Running a business has never been easy. But as a business owner or executive, you’ve faced a particularly rough two years. The COVID-19 pandemic and even mass resignations have created new hurdles for attracting and retaining workers..
In order to clear those hurdles and avoid taking unnecessary risks, it is important to fully understand the laws and regulations surrounding employees and independent contractors. Correctly classifying your team members is essential to prevent lawsuits or trouble with the IRS.
Comparing Employees and Independent Contractors
Are you hiring in 2022? When you need help, your business leaders have to choose between bringing on a part- or full-time employee or working with an independent contractor.
Here’s a quick look at the differences between them.
What is an Employee?
An employee works for a business on an ongoing basis. They typically use the employer’s equipment, tools, and materials, perform the duties the employer assigns, and work the hours the employer dictates. Generally speaking, employees receive direction on what to do, how, and when.
Employees are either “at will,” or a contract or statute defines their term of employment. Most employees are at will, which means they can quit, or their employer can fire them at any time and for virtually any reason. However, employees under a contract or statute may have specific protections or responsibilities surrounding when and how they can leave or be dismissed.
What is an Independent Contractor?
An independent contractor — often referred to as a freelancer — runs their own business. They tend to work with multiple clients at a time, though it isn’t required. They dictate their hours, decide how to perform their tasks, and use their own equipment. The client only demands particular results, and the freelancer decides how to achieve them.
Businesses must withhold income tax, Federal Insurance Contribution Act taxes (FICA), and unemployment taxes on their employees’ behalf. Employers and employees contribute to FICA taxes 50/50, and the employer deducts the employees’ portions from their paychecks.
Freelancers’ clients don’t withhold taxes on their behalf. Instead, independent contractors pay self-employment tax. They’re responsible for 100% of FICA taxes, and the IRS requires them to pay quarterly estimated taxes.
Additionally, employment and labor laws protect employees. Federal and state laws cover issues like minimum wages, overtime, lunch breaks, paid time off, harassment, discrimination, and more.
These protections don’t extend to freelancers. As a result, they’re at a distinct disadvantage and have to define their rights and protections in contracts with their clients.
Classifying Workers Under Federal Law
As a business leader, it’s important to know federal agencies don’t use the same test for distinguishing between employees and independent contractors. The test the IRS uses differs from the U.S. Department of Labor’s test, and so on.
The IRS says someone is an employee if the person or business they work for has the right to control and direct their job performance. It’s about the degree of control.
That sounds simple, but it’s complicated. To decide whether someone’s an employee or independent contractor, the IRS reviews aspects of behavioral control, financial control, and the relationship between the two parties.
The employment test under the Fair Labor Standards Act (FLSA) focuses on the “economic reality” between the two parties. There isn’t one specific test. Instead, the DOL looks at whether the individual depends on the business they serve.
There’s been a great deal of confusion about whether the DOL’s test changed in the past year. The DOL revoked the Trump Administration’s proposed rule for distinguishing between independent contractors and employees.
The rule was originally meant to go into effect on March 8, 2021. However, the DOL delayed the proposed rule in February 2021. After considering public comments and the rule’s inconsistency with the FLSA, the DOL withdrew the proposed rule before it ever took effect.
State Law Impacts Worker Classifications Too
Another complication is that states use their own tests to distinguish between employees and independent contractors. You have to look at the law in each state you do business in and be mindful of hiring independent contractors working in other states. In Michigan, the IRS test is generally the one used for classifying workers.
Why does a state’s rule matter? Because it impacts your state tax liabilities and labor laws. You might run afoul of state laws—such as those governing unemployment and workers compensation insurance—even if you believe you’re classifying a worker correctly for the IRS or FLSA.
About a third of the states use the ABC Test. However, other states use a test similar to the IRS. What’s most important to know is that state laws have been evolving for the past several years, and we can anticipate more changes.
The Consequences of Misclassifying Employees
Misclassifying a worker, even without dubious intent, creates legal and financial risks. For instance, if the IRS finds you misclassified an employee, you’ll become liable for employment taxes. In some cases, you might benefit from a voluntary reclassification program, which gives you some relief from the back taxes.
Another possibility is that misclassified workers could sue you for issues related to minimum wage, overtime, or unpaid vacation and sick leave. There have already been highly publicized cases against Uber and FedEx.
It can be easy for small businesses to think they fly under the radar. But with the rise in the gig economy, freelance work has become popular, and so has abuse within the employment system. The IRS and DOL are well aware of businesses intentionally misclassifying workers to benefit their bottom line, and they will audit small and mid-sized companies.
And in Michigan, the Attorney General’s office is cracking down on misclassification. In 2019, a task force was established to identify and punish employers that fail to pay workers the wages and benefits they are entitled to.
To avoid legal risks, the best option is for you to work with an experienced employment and business lawyer. In all likelihood, you’ll need to consider more than one test. Zana Tomich of Dalton & Tomich, PLC will help you correctly classify new hires from the beginning.