Worker classification, in essence, is a form of legal determination that involves establishing which category a worker falls in. Two factors that impact worker classification include the type of work a worker does and how they do it. Organizations can classify workers as either:
- Employees (full-time, part-time, or temporary)
- Independent contractors (gig workers or freelancers)
A compliant worker classification audit helps organizations arrive at how different workers are paid, which tax forms will be associated with their wages, and which benefits they may have access to. By following worker classification best practices, organizations can keep penalties associated with misclassification and instances of noncompliance at bay.
Three Main Considerations that Determine Worker Classification
The main determinator of classifying a worker either as an employee or an independent contractor is the business relationship a worker may have with the organization. But how do organizations arrive at this determination?
In short, they consider the amount of independence and the degree of control a specific worker has in terms of providing their services to the business. Those who enjoy more control over how and when they work are more often considered independent contractors. These workers have the liberty to set their own hours, work remotely, or use their own equipment. Though states have their own thresholds on who is considered an employee or independent contractor, the IRS uses the Common Law Test to determine the amount of a worker’s independence and control based on three categories:
Financial Considerations
These considerations relate to how much control a business has over the financial aspects of a worker’s job, such as the degree of investment, payment methods, and non-reimbursable expenses, and whether a worker offers their services to other organizations.
Relationship Considerations
The IRS does not require employers to craft a contract stating their relationship with their independent contractors. Instead, workers are classified as employees or independent contractors based on the way organizations and workers work together. Some key considerations that determine an employer-employee relationship include:
- The length of the relationship
- Whether benefits (such as insurance pension, paid time off, or retirement plans) are offered
- The permanency of the position
- Whether a worker’s services are a part of important business activities
Behavioral Considerations
Behavioral considerations cover the type and volume of instructions a worker may require for them to do the work. Other factors that an employer considers include when and where the worker will perform their job, who chooses the order and sequence in which the work will be delivered, and what types of equipment will be used.
Aside from the IRS, other federal agencies (like the DOL or Department of Labor), and local and state jurisdictions also outline certain rules to classify workers as employees or independent contractors.
What Happens When Workers Are Misclassified?
From the tax vantage point, those who are classified as employees receive their wages through the business’s payroll. The business has the responsibility to withhold an employee’s federal, state, and local taxes from their pay, as well as contribute a portion of the employee’s FICA taxes. This information is then used by the business to fill out an annual W-2 form for each employee.
When it comes to independent contractors, however, the employers don’t withhold any taxes from their compensation. These workers are responsible for paying their own taxes, including their local, state, and federal self-employment taxes. Employers must, however, file a 1099-NEC form for any workers they have paid more than $600 in a year.
The process of worker classification can come with several misclassification cracks. Since employers don’t have to provide benefits or pay employment taxes when it comes to independent contractors, many choose to hire independent contractors. However, misclassifying a worker – even when done unintentionally – can come at a heavy cost. In the event of misclassification, an employer can be charged with significant penalties and may be required to pay unpaid compensation coverage, employee benefits, and employee taxes.
To avoid any instances of misclassification, organizations should practice the following:
Best Practices for Worker Classification
To classify your workers accurately, it is critical to take several things into account. These include:
Get the Documentation Together
Use different employment applications when hiring independent workers and employees. While hiring employees is a practice your business may be fluent in, it is critical to pay special attention when hiring independent contractors. Make sure you have all the documents in place that clearly establish a worker as an independent contractor. Include documents such as documentation of payment information, Independent Contractor Agreement, and W9.
Talk to a Legal Professional
Worker classification can be a tricky process. Though you could outsource a classification audit to an attorney, consider the advantages of utilizing VirgilHR’s software. Our compliance solution can assist with white-collar audits and accurately determine the appropriate worker category, ensuring your company remains compliant at the federal, state, and local levels. The cost of misclassification can be high, but using the right tools can keep potential misclassification hiccups at bay.
Consider the Specific Needs of Your Business
Before you begin your onboarding process, it is critical to deep-dive into what type of needs your business has. Understand how exactly these needs will be fulfilled and how the roles of employees and independent contractors will enable you to fulfill them. Getting clarity on your business needs ensures you lay out a smooth worker classification journey from the very beginning.
Ensure Contracts Match with Job Duties
Worker classification doesn’t just end once the onboarding process is complete. Employers must ensure a worker’s employment contract aligns with their work duties. For instance, if you classify a worker as an employee but their job duties reflect the work of an independent contractor, and vice versa, the IRS, and other regulatory bodies will consider the nature of their work.
Consider Every Part of Employer-Employee Relationship
Before you kickstart the classification process, make sure you determine the amount of control you have over the type of work a worker may be assigned and how much money you’d pay them. Make sure you also take into account the duration of their role, their benefits, and contracts to steer clear of misclassification.
The Next Steps
The price of worker misclassification is high. While following best practices of worker classification is critical, employers need more than just an Excel sheet to determine which category their workers fall in. VirgilHR’s worker classification tool enables employers to accurately classify workers during the onboarding process itself. Contact us today to avoid the cost of noncompliance and worker misclassification.
