Properly classifying workers as employees or independent contractors is essential for businesses. While both types of workers contribute to your company’s success, they have different legal, tax, and financial implications. Misclassification can result in penalties, back taxes, and compliance issues.
If you’ve already hired someone and need to determine their correct classification, here’s what you need to know.
Key Factors in Classification
1. Work Structure: How Tasks Are Organized
One of the main distinctions between an employee and a contractor is how the work is structured.
- Employee: Works according to a set schedule, follows company procedures, and may receive ongoing training to align with company expectations.
- Contractor: Works independently, often on a project basis, and determines their own approach to completing tasks.
Example: If a worker is expected to be available during specific hours and follow detailed processes, they are likely an employee. If they manage their own schedule and methods, they are likely a contractor.
2. Financial Setup: Payment, Expenses, and Resources
The financial relationship between a business and a worker also plays a role in classification.
- Employee: Receives a regular wage or salary, with payroll taxes withheld. The company typically provides tools, software, and reimburses business-related expenses.
- Contractor: Sends invoices for work completed, pays their own taxes, and supplies their own equipment and materials.
Example: If your business provides a worker with a laptop, software, and pays for job-related expenses, they are likely an employee. If they use their own resources and invoice you for their services, they are likely a contractor.
3. Relationship Terms: Duration and Benefits
The nature of the working relationship helps determine classification.
- Employee: Typically works on an ongoing basis and may receive benefits such as health insurance, paid time off, or retirement contributions.
- Contractor: Typically works on a short-term or project basis, does not receive benefits, and is responsible for their own business expenses.
Example: If a worker is on your payroll indefinitely and receives benefits, they are likely an employee. If they are contracted for a specific project and have no ongoing obligations, they are likely a contractor.
Department of Labor (DOL) Guidelines for Classification
The DOL uses the Economic Reality Test to determine whether a worker is an employee or an independent contractor. This test evaluates several factors, including:
- Opportunity for Profit or Loss – Can the worker increase their earnings through their own effort, efficiency, or investments? If so, they may be a contractor.
- Investment in Equipment and Materials – Does the worker provide their own tools and equipment, or does the business supply them? Contractors typically make their own investments.
- Degree of Permanence – Is the worker engaged for a specific project, or is there an ongoing relationship? Employees tend to have long-term roles.
- Nature of the Work – Is the work essential to the business’s core operations? Employees often perform integral work, while contractors typically provide specialized services.
- Worker’s Control Over Work – Does the worker have autonomy in performing their tasks? Contractors set their own schedules and methods, while employees follow company direction.
- Skill and Initiative – Is the worker running their own business, bringing specialized skills, and making independent decisions? Contractors operate as independent business entities.
No single factor determines classification. Instead, the DOL considers the overall working relationship to ensure compliance with the Fair Labor Standards Act (FLSA).
Why Proper Classification Matters
Incorrect classification can lead to significant consequences, including:
- DOL Investigations – Misclassified workers can file complaints, leading to government audits.
- Back Wages & Overtime – Businesses may owe unpaid wages, overtime, and benefits.
- Fines & Penalties – Violations can result in financial penalties and legal action.
How to Ensure Proper Classification
To avoid misclassification issues:
At CFO Accounting Services, we assist business owners with payroll management and worker classification to keep operations compliant. If you need help reviewing your workforce setup, reach out today!
