Employee or Contractor? Avoiding Classification Pitfalls

She told me point blank, "I'm going to classify them as a contractor instead of an employee because I don't want to pay taxes and I don't want to have to pay for benefits." Wow. That is not why you classify somebody as a contractor. Thankfully, most people aren't trying to blatantly break the rules when it comes to classifying someone as an employee versus a contractor. But in today's episode, I'm going to break down for you some very simple ways to understand complex rules related to whether or not someone working for you should be classified as an employee or as an independent contractor. I'm also going to share what some of the possible penalties are if you don't do this properly, and what are some of the ways that companies get caught. This video is made for entrepreneurs and small business owners to help you to maintain compliance at your organization in a very simple way. So in the next 10, 15 minutes, I'm going to break this down in a way that my fellow entrepreneurs can understand. And that you can make the decision with your next hire whether that person should be an employee or a contractor and set both you and your worker up for success. Thanks for joining me on Culture and Compliance. My name is Matt Vady. I've spent the last 20 years helping advise organizations on their HR best practices, everything from automation of workflows to compliance to helping them to roll out different programs. And I've served companies from the Fortune 100 to 2 employees and everything in between. I'm excited to help you today on your journey to maintain HR compliance at your organization. So let's go ahead and dive right into a very hot topic. Now, this is one that any time a new client comes to us at Guru, this is something we're looking at very closely is do they have contractors? Should those people be employees? Can we help them to look at the classification and see if it's proper? So it's something I'm very well versed in. Let's look at how the IRS thinks about this. And there are multiple governing bodies that have an vested interest in whether or not somebody is an employee or a contractor, which I'm going to talk about here in just a moment. But The first big 3 things that the IRS specifically looks at are behavioral control, financial control, and relationship type. So what does that mean? Behavioral control often refers to the degree of instruction and direction you give. So are you training and educating this person on how to do what they do? If they're an independent contractor, they generally have a little bit more freedom in how the work gets done and how they decide to complete it than an employee. I often say like an easy bar to use here with this is, are they an expert? If somebody's not an expert when they come to your organization, let's say you're hiring them to bring them in and train them how to do things the way you do them, and they don't come with predefined expertise, then it's likely that they're going to be an employee and not a contractor. Let's say you hire a graphic designer to help you design your new website, and it's gonna be a one-time project, and maybe you're gonna need them here and there going forward in the future. That person's gonna more likely lean towards being a contractor because they are an expert. It's project-based, and it's not something where you are going to control their behavior and how that work gets done because you don't have the expertise yourself. So behavioral control is number one. Next is financial control. So employees, again, usually receive a regular wage, benefits, they have their expenses reimbursed. On the other hand, contractors are typically paid per project, cover their own expenses, and have the opportunity for a profit and loss. And I'm going to talk here in just a couple minutes about, there is a wonderful regulation that's actually, I hate to call it a wonderful regulation, but the Department of Labor actually reinstated their longstanding independent contractor test, which helps us to break this down. It's called the Economic Reality Test. And the Economic Reality Test is perfect for this financial control situation because it tells us based on the economic reality of the contractor who has the financial control. So they look at 6 key factors. They look at whether or not the worker has an opportunity for a profit or a loss, the investments made by the worker and the employer, the degree of permanence of the work relationship, the nature and degree of control an employer has over the person's work, whether the person does— is essential to the employer's business and the worker's skill and initiative. So let's break this down a little bit. That second to last bullet is critical. Is the work they do essential to the employer's business? And so what this means, is it essential to the delivery of your product or service? So let's go back to that marketing example. So if I hire a graphic designer and I offer graphic design services, and this person is consistently creating graphic design work for me, and I am their number one source of income, then that's checked two boxes here on the economic reality test. They're dependent on me for their primary source of income, and they're providing a service, quote unquote, that is part of my service. So they're critical to the delivery of my service. So that person would likely become an employee in that situation. Whereas in the first example where I hired, let's say I'm Guru and I'm an HR outsourcing and software company and I hire them to do some graphic design work for my website, etc. Even if I keep them working every single month for years, that doesn't, that's not critical to our business operation that, that we're not delivering that product to our clients. And it's something where they're bringing a level of expertise. I'm not training them how to do graphic design. Even if I'm paying them by the hour, it doesn't matter in that circumstance. Circumstance, as long as some of these other boxes are checked, which we're going to talk about in just a moment. We've got behavioral control, financial control, and then the next big one is relationship type. So employees often have an ongoing relationship with things like benefits, health insurance, paid leave. This is a big one I see, a huge red flag is people want to start offering more benefits to their contractors. Well, that's great. You know, we see it with speech therapy companies as an example. We have a lot of speech therapy clients and and other healthcare-related professionals like that where they hire people as 1099 workers, but then they realize that people don't necessarily want to be a 1099 in that industry. They want benefits, they want time off, they want the consistency of the relationship to be more like that of an employee. And so they start offering those things and try to keep them as 1099 contract workers. Well, you can't do that. Once you start changing that relationship to be more of employer-employee, Well, you're defining the relationship with your action. So contractors, again, usually have a project-based relationship with no benefits. A couple of other small things that the IRS is going to look at is the level of investment. Employees generally have less personal investment in tools and equipment, whereas contractors often invest in their own resources. I think about the example where we have conferences and events and I bring a photographer to the conference and event. Even though I'm defining where and what time the work needs to be done, again, they're an expert bringing their own equipment and it's a project. And so they're going to be a contractor. I'm going to pay them as a contractor. I don't need to hire them as an employee. And now the other thing to consider is their services availability to the market. If the person offers their services to the market, most contractors will work with multiple clients while employees usually work exclusively for you. So that's going back to that economic reality test as well. So those are some key things to consider. I often think about it like, or think about it like you're a general contractor and then you've got a project where you're building a building. You've won the bid to build a school and now you need to hire all of your subcontractors who you're going to pay them an amount of money to do the work to finish, you know, whether it's the HVAC, the plumbing, the electrical, but they're going to come, they're going to bring their own expertise. They're going to bring their own tools, even though you're going to dictate the schedule of when things need to be done, when and how they can be on the job site. Ultimately, how the work gets done inside of their project is up to them. And so when we're thinking about contractors, we can think about them very much the same way in that they're going to dictate how the work gets done. I'm gonna tell them what the outcome should be. All right, so who actually enforces this? And this is a big thing that people are like, eh, you know, I'm never gonna get audited, so I'm not worried about this. The chances are 1%, 2%, 3% I get audited. Well, I'll tell you right now, the number one reason why people get busted, quote unquote, as it relates to having a contractor that should have been an employee is the person, the worker themselves realizes that they are misclassified. And so they are going to try to get back at you because they've been having to pay self-employment taxes instead of you paying the employer portion of their taxes. And this often happens at tax filing season when they realize that, hey, you haven't been paying your portion of the taxes. Now I'm having to pay self-employment tax, which means I pay both the employer and employee portion, uh, of the FICA taxes. And then so also if they go to file for unemployment, I heard about this once, uh, for someone who worked for us, she said she worked for an ice cream stand, uh, for 2 years, you know, made $10 an hour or whatever it was. And then after she got laid off, she went to go file for unemployment and then find out she was a contractor, non-employee. So that's another key thing. If you want to know a couple of the small ways you can tell whether or not somebody should be a contractor, do they know they're a contractor? Right? So did we properly define that relationship on the front end and put it in writing and educate them on what that means? If you have to educate somebody on what it means to be a contractor, that's probably a red flag in and of itself. So who is regulating this? The IRS, the Department of Labor, state agencies, workers' comp boards, a bunch of different folks, and they're all using a slightly different variation of what I just described. But if you follow what I just laid out there for you as it relates to relationship, financial, behavioral control, and some of those other more common sense things as it relates to where is the dependency in the financial relationship— is this their primary source of income? Are they dependent on me as an employer to provide for themselves and their families? That smells a lot more like an employee than contractor, right? So make sure that you're going through the proper steps to classify this on the front end so that you don't have to face— because the reality is not only could you possibly owe back taxes on those wages, you're also going to owe penalties and interest, uh, wages filed, and also potentially have some punitive action taken against you as well, uh, for the burden that this puts on a worker who is misclassified. So always make sure that you take this very seriously and And in all cases where you're completely unsure and it's getting too blurry and it's right down the middle, classify them as an employee. You just completely remove the burden of the, you know, the concern, the worry, the potential liability that could be hanging out for you down the road just to pay, you know, the extra 15%, whatever it is, month over month in taxes and overhead for that employee and to play it safe and to put you both in a position to succeed. And then you can also have somebody who's more invested in the success of your organization going forward. As always, this is not legal advice. And if you do hit a point where you're unsure completely, you should consult an attorney in your state who knows your laws and regulations as it relates to employee versus contractor. Thank you so much for joining me today. My name is Matt Vadie. I appreciate you coming by. 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