As your business grows, you’ll need to scale your operations which often includes hiring more people. Depending on how you operate, you may need full-time, part-time, freelance employees, or some of each.
Knowing and assigning classifications to workers based on how they work for you is important for workplace organization, office dynamics, accounting, and contractor compliance. In addition to specific conditions in your contract with them, workplace classification dictates the types of benefits that employees are entitled to. Such benefits may include healthcare, paid time-off, and paying taxes on behalf of the employee among others.
Moreover, getting employment classification right can save a business from penalties and other similar issues down the road. This is why it’s important to properly classify employees as you hire them.
If you’re not sure exactly what this means for you and how to classify employees, don’t worry. We’re here to help. This article will tell you all you need to know about worker classification.
Table of Contents
What Is Worker Classification?
Worker classification determines what the contract of a worker entails and the employer’s legal obligations regarding:
- Worker’s compensation
- Work hours and overtime
- Unemployment insurance
- Wage payments
- Civil rights protection
- Social security and Medicare taxes
- Paid leave
- Other miscellaneous benefits
But how do you classify employees? Take a look at the next section…
Best Strategies for Classifying Employees
Classifying workers as independent contractors and regular employees can get confusing if you don’t know what to look for.
The IRS determines classifications based on three main factors: the behavioral and financial control the company has over the individual and the type of relationship between the employer and employee.
An effective strategy to avoid misclassifying employees is to thoroughly understand these categories and focus on them when drafting your agreements with your workers:
Financial
How much control does the company have over how the worker is paid? Is the worker allowed to seek other jobs and enter into contracts with other clients or does the company have a sole monopoly over their time and skills?
If the company exerts more control over the worker, then the individual is an employee. Otherwise, they may be an independent contractor.
Behavioral
The degree of behavioral control the company has over a worker is another aspect that aids classification.
Does the company dictate how the worker conducts themselves and does the job? Do they have control over the worker’s schedule, tools, location, work hours, methods, and techniques for working and completing tasks? Do they supervise a worker’s dress code or set expectations regarding attending company events and other aspects?
If the answer to these questions is yes and the company has behavioral control over a worker, they can be classified as an employee.
Type of Relationship
Companies are responsible for providing employees with benefits such as health insurance, paid time off, 401(k), etc. If a company enters a business relationship that doesn’t offer these benefits, it is hiring an independent contractor.
However, in addition to the inclusion of the aforementioned benefits, other aspects of the relationship are also considered:
- Job duration – if the job is meant to go on indefinitely or if it’s a temporary or short-term job
- Terms of employment – Is there a written contract with clearly defined stipulations regarding the business relationship?
Companies must consider these three main distinctions and categories to define worker classification when writing their contracts.
However, contractual agreements stating workers’ statuses are not enough. Documentation and proof are also required to explain how this classification was decided based on the three factors.
Differences Between Employees and Independent Contractors
Employees and independent contractors are classified as two separate entities. Their payments, taxes, and other work aspects are vastly different from each other. It is, therefore, essential to know whether your worker should be classified as an employee or as an independent contractor.
Here’s how to differentiate the two:
Who Should Be Classified as an Independent Contractor?
An independent contractor is a self-employed individual who performs their duties in collaboration with other businesses through short-term or freelance contracts.
Their job descriptions vary depending on specialization and niche. However, each contract specifies the job/s that they are meant to do with clear goals and targets.
They focus on very specific or specialized tasks and perform a single, specific role for a project. Companies cannot expect independent contractors to do the job of regular employees and pick up slack just because they are “on company time” as they have a clearly defined scope of work.
Independent contractors have the freedom to determine their work hours, use their own tools, and work from wherever they wish unless the job requires them to be on-site. They are also free to work for multiple organizations simultaneously. Their clients do not demand exclusivity of their time and services.
Since independent contractors are self-employed individuals, they are required to file and pay their own taxes. They are also responsible for their own benefits such as healthcare, 401(k), paid leaves, etc. Though some projects may take longer to complete, they are not paid overtime.
Independent contractors should thus take these factors into consideration when determining their rates and fees.
Who Should Be Classified as an Employee?
Employees are workers hired by a company on a full-time or part-time basis. The organization can thus dictate their work hours and work location. They can also demand that employees begin and end their shifts at certain times as long as it is within legal bounds.
Employees are often given training along with the required tools and equipment to complete the tasks outlined in their job descriptions and contracts.
Employees can also have relatively flexible job descriptions and be asked to do additional work during work hours. In case they are required to work beyond their regular work hours, employees are entitled to overtime compensation.
Full-time and part-time employees receive several benefits such as healthcare, paid time off, and 401(k) retirement benefits. Companies are also required to pay taxes on behalf of their employees by withholding the amount from their wages. This saves employees the hassle of filing their taxes.
Common Law Rules: Misclassification of Workers and Taxation Policies
Correctly classifying workers is extremely important. The distinctions between employees and independent contractors must be understood and maintained across all company records.
Classifying workers correctly may seem like a straightforward process but some businesses still struggle to get it right.
In case you misclassify a regular employee as an independent contractor, you will have to retroactively pay their taxes and benefits. Such mistakes also come with financial penalties:
- Workers’ compensation for misclassifying employees
- Providing benefits that are given to other employees but not to contractors such as insurance, retirement benefits, paid leave, etc.
- Reimbursement of wages that were not previously applicable including minimum wage rates and overtime.
- Penalties and back taxes for Medicare, income taxes, social security, and unemployment
Are Employees and Independent Contractors Taxed Differently?
Employees and independent contractors are taxed differently. As an employer, it is important to understand your tax obligations to your employees.
Depending on a worker’s classification, there are two taxes to consider:
109 Taxes (For Independent Contractors)
1099-NEC is an IRS form that lists all the payments or compensation paid to an individual during a tax year. The individual filing 109 taxes must be an independent contractor or freelancer who is responsible for their own income taxes.
1099-NECs are required from workers who receive at least $600 for their services. Their taxes are not withheld by their employer because of their employment agreement.
W2 Taxes (For Employees)
The W2 is an IRS form that declares an employee’s wages and taxes during a financial year. It records all the benefits and compensation paid to an employee and the taxes withheld by the employer during a tax year.
W2s are filed by companies on behalf of employees as long as they were employed at any time during the year regardless of whether it was on a part-time or full-time basis.
This includes all employers who were paid a minimum of $600 during the tax year and other employees whose taxes were withheld by their employers even if they were paid less than $600.
Conclusion
If you’ve never dealt with worker classifications before, it may seem like a lot to take in. But with this guide, you’ll be on your way to implementing proper worker classifications and settling your obligations to employees like a pro.
Understanding the financial, behavioral, and relationship aspects as well as the differences between regular employees and contractors is a big step in the right direction. It can help you make more informed hiring decisions, allow you to be better acquainted with your responsibilities towards your employees, and avoid costly penalties.
For additional guidance and assistance, Worksuite can help you hire, onboard, pay, and manage your contractors. Our San Francisco-based firm has a deep understanding of the intricacies involved in freelancer engagement and management. By partnering with us, you can leverage our experience, knowledge, and platform without worrying about details like compliance and payments because we can do it for you.
