Worker classification is tricky business. When you hire a variety of people, some part-time or temporary, it can be confusing to determine how to properly classify and pay them. What makes someone an employee?
Through the following examples, we’ll outline the differences between employees and independent contractors, and help call out some of the important factors in correctly classifying them.
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Scenario 1: Bridal Jewelers needs a bookkeeper for three hours every Tuesday to process payroll. The work is very specific and must be performed at the store using the business computer. The rate is $25 per hour. Is the individual an employee or an independent contractor?
Scenario 2: Jiffy Used Cars hasn't had its bank statements reconciled for a year. Not all checks have been recorded, so the individual hired to perform the work has to reconcile the bank statements using the company's bookkeeping software. The work needs to be performed one time and will require two or three days of work. The rate is $25 per hour. Is the individual an employee or an independent contractor?
Scenario 3: Majestic Engineering has just decided to institute a new policy for handling expense reimbursements to employees. The company wants to hire a technical writer to prepare the new section of the Employee Handbook. The writer has to meet with the company's representatives in order to gain an understanding of the new policy, and he will be paid a flat fee. Is the individual an employee or an independent contractor?
Learn how to correctly classify all seven employee types.
Employee Vs. Independent Contractor
Why Make Someone An Employee?
The inclination of some employers is to hire and pay all of these individuals as independent contractors.
The part-time worker (Scenario 1) is only earning $75 every two weeks. The temporary worker (Scenario 2) will earn a one-time amount between $400 and $600.
In our article Contractor or Vendor: How Do Businesses Classify for Correct Payment?, we outlined how to determine whether a worker should be considered an independent contractor. And pages 7-9 of this IRS Publication, Employer's Supplemental Tax Guide, provide a more detailed analysis for determining independent contractor status.
Much of the distinction between an employee and an independent contractor has to do with control. For instance, in Scenario 3, Majestic Engineering has no control over how, when, or where the contractor performs the work. Control is one of the key components used to determine independent contractor status.
Additionally, in the arrangement in Scenario 3, there is the possibility that the worker will make a profit or experience a loss, especially if the work takes too long to complete. The individual will provide their own materials.
But what about Scenarios 1 and 2?
In Scenario 1, Bridal Jewelers controls where the work is performed, when it must be done, what work is performed, and how it is to be done.
Control is one of the key components used to determine independent contractor status.
Given the level of control, the individual looks more like an employee, and less like an independent contractor. Every two weeks, they receive a net paycheck of $69.26 ($75 wages minus $5.74 in FICA taxes.)
In Scenario 2, Jiffy Used Cars still has control over what work is to be performed, how it should be done, where it should be done, and when it should be done — even though the work is only temporary. Given the level of control, this individual, too, looks more like an employee, and less like an independent contractor.
Although the individual may only be working for two or three days, the employer probably needs to go through the process of hiring the employee, having the employee complete all necessary paperwork, withholding taxes from the employee's pay, and reporting all wages and withheld taxes on Form W-2.
Potential for Profit or Loss
When identifying whether or not a worker is an independent contractor, one factor is whether or not the arrangement provides the individual with the potential for profit or loss.
A freelance bookkeeper, assuming that the work would take up to three days, could quote a fixed fee of $600, based on their projected rate of $25 per hour. They could arrange to collate all of the bank statements, reorder all of the canceled checks, and locate all of the missing checks working from their home office.
The only task they would perform in the company's office would be to complete the reconciliations using the company's bookkeeping software. If the work took more than three days to complete, the bookkeeper would lose money on the project.
Under such arrangement, the worker is paid for the final product, not the time spent completing the task. As such, the amount of time spent on a job becomes more relevant to whether the worker will earn a profit or experience a loss. Even part-time and temporary workers must be paid as employees if the employer has behavioral and economic control over how the work is performed.
Making the correct distinction is critical. You risk runing into numerous consequences if you misclassify your employees or contractors, such as penalties and fines. By carefully endeavoring to classify correctly, and consulting with employment counsel when necessary, you can set yourself and your business up for success.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, legal or tax advice. If you have any legal or tax questions regarding this content or related issues, then you should consult with your professional legal or tax advisor.