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Avoiding Misclassification – Employee or Independent Contractor?

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In a previous post called “Hiring Tips for First Time Entrepreneurs,” we briefly discussed some of the factors considered by the IRS in classifying a worker as an independent contractor versus an employee (e.g. whether the worker operates under a separate business name, whether the worker uses his or her own tools for the job and sets his or her own working hours, and whether the worker serves more than one client). As the previous post noted, the IRS worker classification test centers around the degree of control or supervision the employer exercises over the worker. This post will break down some of the key additional factors that can help your startup determine whether to classify a worker as an employee or an independent contractor.

It is important for any business to avoid misclassification; however, it is even more important for a startup, because startups need to be especially careful with keeping costs and liabilities down, and the consequences of misclassification are expensive.  Misclassification can leave your startup subject to class actions and individual lawsuits, and liable for thousands of dollars in back wages, penalties, fines, workers compensation premiums, insurance contributions, and tax liabilities. So, the consequences of misclassification are serious, and your startup needs to be careful to avoid them. The IRS uses a test that focuses on three basic categories to weigh against each other and assist in making its determination on the question of whether a worker has been properly classified: (1) behavioral control, (2) financial control, and (3) type of relationship.

Behavioral: Does the startup control (or have the right to control) what the worker does for the startup and the method in which the worker does it? Ask yourself if your startup is doing any of the following:

  • providing training to the worker
  • giving detailed instructions on how to perform the task

If this is the case, your startup is exercising behavioral control over the worker, and this may favor classification as an employee. Independent contractors are usually just that—independent. This means they should have control over the methods they use in carrying out the task.

Financial: Does the startup control (or have the right to control) the financial/economic aspects of the work? Ask yourself if your startup is doing any of the following:

  • providing tools and supplies for the worker
  • reimbursing the worker for expenses
  • paying the worker a salary or guaranteed wage on a regular basis (e.g. a wage that is paid hourly, weekly, etc.)

If this is the case, your startup is exercising financial control, and this may favor classification as an employee. Independent contractors should be making their own investment into their business by covering their own expenses, and are typically paid a flat fee for their services.

Relationship: How do your startup and the worker perceive the relationship? Ask yourself if the worker is doing any of the following:

  • working for an indefinite period of time for your startup
  • receiving employee benefits from your startup (e.g. sick leave, insurance, etc.)
  • providing services that are integral to an essential part of your startup

If this is the case, the relationship favors classification as an employee. Independent contractors are usually hired for a specific period of time, do not receive benefits, and are not providing a service that is essential to the core of the startup’s business. Additionally, while the IRS does not have to confirm independent contractor status simply because an employer has a contract stating that the worker is such, it is helpful for your startup to have a contract in writing that (1) states that the worker is an independent contractor, and (2) explains the nature of the relationship in the context of the factors listed above.

Since the IRS weighs these factors, and working relationships evolve over time, it is likely not possible for an employer to know for certain that a worker has been properly classified. This is why it is important for your startup to do the following prior to classifying a worker: (1) review all of the factors provided by the IRS (located at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee), (2) put the agreement in writing, and (3) audit to ensure that your startup’s relationship with the worker is not evolving into one that would be considered an employer-employee relationship in view of these factors.

 

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