Posted in Payroll | by: Erin Colbert

Employees? Contractors? Why Worker Classification Is So Important

As the economy continues to try and find its footing, a growing trend has emerged among businesses nationwide – the return of the freelance contractor. The trend of hiring independent contractors to handle jobs once performed by full-time employees has caused the freelance sector to explode with workers. According to a recent report published by the Freelancer’s Union, today, one in three workers in the United States is considered an “independent worker.”

This fact is important for you as a business owners because it reintroduces the question – should I hire a full-time employee or a contractor? But, before you can make this all-important staffing decision for your business, you need to fully understand both types of workers and the importance of classifying them correctly, because failing to do so could cost your business.

The Employee Defined

According to the Internal Revenue Service, an employee is defined by meeting three primary factors:

  1. Behavioral Control: The company has control over all aspects of the individual and how he performs the job, such as when, where, and how the work is performed.
  2. Financial Control: The company has control over all financial-based business aspects such as how and when the worker is paid, whether or not expenses are reimbursed, the type and cost of benefit packages, and any other financial matters concerning the job.
  3. Type of Relationship: The work being performed is a key aspect of the business’s daily operations and the working relationship between the individual and the company extends beyond the duration of a particular job.

What often makes classifying workers difficult is that an independent contractor can sometimes fit into one or more of the above guidelines. It can be entirely possible for an independent contractor to dedicate 40 hours a week to one company and yet still not be considered an employee, or vice-versa. Here’s a further, simplified breakdown:

Independent Contractors:
  • Use their own materials for work performed
  • Have a temporary relationship with employer
  • Are paid a flat fee and complete invoices for a job
  • Control manner and means of how work will be done
  • Cannot terminate services without liability
  • Are not eligible for unemployment benefits or worker’s compensation
  • Are paid regularly (hourly, weekly, monthly) for guaranteed work
  • Have an indefinite relationship with the employer
  • May receive benefits, pension plans and vacation pay
  • Are an integral part of a business’s permanent day-to-day operations
  • Works within constraint of workplace
  • May receive company-provided training
  • Employer controls what and how work will be done

The Cost of Misclassification

When hiring an employee can cost 25-30% more than hiring an independent contractor, it’s clear to see the benefit to employers. Government figures estimate 25-30% of all employees are misclassified as independent contractors.

And that is because, “generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. You do not generally have to withhold or pay any taxes on payments to independent contractors,” the IRS explains. Additionally, full time employees are often entitled to health benefits.



But regardless of whether the misclassification was intentional or unintentional, your business could face serious legal and financial consequences for doing so. This could include reimbursement for unpaid wages, including overtime wages, paying the individual’s workers’ compensation benefits, retirement contributions, employee benefits, Medicare and Social Security contributions, unemployment insurance, health insurance, and any other employee-related costs like back taxes and any applicable penalties for state and federal income taxes.

If You Need Further Help

If worker classification still has you scratching your head, submit Form SS-8 and the IRS will make the final determination of your worker’s status. While it could take up to 6 months to respond to your inquiry, knowing you’re fully compliant will give you the peace of mind to continue running your business.