractors typically do not need to be trained on how to perform their jobs. Employer-provided training can suggest that the company is controlling the methods that the individual must use, which is a flag indicating that an employer-employee relationship exists.
2. Did the employer furnish the tools, materials and supplies? Independent contractors tend to supply their own.
3. Did the employer dictate the work hours and days? If so, this suggests that the individual is an employee. Independent contractors normally have much more control over when they work.
4. Did the employer require that the work be performed on his premises even if it could be performed elsewhere? Independent contractors are usually free to work from home or their own offices.
5. Did the employer dictate the sequence of work? Employees may be required to follow a particular sequence, but contractors normally plan tasks using their own methods.
6. Who hired, supervised and paid the worker’s assistants? If it was the company, this suggests an employee-employer relationship.
7. Was the worker free to work for others? One of the hallmarks of an independent contractor is that he or she operates a business and is free to work for many different clients.
8. Did the employer reimburse the individual’s expenses for travel, lodging, tools, supplies or other expenses? Direct reimbursement suggests an employee-employer relationship. Independent contractors normally include these costs when determining a rate unless their contracts state that the client will reimburse certain expenses.
9. How often was the individual paid? Weekly payments tend to support that the individual is an employee. However, an independent contractor may include a requirement for interim payments in his or her contract.
10. What was the length of the relationship? Continuous or indefinite relationships are more indicative of an employer-employee relationship. Independent contractors are typically engaged to complete a specific task although they may enter into additional contracts with the same client.
11. Did the company have the unilateral right to terminate the worker? This suggests an employee-employer relationship. Independent contractors can typically be terminated only according to the terms contained in the contract.
12. Did the worker have the right to quit without repercussions? An employee has that right, but independent contractors must abide by the contract terms or face potential liability for breaching the contract.
13. Did the company provide any fringe benefits? Vacation time, sick days, health insurance and other benefits signify an employee.
14. Did the employer require that the worker purchase supplies or tools from a specific vendor? Employees may be restricted on the vendors to patronize, but since independent contractors are running their own businesses, they are typically free to make purchases from vendors of their own choosing.
15. Was the worker paid by the hour or by the job? Although some independent contractors may charge an hourly rate, hourly wages usually suggest an employee. Independent contractors are more likely to be paid by the job.
16. What type of evaluation system was used? Employees frequently receive evaluations that measure assorted work-related details, including attendance and productivity. Independent contractors are more likely to receive an evaluation that only measures the end result.
17. Does a written contract exist, and is it signed by both parties? The contract should define the relationship between the two parties, but this alone is insufficient proof of the worker’s status.
18. Were the services provided integrated into the normal business operations? Employees answer phones, respond to emails, pack orders, prepare bank deposits, assist customers in the store, prepare invoices and perform similar tasks. Independent contractors typically perform tasks that are outside of routine operations.
19. Did the worker have the opportunity to earn a profit or suffer a loss? Employees receive a wage, but independent contractors, like all businesses, have opportunities to earn a profit from their work or incur a loss.
20. Did the worker provide services that are key activities of or crucial to the business? If so, this could indicate an employee-employer relationship.
Possible Consequences of Classifying an Employee as an Independent Contractor
Although the IRS and the Department of Labor have the power to levy substantial fines, the heaviest fines are typically reserved for flagrant or repeat offenders. However, even the lighter fines and penalties can be financially disastrous for a small company. Potentially, you could be forced to pay any of the following that apply to your situation.
1. Ordinarily, you would deduct the employee portion of FICA and Medicare taxes. If you incorrectly classify an employee as a contractor, you can expect to pay both the employee and employer contributions, retroactive for up to three years.
2. If the employee worked more than 40 hours in a week, you could owe overtime pay. If the hourly wage was less than the prevailing minimum wage, you could owe the difference. The look-back period is typically three years.
3. The Department of Labor will levy a fine for improper recordkeeping, and your company will probably be audited to check for other violations.
4. You will have to pay federal unemployment taxes, and state agencies will likely demand that you also pay state unemployment taxes.
5. If your state requires employers to contribute to a state-sponsored workers’ compensation plan, you can expect to pay this as well as any fines for late payment.
6. The IRS can fine you for failing to file payroll tax returns, failing to make payroll tax deposits, and failing to provide accurate payee statements. These fines can easily come to half of the total payments made to the individual.
It should be noted that there is some possibility for relief from the IRS under the Revenue Act of 1978, especially if the error in classification was unintentional. However, it is much more difficult to find relief from the Department of Labor, and the availability of relief from state agencies depends on the state. Therefore, if you have any doubt about whether you have hired an employee or engaged an independent contractor, you might want to consult a qualified attorney with experience in labor laws in your state as well as at the federal level.
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