Worker Classification (4)
Employees are classified as either exempt from overtime, and are normally paid salary, or nonexempt, and are paid hourly with overtime for over 40 hours in a workweek. Classification can be difficult. There are also independent contractors and booth renters, which are not legally “employees.” If there is a disagreement between you and the IRS in how you classified a new hire, a court will decide how your employee should be classified.
If an employee is classified as nonexempt from overtime but actually should receive overtime, then any overtime they have worked you must pay them and the associated taxes. The courts will enforce this.
It’s important to always keep clear records of hours worked by all employees. If you were paying overtime and they were really exempt you have a different problem. You paid them overtime wages they were not due. Trying to get that back is going to be difficult internally with a very upset worker and may be impossible to enforce if the employee objects.
In the last few decades the numbers of independent contractors has mushroomed. The reason in many cases is to force workers to pay for an “opportunity to work” rather than paying wages and overtime, like a worker who purchases a “contract” to clean a building, or a taxi driver who rents a cab for a twelve hour shift. There is very little difference in the work done between these independent contractors and full time employees doing the same job. But the independent contractor (IC) label keeps workers from getting the protection of the labor laws at the Federal and State level as well as denying them the right to organized into a labor union.
Advantages of hiring IC over employees.
- There is reduced overhead costs in using independent contracts.
- Reduced payroll taxes and the expenses of paying and accounting for such payroll.
- No benefits for independent contacts means no health insurance, no vacation, no jury duty, no time off with pay.
- The independent contractor works when the employer wants him to. There is full flexibility about when they work with no overtime pay and no pay for down times.
- You can get very experienced and well trained contractors.
Disadvantages to hiring IC over employees.
- No or limited employee loyalty. Loyal and dedicated employees tend to be very productive.
- Getting ICs to do extra work. Since they are technically self employed, they will not be as willing to lend a hand in running your business like an employee will.
- ICs may set their own schedules because of other contracts they are fulfilling at the same time.
Disadvantages to hiring employees.
- You now have a person who is depending on you to provide for them and their family. You may be in an employment-at-will situation but employment generally means permanency or long-term employment.
- If you layoff an employee, you’ll have unemployment costs which can be very expensive.
- You have extra overhead, facilities, taxes, benefits and the like.
- The employee that stays with you is going to expect supervision, growth, training and a maybe future path to a higher position.
As there are downsides to employees, there are downsides to independent contractors besides scheduling, as mentioned above. Independent contractors are not, as we will discuss later, subject to your control. Their charges are subject to market variation and demand. You may pay them $25.00 an hour this month and with changes in the market and demands on their time next month you may find their rate to be double.
If you have misclassified a new hire as independent contractors and the IRS says they are really employees the taxes, penalties and interest due can be devastating. Remember that the IRS and the Department of Labor would prefer there be no independent contractors.
How does the IRS decide who is an employee and who is an IC?
In 1987, the IRS created a list of 20 factors they consider relevant after examining the case law.
The amount of weight given to each of the twenty factors depends on the job and the actual situation that the worker operates in. The twenty items listed in the IRS Revenue Ruling 87- 41 include the following:
- Instructions: If the employer has the right to require the worker to comply with the employers instructions.
- Training: If the worker can be require to attend training as to how the work is done.
- Integration: Are the services performed by the work integrated into the normal operations of the business.
- Personal Service: Does the employer require that the worker perform the services or can the worker at their own behest substitute another person.
- Hiring, supervising, and paying: If the employer hires, pays, and supervises assistants for the worker rather than the worker hiring, paying and supervising his or her own assistants. This is an indication of control.
- Continuing relationship: That the employer and the worker maintain an ongoing and continuous relationship.
- Set hours of work: The worker has established regular hours for work set by the employer.
- Full time required: The worker should work full time for the employer rather than be free to work for whomever they want to and whenever they want to.
- Work on employer’s premises: The services performed by the worker are performed in facilities controlled by the employer.
- Sequence test: The worker performs tasks in the order that the employer specifics.
- Reporting: The worker must submit reports either verbally or in writing on a regular basis.
- Payment: The work is paid by a time unit (Hour/day/week/etc.) as opposed to being paid by the job.
- Expenses: If the employer pays the expenses for the worker it leans toward an employment status.
- Tools: Normally if the workers tools are provided this would indicate that the worker is an employee.
- Investment: If the worker has made significant investment in the facilities where the work is performed it indicates that the worker may be an independent contractor.
- Profit or loss: A worker who is an employee does not normally make a profit or a loss in addition to his normal pay.
- One Employer: Normally a worker who performs the same service for multiple employers at the same time is indicative of an independent contractor.
- Generally Available: If the worker makes his services available to the general public it is indicative of an independent contract.
- Discharge: The ability of an employer to fire a worker leans toward the worker being an employee.
- Termination: A worker who can quit at any time indicates that the worker is an employee.
Employment conditions that play a role in new hire classification.
The IRS has identified three types of conditions could be used in determining the status of a worker as an independent contractor or an employee:
(1) Behavioral control;
(2) Financial control; and
(3) Relationship of the parties.
The IRS makes the point that in addition to the twenty common law tests there other factors that may be relevant to the status and that the weight allocated to each factor may vary based on the situation.
In general the following is true. Individuals who offer the services they perform in the course of their professional to the general public are normally independent contractors.
Courts realize that highly skilled or highly educated workers don’t require the minute by minute supervision so day to day control over a worker in not necessarily helpful in determining status. The courts are tending to focus on the workers ability to realize the profit or loss from their services particularly as shown by who pays expenses and who finances the business.
I just wrote a blog post about this debunking some ideas about payroll. This was one of the myths. Read the entire blog post, but here’s my answer to that question.
- The savings in using independent contractor are mostly illusionary. If you are not paying the Social Security and Medicare taxes, independent contractors have to pay them.
- Independent contractors also have to handle their benefits on what you pay them. If you think you are saving money, you are in reality cheating the contractor.
- You should be paying them all of the costs that you are making them pay for. There is no free lunch.
You are also forgoing the upside of hiring employees.
- You don’t get to decide whether a worker is an employee or an independent contractor.
- There are 20 common law rules for determining whether a worker is an independent contractor or not. See them here.
- A preponderance of those 20 rules determines the outcome. The common law rules are the law.
In the end, if there is a dispute, the court will decide.
Learn more about W2s versus 1099s here.
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