One of the biggest decisions that a business owner makes is establishing employee pay structure. Employers such as storeowners must not only offer (or accept) a rate and pay schedule, but also distinguish the type of worker they have hired–should a worker be considered a true employee or are they better classified as an independent contractor?
This decision has a major impact on workers and company owners alike, so understanding the nuanced differences between contractors and employees is critical to creating and maintaining a healthy business. Misclassifying workers can lead to stiff penalties, interest and missing payroll taxes–not to mention the detrimental effect on business overall. Properly paying and categorizing staff is especially relevant now, as the government has begun to actively hone in on this issue and is taking action in instances of misrepresentation. As a business owner, the only way to ensure that a hired worker is offered the correct pay structure is to be fully aware of how your staff best matches up with the distinctions between employee and contractor.
Pay and Tax Differences Between Employees and Contractors
Michael Kern, CPA and founder of Talent Financial, a personal finance and small business consulting firm, notes that whether workers should be classified as contractors or employees is one of the most pressing questions that business owners face. Contractors and employees differ in a number of ways, but these differences are most pronounced in regard to payment and taxes. “Contractors are very easy to pay,” says Kern. “Typically, they will send an invoice or will be paid a regularly scheduled amount.” With this type of pay structure, the business owner will run a contractor’s check through accounts payable, compensating them like any other external vendor. Employees, on the other hand, must be paid through a payroll system with mandatory withholdings, including federal, state, local, FICA and unemployment tax.
“Employers typically do not withhold any taxes on a contractor’s pay,” Kern explains. Instead, the contractor is responsible for paying all of their taxes to the appropriate government authority. “With employees, employers are required to withhold any taxes and remit them to the government,” he notes.
Another important difference is that the employer is responsible for FICA taxes totaling 7.65 percent of the earnings for all employees. “When it comes to contractors, the employer does not pay any portion of tax and the contractor must pay the full 15.3 percent of self-employment taxes,” Kern adds. This means that as a business owner, it is cheaper to hire contract labor–which explains both the incentive for employers to do so and the reason why the government has an interest in penalizing companies that misclassify workers.
“There are exceptions,” Kern continues, “but in general, employers are required to file a 1099-MISC form with the IRS and send the contractor a copy if they were paid more than $600. For employees, the employer must file a W-2 form with the IRS and send a copy to their employees regardless of how much they were paid, if taxes were withheld.”
Ultimately, workers are evaluated as employees or contractors on a case-by-case basis, although the IRS has issued guidance on how to classify workers. In general, according to the agency, a worker is an independent contractor “if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.” There is a further three-part test to help elucidate the most accurate description of a worker, including whether they have any behavioral or financial control of their work, and the overall relationship:
Behavioral Control: Does the employer have the right to control where, when and how the work is completed? A contractor will have total control of these factors while an employee must report to a designated location as determined by the employer.
Financial Control: Does the employer have the right to control the financial and business aspects of the job? If the employer is in full control of all financial and business decisions, then the worker is an employee.
Relationship: How is the employer and worker relationship under- stood? Is the relationship indefinite or is there an end date? For an employee, the work is central to overall business operations and will continue with no set end date.
“After applying the three-part test, the business owner should have
a good idea of whether the worker is an employee or a contractor,” Kern says. Of course, there is often ambiguity, especially when an employee or independent contractor technically ticks multiple boxes. Consulting case memos from the IRS to get more clarity is a good idea, according to Thomas J. Williams, EA, tax accountant, author and cofounder of Deducting the Right Way, an online resource for small businesses. “The IRS has a list of factors you can cross-reference,” Williams says. But he also warns against the tendency of business owners “to twist its meaning to their favor.” Instead, the best way to determine the actual intent behind any rules is to “review the IRS memos and U.S. tax court cases, so you can see how your facts and circumstances stack up to real-life examples,” Williams says.
Photo by Charisse Kenion on Unsplash
The Increase of Independent Contractors
According to the U.S. Department of Labor, one in ten workers is an independent contractor, and the trend of hiring independent contractors is most likely on the rise. In fact, a more recent poll sponsored by NPR/Marist found that one out of every five jobs in America is held by a worker who is under contract– suggesting that contractors and freelancers could become half of the American workforce within only a decade. The benefits of being a contractor versus an employee depend on the unique needs of the worker. For instance, the same Department of Labor survey found that “79 percent of independent contractors preferred their arrangement over a traditional job, but only 44 percent of on-call workers and 39 percent of temporary help agency workers preferred their work arrangement.” As one might expect, the increased hiring of workers as independent contractors has prompted the government to treat these arrangements with increased scrutiny.
Penalties for Misclassifying Workers
Though a contract arrangement may be more financially desirable for a business owner (and a worker, potentially), the increased scrutiny and threat of penalties should discourage employers from misclassifying workers. Especially for a small business, it may be challenging to pay its share of an employee’s Social Security and Medicare taxes, as well as overtime pay and employee benefits–including vacations, holidays, sick pay, unemployment compensation tax and workers’ compensation insurance. However, a business cannot afford not to pay them.
Failing to pay the IRS may come to the attention of the government
in a number of ways, whether an employee reports the situation to a government agency firsthand, files for unemployment benefits or suffers an injury when traveling to work and thereby has to open a worker’s compensation claim. Alternatively, the government may discover that employees have been misclassified when performing audits, which occur on both the state and federal level. A standard Department of Labor or IRS audit of a business will include all employees and independent contractors over a three-year period. The penalties for violating tax law and misclassifying employees differ if the government believes the misclassification was unintentional, or if it was done in a fraudulent manner.
In all cases following an audit that identifies misclassified employees, the employer must change all payment to those contractors into wages and forfeit $50 for every W-2 that was never filed. The business must also pay 1.5 percent of the wages, plus 40 percent of the FICA taxes (Social Security and Medicare) that were not withheld from the employee, and 100 percent of the matching FICA taxes that should have been paid (with interest, starting from the original date of issuance). Businesses may also face a “Failure
to Pay Taxes” penalty, which is equivalent to 0.5 percent of the unpaid tax liability for each month, and up to 25 percent of the total tax liability. Additional punishment is at the discretion of the IRS, especially if there is suspicion of fraud. An employer could potentially serve a one-year prison sentence, pay $1,000 for each worker that was misclassified, and assume personal liability for any employee tax not collected over the period.
There’s simply no excuse for being less than crystal clear about who on your staff is an employee and who is an independent contractor–whether that means consulting an accountant or seeking out an established IRS precedent for comparison. Once the nature of your staff’s employment has been established, you can rest assured knowing that you’re paying staff correctly while avoiding any unnecessary government attention.