Employers can hire two types of workers – employees and independent contractors – and there are serious consequences to misclassifying workers as independent contractors when they are actually employees.
Generally, you must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to employees. You do not generally have to withhold or pay any taxes on payments to independent contractors.
Employees also enjoy many workplace protections to which independent contractors generally are not entitled, including coverage under wage and hour laws (such as minimum wage and overtime), workers’ compensation coverage, and protection against discrimination, harassment, and retaliation.
How can I determine if I should classify a worker as an employee or an independent contractor?
Generally speaking, whether a worker should be classified as an employee or an independent contractor depends on the employer’s degree of control over the worker.
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? This includes, for example, the extent to which the worker (1) pays his own business expenses; (2) invests in the facilities or tools used in performing services; (3) makes his or her services available to the relevant market; and (4) can realize a profit or incur a loss.
- Type of Relationship: Are there written contracts or employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue? Is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. The more control the employer exercises over the worker, the more likely he or she is to be an employee.
How are employees and independent contractors paid?
Independent contractors should generally be paid per project, while employees may be paid with a salary or by the hour. An employer must prepare and submit to the IRS a W-2 form for each employee indicating the employee’s wages and deductions for the tax year. With independent contractors, an employer must prepare a 1099 form and leave it up to the independent contractor to self-report taxes to the IRS. While employees typically receive benefits such as paid vacation, sick and medical leave, and 401k, independent contractors do not.
Which employees must be paid overtime?
The federal overtime provisions are contained in the Fair Labor Standards Act (FLSA). Unless exempt from overtime, employees covered by the FLSA must receive overtime pay at time and one-half their regular rate of pay for hours worked in excess of 40. These employees by default are “non-exempt employees.”
What types of employees qualify as exempt from the overtime requirements?
There are many different exemption categories, but the most common ones apply to employees who earn a salary of at least $455 per week ($23,660 per year) and whose primary duty meets the test for the exemption. The salary requirement is “per week,” and employees whose salary at any given week falls below the minimum requirement, are not exempt. The most common exemptions are:
- Executive exemption (e.g., CEO, manager of a sizable department who makes personnel decisions, etc.)
- Administrative exemption (e.g., HR manager, controller, etc.)
- Professional exemption (e.g., accountant, lawyer, etc.)
Other common exemptions for overtime subject to different tests are:
- Computer employee exemption (e.g., computer system analysts, programmers, software engineers, etc.)
- Outside sales exemption (e.g., traveling salesmen)
- Highly compensated employee exemption for those who earn $100,000 or more
What are the repercussions if an employer misclassifies an employee?
If you misclassify an employee as an independent contractor, you may be held liable for certain types of employment taxes and penalties for that worker. Additionally, if an employee is misclassified as an independent contractor or an exempt employee, he/she may bring a civil lawsuit against you claiming, for example, that he/she is owed overtime or minimum wage. If a number of employees are misclassified in a similar way, you may be facing a costly class action.