If you hire independent contractors to work for your business, you need to make sure that they aren’t actually considered employees in the eyes of the IRS. As many large and small companies have discovered (most recently Google, Amazon, and Uber), misclassifying workers can be expensive. In fact, it could destroy your business entirely, which is exactly what happened to cleaning services company Homejoy earlier this year.
Do You Have an Employee or Independent Contractor?
Independent contractors are not your company’s employees. That means you don’t pay them through your company’s payroll system. And that means you don’t have to pay employment taxes or withhold other taxes like Social Security and Medicare from their paychecks. Independent contractors are responsible for paying all of those taxes themselves.
You also don’t have to offer independent contractors any kind of medical insurance, time off, or other benefits. In other words, you can save a lot of money by using independent contractors rather than hiring employees.
But there’s a problem. In fact, there’s a very, very big problem.
Employee Misclassification Could Cost You Your Business
Employee misclassification can be a very expensive problem. Basically, if you provide the place of work, you control the hours of work, and you control the quality of work, you have an employee. An independent contractor can’t be engaged and expected to report to the office on a day to day basis. They’re allowed to do the job in whatever way they choose.
Misclassifying employees can also get you into a lot of trouble. If the IRS or another auditing agency intervenes, you could face significant penalties. For example, you’re responsible for withholding taxes from your employees’ wages. If you’re caught misclassifying an employee, you can’t go back to the employee and get the money you should have withheld, so you’re going to be responsible for all of the taxes that should have been withheld from the employee as well as all of the taxes that you should have been paying on behalf of the company.
In addition, you’re going to have to pay penalties and interest for the period of time that the lapses occurred, which could be substantial depending. The general open audit period with the IRS is three years, so they’ll look back at least that far if they review your business, and if they find fraud, there’s no statute of limitations.
3 Questions to Determine if a Worker is an Employee or Independent Contractor
To help you correctly classify your workers as employees or independent contractors, ask the following questions about each worker:
1. Do you control the work that the worker does?
If you direct how, when, and where someone works for you, then you have an employee, not an independent contractor.
2. Do you provide the worker with equipment to perform the work?
If you give a worker a computer or other equipment that they use to perform work for you, then that worker is probably an employee, not an independent contractor.
3. Do they only work for you?
Independent contractors must be free to work for anyone they choose. If they’re only working for you, then they could be an employee, not an independent contractor. Even if they don’t have any other clients that they work for, it must be clear that they are free to work with other clients at any time without asking for your permission or they could be considered an employee.
Get Help to Avoid Making Employee Classification Errors
Employee classification errors can destroy your business, so familiarize yourself with employment law! Create independent contractor contracts that ensure your contractors aren’t employees, and make sure you pay and record all taxes correctly.
This is very insightful, however, why doesn’t anyone ever include Labour Hire in these comparisons? It’s very easy to think “I’m an employee”, but you aren’t under the “Labour Hire” rules. Would it be at all possible to do that comparison?
Tara, we don’t use the term “labour hire” here in the U.S. I did some research and see that it’s a term used in Australia and New Zealand (I’m not sure if it’s used elsewhere). I don’t know what the equivalent would be in the U.S. For tax purposes in the U.S. (where we’re based), you’re either an employee or a contractor (you get a W-2 or a 1099 MISC to file your tax return).