Ensuring Compliance for Independent Contractors and Employees in Your Small Business
Ensuring compliance with tax regulations is crucial. For small businesses, this is especially true when it comes to distinguishing between independent contractors and employees. One of the top questions clients ask CPR is:
“Why can’t I classify anyone I hire as an independent contractor?”
This is a dangerous game to play. Small businesses owners are typically uninformed about classifying workers. Misclassifying workers or paying workers “under the table” can lead to significant legal troubles and financial setbacks enforced in fines levied by the U.S. Department of Labor (DOL), Internal Revenue Service (IRS), and state agencies. The problem with misclassifying workers at your small business is that it potentially shortchanges over $12 billion per year in payments to workers who are entitled to benefits such as Social Security, unemployment insurance, and workers’ compensation.
In this blog post, we'll explore the essential steps small business owners should take to guarantee classification compliance to avoid potential pitfalls.
Understanding the Distinction Between Independent Contractors & Employees
Common Independent Contractors Characteristics:
Typically hired for specific projects or to add specialized expertise for a defined period of time.
Have control over when, where, and how they perform their work.
Use their own tools, equipment, and resources.
Can assign the work to a subcontractor or their own employee.
Paid only upon submitting an invoice.
Not entitled to benefits such as insurance or paid leave.
Not entitled to legal protections such as unemployment, anti-discrimination, and workers’ compensation.
Tax Implications: Independent contractors are responsible for paying their taxes, including self-employment taxes. Businesses are required to annually issue Form 1099-NEC, 1099-K, or 100-MISC to independent contractors outlining all payments.
Common Employee Characteristics:
Typically hired for work that is ongoing and for a core function of the business.
Follow a set schedule and work location.
Use company-provided tools, equipment, and resources.
Performs the work themselves.
Paid on a regular frequency and may complete a timesheet.
Entitled to benefits such as insurance or paid leave.
Entitled to legal protections such as unemployment, anti-discrimination, and workers’ compensation.
Tax Implications: Employers are responsible for withholding income taxes, Social Security, Medicare taxes, and unemployment insurance from employees. Employers are required to annually issue Form W-2 to employees outlining all wages, tips, and earnings.
The problem with misclassifying workers at your small business is that it potentially shortchanges over $12 billion per year in payments to workers...
Key Steps for Ensuring Compliance
First, understand the IRS Guidelines on worker classification here. Following IRS Guidelines ensures you're in compliance and reduces the risk of misclassification.
Next, conduct a thorough review of your workforce to ensure accurate classifications. Ensure documents are thorough and explicitly spell out the nature of the relationship. Proper documentation will serve as evidence of worker classification in the event of an audit. Review the following to maintain clear and comprehensive records:
For independent contractors, review contracts, invoices, and consulting/subcontractor agreements.
For employees, review records of hiring documents (ie. employment applications, offer letters, and job descriptions), employment agreements, and policy acknowledgements. For example, if you have employment application on file for an independent contractor, this is a misclassification red flag.
Lastly, evaluate the nature of your working relationships. Independent contractors should have a degree of independence in how they complete their tasks. Employees must follow your instructions on how to perform their job responsibilities. For example, small businesses should be careful inviting independent contractors to attend meetings or events designated for employees, providing a uniform to wear, issuing company-provided equipment, or offering employee benefits. These typical actions muddy the nature of the independent contractor relationship with your business in the event of an audit. The DOL offers more about misclassification here.
The Risks of Non-Compliance
Penalties and Fines: Misclassification can lead to fines and penalties imposed by tax authorities. For example, tax violation fines are $50 per W-2 tax form and penalties of up to $1,000 per misclassified worker.
Legal Consequences: Misclassified workers may file legal claims for benefits they think they may have missed out on, leading to legal battles and potential settlements. Some consequences include class action lawsuits, punitive damages, and even jail time.
Reputational Damage: Non-compliance can damage your small business' reputation, affecting relationships with clients, investors, and potential hires.
Conclusion
Distinguishing between independent contractors and employees is not only a legal requirement but a key step in safeguarding your business’ financial health and reputation. You can navigate tax season with confidence by following the outlined steps and seeking professional guidance. CPR and your tax professional can provide tailored advice based on your small business’ specific circumstances, reducing the risk of errors.
Update - April 20, 2024:
As of March 11, 2024, the Department of Labor (DOL) revised guidance for employers on how to analyze who is an employee or independent contractor under the Fair Labor Standards Act (FLSA). Missclassification of workers has been prevalent due to the growth of the gig economy. Early research indicates that industries such as construction, transportation, trucking, and media could be significantly impacted by these new changes.
Previously, some factors had greater weight than others when considering someone an employee or an independent contractor. However, the tips provided in this blog post generally still apply.
Disclaimer: The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information, content, and materials available on this site are for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information.
