Business Owners Beware — Is Your Contractor Really an Employee? Here's Why a Misclassification Can Be Costly. Here's why it's important for business leaders to fully understand the difference between a contractor and an employee.
By Doreen (Clark) Pierce Edited by Chelsea Brown
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The past few years have seen a complete shakeup for both organizations and workers alike. Though contractors have consistently been used to fill a temporary need, the recent transition from in-office to a remote workforce has made organizations rethink their hiring processes and, in turn, has spearheaded the era of the freelancer. Today, contractors are commonplace, they are filling roles across all levels of an organization, from startup to global. Not only are they thriving, but they are consciously making the choice to be independent — but the real question is are they being treated that way?
It is clear that organizations can benefit from taking on freelancers, however, it is the organization's responsibility to have a clear understanding of the difference between an employee and a contractor, as the risk, if a misclassification should occur, can be steep. Simply calling a contractor a contractor is not enough. In this case, actions speak louder than words:
Related: What You Need to Know Before Hiring Independent Contractors
Contractor vs. Employee
For starters, lack of knowledge is never a defense. Many organizations use contractors as it is believed that they can serve as a cost savings. But beware. Contractors have rights, and if an organization crosses into murky waters, even unknowingly, there may be major penalties to pay.
So, what are the key differences between a contractor and an employee? The simple answer, according to the IRS, is that your new hire is not an independent contractor if you control the services performed (what will be done and how it will be done). They continue to state, if an employer-employee relationship exists (regardless of what the relationship is called), a contractor is not the correct classification, and the individual will not be subject to self-employment tax — and earnings may be subject to FICA and income tax withholding as an employee.
Employees are directed as to when, where and how to work. They are often given detailed instructions and onboarding processes, and they are paid through the organization with taxes withheld. According to the IRS, the more control the organization has, the more likely that the classification is that of an employee.
On the other side of the spectrum, a contractor is self-employed and can work for more than one company at a time. But the most defining factor is not that of pay or withholdings, though that matters, but the notion that a contractor directs their own "how" and "when" the job is done.
Many organizations may not understand the legal difference between a contractor and an employee, and the mistake can be costly.
The misclassification mistake
The IRS takes the relationship classification seriously. According to Mark Tyson, Founding Partner of TKN Tyson, counsel representing startups, "If a company misclassifies an employee as a contractor, they can face legal and financial consequences." Tyson continued, stating that this may "include tax penalties for failing to withhold taxes from the worker's wages, paying their portion of Social Security and Medicare taxes, legal claims from the misclassified employee, and even government audits and fines from agencies such as the Department of Labor and the IRS."
The bottom line? Calling a new hire a contractor may not make it so, and it is on the company to know the difference to prevent an impending headache.
According to recent data by Fiverr, 73% of U.S. workers plan to freelance this year. Therefore, companies need to get it right. Tyson states, "the trends reflect a growing awareness of the need to protect workers' rights and clarify their legal status." Today, business owners are changing their game plans when it comes to staffing. Freelancers are being used more than ever before and not just for short-term entry-level work. Contractors are also hired to be fractional executives in highly specialized and skilled roles.
Related: 3 Factors When Choosing Between a Contractor or Full-Time Employee
No matter the reason for the contract hire, if the relationship desired is for a contractor, organizations must be sure it fits the definition. The bottom line? If you want a full-time person, one that is part of a team, takes direction as to role and responsibilities and can have a job description that is able to evolve and be altered as the organization does, a hire that is classified as an employee may be in the cards.
If the company is in a position where it can take a step back from control and allow projects to be completed without direction of when or how, a contractor may be the right step — or maybe the hire starts as one classification and evolves to the other, with their approval. Once the company has defined exactly what is wanted and it is understood how to combine that with the rights of the potential hire, it will be smooth sailing, and the business can safely grow and prosper.
