Independent Contractor or W-2 Employee?

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Independent-contractor-or-W2-employeeMany employers are drawn to the appeal of hiring independent contractors rather than traditional W-2 employees. From a business owner’s perspective, at first glance, independent contractors seem like a great idea! After all, there are many advantages to using independent contractors.

Independent contractors typically cost less, because employers are not required to make contributions to Social Security, Medicare, unemployment compensation insurance or workers’ compensation insurance on their behalf. These employee payroll expenses can increase an employer’s payroll cost by at least 20-30 percent.

Employers who use independent contractors often enjoy greater staffing flexibility and often greater efficiency – especially if their business experiences fluctuating workloads. They can hire an independent contractor, and their specialized expertise, for just the duration of the project and know that the worker (and the related expense and liability) will be gone when the job is finished.

Using independent contractors offers employers some protection from exposure to a variety of legal claims that can be brought by employees for violations of federal and/or state employment laws. Independent contractors are not entitled to the same protection against discrimination as employees. Since independent contractors are self-employed businesspeople, they are not protected by the Fair Labor Standards Act, which ensures that employees receive at least minimum wage and payment for overtime, among other things.

Working with independent contractors sounds pretty good, right? Not so fast. There are some significant disadvantages to using independent contractors, such as less control over their schedules, higher turnover and potential liability for any accidents or injuries an independent contractor suffers on the job. Further, while independent contractors seem to offer greater flexibility, an employer’s right to terminate their services depends upon whether a written agreement exists between the contractor and the employer. Failing to live up to a binding contract can result in a breach-of-contract claim being brought against an employer.

Next, and possibly most important, an employer can’t simply decide to classify someone as an independent contractor because it is more convenient, efficient or less expensive – or even because both the employer and individual would like it that way. There are very strict criteria that an employer must ensure are met before a worker can be classified as an independent contractor. These criteria are set by both the Fair Labor Standards Act (FLSA) and the IRS.

The IRS considers many common law factors in its determination of whether an individual is an independent contractor or employee. These factors can be broken down into three basic categories:

Behavioral: Does the company control (or have the right to control) what the worker does and how he or she does their job?
Financial: Are the business aspects of the worker’s job controlled by the employer? Are expenses reimbursed? How is the worker paid? Does the employer or individual provide the tools required to do the job?
Type of Relationship: Does a written agreement exist? Are benefits (such as a pension plan, vacation or insurance) offered? Is the work performed a key aspect of the business?
The Fair Labor Standards Act is a federal law which requires employers to pay employees minimum wage and overtime pay, provide workers’ compensation insurance and provide family and medical leave in some instances. Independent contractors do not receive these benefits. As such, the Department of Labor has established standards to ensure that employees are not improperly classified as independent contractors and wrongfully denied the protection of the FLSA. The DOL essentially considers six factors when making a determination if a worker is an employee or independent contractor:

Is the work an integral part of the employer’s business?
Does the worker’s managerial skill affect his or her opportunity for profit and loss?
Relative investments of the worker and the employer
The worker’s skill and initiative
The permanency of the relationship between the worker and the employer
Employer control of the employment relationship.
Both the IRS and DOL are clear that there is no single exclusive factor for making the determination, and even indicate that their lists are not exclusive. In other words, it is incumbent upon an employer to thoughtfully analyze the employment relationship considering all the factors mentioned and any other relevant facts specific to the situation.

Misclassifying an employee carries heavy penalties. An employer who incorrectly classifies an individual as an independent contractor can be subject to back taxes and penalties, which can equate to as much as 41.5% of the independent contractor’s wages. And these penalties can go back for three years! Further, an employer could also be subject to back wages, overtime and penalties for wages the individual should have received as an employee.

Obviously, employee classification is not something a business owner wants to get wrong! Proper employee classification is just one area of Human Resources compliance that a Professional Employer Organization (PEO) can help employers navigate.

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