Hiring workers is an important step most business owners make sooner or later. However, business owners have a choice on how to classify that new worker. New workers can be classified as either employees or independent contractors; the classification choice you make will impact your business and your responsibilities not only to the individual worker, but also to various government entities.
What’s the difference?
The IRS defines an employee as an individual who is under an organization’s control as to what work is to be done and how it is done. That vague definition is expanded in other IRS material, in general, an employee is be someone that is overseen and controlled by someone at your organization. If a person does not meet the definition of an employee, then they are an independent contractor.
Key distinction is direction and control
When thinking about how you should classify your workforce, you should think about how much control you want to have over them. If you plan on asking your workforce to wear uniforms, report to work at a certain time, oversee, direct and manage their job functions, then you should classify those workers as employees. However, if you give a worker general direction, and provide them with a general set of standards to abide by, then those individuals are most likely independent contractors.
Importance of formalities
Business owners tend to be practical and may question the need for what they see as superfluous paperwork and formalities. However, if you decide that you are going to hire an individual, then you should have certain forms ready to formalize the arrangement. For example, you should have independent contractor and employment agreements. These forms will help bring clarity to the relationship you have with the worker and can be used to help establish whether the individual was classified correctly.
Independent contractors and their own LLCs
While some workers will insist that it is unnecessary, you should always ask that any independent contractor you hire have a business entity formed. This is another small step that may seem unnecessary or inconvenient, but that can help you if the IRS or the State tries to reclassify your worker.
What can go wrong?
The IRS looks at a series of factors to determine whether the worker you have meets the classification you assign them. If the worker’s classification is at issue, the IRS will generally ask that you submit paperwork to back up your claim. That is why it is important to follow the formalities we previously discussed. Additionally, you want to make sure that you are not treating independent contractors as employees in practice. State offices will also generally follow IRS procedure for determining whether a worker is properly classified, therefore those documents can help you in that instance.
If you do not have the documentation you need and a worker is found to be improperly classified, you could face some serious fines. This is because the IRS requires that employers withhold and remit certain portions of an employee’s wages. Failure to withhold and remit those amounts to the IRS opens the employer to penalties. Similarly, the State requires that you have workers’ compensation insurance once you have a certain number of employees. The state also requires that you pay unemployment insurance for employees. Failing to pay those requirements amounts can also lead to penalties.