Worker Classification: Why it Matters

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At some point, many successful freelancers and entrepreneurs face the same problem: their business is growing fast, they’re taking on more and more work, and the workload is getting to be too much for one person to handle. They start thinking about hiring some help. It seems like a simple solution to a simple problem–too much work? Pay people to help. In the U.S., it can be much more complex than it seems, and if you’re not careful, you could wind up running into a number of legal issues. So how do you make sure you’re on the right side of the law when you bring someone on to help support your business? 

Independent Contractors v. Employees: What’s the Difference? 

In the U.S., independent contractors and employees are treated differently under the law. Independent contractors (also called “1099 independent contractors” or “1099s,” in reference to the tax form used for these types of workers) are generally considered project-based workers engaged by the company or individual to work on a specific task or set of tasks, usually with a defined end date. The company or individual who engages the worker doesn’t control the manner and means by which the worker performs the work (meaning, they don’t tell them how, when, where, etc. to do the work); they only control the result of the work. Employees (also called “W-2 employees” or “W2s” in reference to the tax form issued to these types of workers by employers), on the other hand, are managed much more closely and subject to any lawful direction about how to perform the work by their employer. 

Whether a worker is considered an independent contractor or an employee under the law is a factual determination based on the circumstances of the work and the relationship between the company/individual and the worker. It doesn’t matter what the contract between the parties says; if the worker is treated like an independent contractor, they will be considered an independent contractor and if the worker is treated like an employee, they will be considered an employee.

For example, a company might engage a graphic designer to design a new logo for the company. If the company has the designer attend company meetings, has a supervisor reviewing the work of the designer along the way, provides company tools and equipment to the designer to work on the company logo, and disciplines the designer for failing to follow the company’s instructions, the designer would likely be considered an employee under the law. However, if the company didn’t take any of those actions and simply told the designer to deliver a draft of the new company logo to a representative of the company in two weeks, the designer might be considered an independent contractor under the law. 

What Happens if you Misclassify a Worker?

The U.S. federal government (through agencies like the Department of Labor and Internal Revenue Service) and each U.S. state monitor worker classification, and they have tests to determine whether a worker is an independent contractor or an employee. If you hire someone as an employee and they really should be an independent contractor, you’re generally giving the worker more than they’re entitled to under the law, so it’s unlikely that you would face any penalties for this type of misclassification. However, if you engage a worker as an independent contractor and they really should be an employee, you might have some big problems. The worker could bring legal claims against you to receive the things you would have given them as an employee–things like back pay if you paid them less than minimum wage, health benefits coverage, overtime pay, and workers’ compensation coverage. If you misclassify more thans one employee, they could bring a class action lawsuit against your company to assert these claims. State and federal regulatory agencies could bring actions against your company, as well, and they can levy a variety of penalties, including a full shutdown of your business.

How Can You Make Sure You Classify Your Workers Correctly?

Definitely talk to a qualified lawyer if you’re going to start hiring people. Even one or two conversations is money well spent so you don’t end up in legal trouble later on. The U.S. Department of Labor has various fact sheets and other informational guides on worker classification that walk you through how to determine whether a worker is an employee or an independent contractor. Many states also have online guides on the same topic. The California Department of Industrial Relations, for example, has a question and answer guide on worker classification and Assembly Bill (AB) 5 (check out our Instagram post for a quick breakdown of A.B.5!).

How Does This Impact Your Business?

Aside from the penalties described above, hiring employees can have other effects on your business. Depending on the number of employees you hire, you might need to set up payroll, offer health benefits, set up employment documents, verify employment eligibility, and establish new employment policies and practices (like a vacation time policy, an anti-harassment policy, and time tracking processes). There are a number of PEOs (professional employer organizations) that can handle these things for you (for a fee). There are also outsourced HR (human resources) companies that provide a little less support than PEOs but can still be quite helpful. Many early-stage companies engage PEOs to start before they hire internal human resources professionals to manage the workforce. 

Legal obligations vary by state and depend on the number of employees you hire, so this is another area where it’s helpful to talk to a qualified lawyer. There are also a lot of online resources to get you started. For example, the Society for Human Resource Management (SHRM) is a well-respected organization with useful information online (though, some of the information is behind a paywall).

Engaging independent contractors is a little bit easier in that you generally don’t need to set up payroll, provide employment health benefits, or put in place employment policies (you don’t need a vacation time policy, for example). You should still have the worker sign an independent contractor agreement that clearly sets out the duration of the engagement, termination rights, the type of work they will be doing, the payment rate for that work, who will own the rights to the work product (typically, the company owns the rights to the work product), confidentiality obligations, and any other considerations. You can find two template Services Agreements in the Contracts section of our Path platform (these are meant for you to use when you are engaged as an independent contractor by a client, but they can be adapted if you want to engage an independent contractor to work for you).

In terms of tax considerations, whenever you pay someone over a certain dollar amount to perform work for you (assuming the payment is not otherwise exempt from tax and reporting requirements), you need to report those payments to the U.S. Internal Revenue Service (IRS) and state tax agency, and the recipient needs to report those payments when they file their tax returns. Payments made to independent contractors over a certain dollar amount need to be reported to the IRS and applicable state tax agency at the end of the year and tax forms must be provided to the worker as well (usually using Form 1099). Payments to employees are more complex in that the employer needs to withhold the taxes the employee will pay from the payment (usually done by deducting the withholdings from each payroll payment to the employee), make payments to the state and federal government agencies to cover employer taxes and benefits, and report all of these payments to the IRS and state tax agencies. Employers also need to issue Form W-2 Wage and Tax Statement to employees after the end of the calendar year so that employees can report their income on their tax returns. PEOs and outsourced HR services typically handle these tax and reporting obligations for employers. The IRS has a lot of information on taxes and reporting obligations as well. 

What Should You Do If You are Misclassified?

Classifying your workers correctly is one thing, but what about if you take a job and suspect you may be misclassified? Again, you should talk to a qualified lawyer to understand whether you are misclassified and what impact it might have on your earnings, benefits, and any other rights. You can also reach out to state and federal government regulatory agencies for help. Unfortunately, worker misclassification is fairly common, especially when it comes to short term jobs and freelancing. It’s less expensive and easier to hire an independent contractor than an employee, so employers often try to engage workers at independent contractors. Make sure you understand your rights!

Check our Fast Track Business Guide on our Path platform for more information on hiring workers for your business and protecting yourself!

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