Experts

Employee vs. independent contractor – how to choose?

Some may think that hiring contract workers rather than employees is a way to save money, however, this option comes with a big risk. In this video, Nayo Carter-Gray explains the different types of workers and the consequences of misclassifying them.

Nayo Carter-Gray
Nayo Carter-Gray

“Making Accounting a Little Less Taxing”® is Nayo Carter-Gray’s goal as owner and founder of 1st Step Accounting, a virtual accounting practice located in Baltimore, MD. Nayo is an Enrolled Agent, a Gusto Ambassador, and a QuickBooks Online Advanced Certified Pro-Advisor. She was also named one of the Top 50 Women in Accounting and Forbes Top 100 Tax Twitter accounts to follow two years in a row.

What does worker classification actually mean?

Worker classification refers to the status of the worker in the eyes of the government. It matters because employees are entitled to wages and benefits and sometimes have more protections than contractors. A 2000 study commissioned by the U.S. Department of Labor stated that misclassifying just one percent of workers as independent contractors resulted in a 198 million dollar hit to unemployment insurance funds paid to the government by employers annually.

Penalties for this misclassification can be high, which is why it’s in your best financial interest as a business owner to categorize your workers properly. 

This is what you should consider:

  • The law (and not the business owner) dictates who’s an independent contractor and who’s an employee. No matter what your arrangement is, employment classification is ultimately based on the nature of the work that they do and how they do it. 
  • Employees and independent contractors are treated differently for tax purposes. Companies are expected to pay certain taxes on behalf of their employees. This includes employment tax for both the state and federal governments, Social Security and Medicare taxes, and premiums for workers compensation and disability. Contractors are responsible for their own taxes.
  • Independent contractors can come with more liability. For example, in many cases employees are the only ones who can receive workers compensation if they get hurt on the job. However, independent contractors may be able to sue you.
  • Employees are subject to different work expectations. Some industries like health care and education are a jungle gym of rules and regulations that can have a real impact on your employees’ lives. If you are in a highly specialized or professional industry you may need to document additional rules surrounding the work your employees do.

“Penalties for this misclassification can be high, which is why it’s in your best financial interest as a business owner to categorize your workers properly.”

Employee vs. independent contractor – the main characteristics

The worker classification is monitored and regulated by three agencies: The Department of Labor, The Internal Revenue Service (IRS) and the National Labor Relations Board.
Each of these agencies has a set of tests to determine the correct classification, but they all look at three main categories in order to determine who controls the work and if the worker is truly independent:

1. Behaviour

Does the company control or have the right to control what the worker does and how the worker does it?

2. Financial

How is the worker paid? Are expenses reimbursed? Who’s providing the tools and supplies?

3. Relationship

Are there any written contracts or employment benefits like pension plans, insurance, vacation pay, etc.?

“The worker classification is monitored and regulated by three agencies: The Department of Labor, The Internal Revenue Service (IRS) and the National Labor Relations Board.”

How to choose? Learn your ABCs!

In order to determine whether an individual is an employee or an independent contractor, and fully understand who’s covered by certain workplace laws, more than 20 states have adopted the ABC test. 

This test presumes that the person performing the work is an employee unless the employer can establish “yes” answers to all these three factors: 

A – The work is done without the direction and control of the employer. 

Ask yourself: are you standing over the employee’s shoulder as he or she is working?

B – The work is performed outside the usual course of the employer’s business.

Think outside of normal business hours or in a completely different location.

C – The work is done by someone who has their own independent business doing that kind of work. 

For example, an accounting firm that handles the bookkeeping and accounting for your business and several others.

“In order to determine whether an individual is an employee or an independent contractor, and fully understand who’s covered by certain workplace laws, more than 20 states have adopted the ABC test.”

Worker misclassification, whether intentional or unintentional, can come with serious legal and financial consequences. Knowing how to properly classify an employee versus an independent contractor will help you avoid these costly mistakes. In order to do so, all you have to do is remember your ABCs.

*The purpose of this page is solely to provide information and should not be considered as financial advice
**Melio does not provide legal, tax or accounting advice; you should consult a professional advisor before making any financial decisions.