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Understanding Employee Status

“Always treat your employees exactly as you want them to treat your best customers.”

—STEPHEN R COVEY

Once you’ve decided to hire, you’ll need at least a basic understanding of the many laws affecting how you, as an employer, treat the people who work for you. In the next few chapters, you’ll learn about the basics of employment and labor law, payroll taxes, and ways to manage your payroll. But first you need to be aware of how the law deals with the day-to-day status and treatment of your employees.

Determining Your Worker’s Status

You’re ready to hire someone, and they’re going to be your employee, right? Well, yes, but how do you classify that worker? You can hire them as an employee or independent contractor, for instance—but laws regulate your choice. As an employee, they might be covered by overtime and minimum wage laws or they might not. You might give them a contract or you might hire them in such a way that you can fire them whenever you need or want.

All of this matters, so you need to know the basics of what determines a worker’s legal employment status. An employee’s status in the eyes of the government helps determine how much control over a worker you have, how much you have to pay them and for what, what rights they have, how much tax you have to pay, and more.

When determining your employee’s status—in the eyes of the law, the major categories are:

Employee versus independent contractor

Exempt versus non-exempt employee

At-will versus contract employee

Full-time versus part-time employee

Employee or Independent Contractor

Your business is growing—or you want it to grow—so you’ve got to get help. One of the first things you’ll have to figure out is whether the person you hire will be an:

Employee or

Independent contractor

Few areas of tax law are murkier than—or can get a business in as much trouble as—the laws relating to classifying workers as employees versus independent contractors. The IRS and labor agencies aggressively pursue companies that intentionally—or unintentionally—classify someone as an independent contractor yet treat them as an employee. The IRS has gone after huge corporations as well as small businesses, and once they find a violation, they’re likely to go back through many past years of your taxes. So be careful.

Many companies would prefer to classify workers as independent contractors rather than employees. Here’s why:

Employees are subject to payroll taxes and come under labor laws; independent contractors do not.

And some workers would rather be classified as independent contractors. Here’s why:

Independent contractors do not have payroll taxes deducted from each paycheck, and many of their business expenses are tax deductible.

While classifying workers as independent contractors may benefit you financially, even if both you and the worker agree to such classification, employment laws limit that choice. So it’s important to understand the basic outline of what makes an employee an employee and under which circumstances you can classify them as an independent contractor.

Criteria for employee vs. independent contractor

In a nutshell, the question of who “controls” the worker determines that worker’s status. The more control you have over the worker—such as when, where and how they work—the more likely the worker is your employee. The nature of the work they do for you does not alone determine their status.

The IRS and other government agencies prefer employers to classify their workers as employees. Why? Federal, state and city governments want to make certain that anyone doing the work of an employee gets treated as such. Employees are entitled to many legal protections, including rules regarding overtime and unemployment. And the government wants to protect as many workers as possible.

HIRE Learning

Form 1099-MISC for Independent Contractors

For each and every independent contractor you pay $600 or more in any calendar year, you must complete and file a Form 1099-MISC, which reports miscellaneous income to the IRS. It is due no later than January 31 of the year following the one in which the independent contractor worked for you. You must also give the independent contractor a copy of the 1099-MISC form by the same due date.

Also, because employers are legally responsible to withhold tax money from employees’ salaries, government agencies can depend on receiving full, timely tax payments. Independent contractors, on the other hand, invoice employers and receive paychecks from which no deductions have been withheld. They manage their own tax payments and can be less reliable about submitting their taxes.

If you misclassify a worker, penalties will likely include fines and back taxes for:

Employee and employer’s share of Social Security and Medicare taxes

Federal and State income taxes that should have been withheld

Unemployment taxes

The IRS’ unclear guidelines make classifying independent contractors even more difficult. However, the main issue the IRS uses to determine employee status is who “controls” the worker. The IRS once had a list of specific rules governing independent contractor status, but, responding to the legitimate needs of businesses for greater flexibility in hiring independent contractors, made the rules broader.

But this means there’s more room for misunderstanding. The IRS looks at three areas:

1. Behavioral. Does the worker control how they do the work? The IRS looks at issues such as who determines the employee’s work hours and location, who controls the order or sequence of the employee’s work processes and who owns the tools or equipment the worker uses to get the job done.

2. Type of relationship. How permanent is the relationship? Is the work performed a critical and regular part of the business? Is there a written contract? Is the worker responsible for their own benefits?

3. Financial. Does the worker have a significant investment—i.e., do they own their own tools? Do they make their services available to other and/or work for other businesses?

Because the rules are somewhat fuzzy, the IRS does provide some protections for businesses that make mistakes in treating employees as independent contractors—as long as those mistakes were made in good faith. They’ll investigate whether a business relied on the advice of an attorney or accountant, followed industry practice, and acted consistently.

Here’s More from the IRS:

Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no “magic” or set number of factors that “makes” the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another. The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.

—U.S. Internal Revenue Service

But—and this is important—there’s absolutely no protection for a company that doesn’t file the necessary tax forms for independent contractors. Each year, you must file 1099-MISC forms which report payment to independent contractors over a certain dollar figure. If you fail to file 1099’s and the IRS later challenges you on the classification of your independent contractors, you’re in very hot water.

Review the “Right Classification” Table for the criteria the IRS uses to evaluate control of a worker and therefore how they are classified. Remember, you run into danger by misclassifying an employee as an independent contractor, and never the other way ‘round. The IRS won’t tell you that you should have classified an employee as an independent contractor.

If you have doubts about how to classify a new worker, request an employee status determination from the IRS. To do so, both you and your employee will file IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, available online at www.irs.gov. Until you hear back from the IRS, deduct and submit taxes as you would for an employee. If the IRS decides your employee is a contractor, you can apply for a refund of those taxes. If the IRS decides your employee is in fact an employee, you have saved yourself time, money and a headache.

If you plan on using independent contractors in addition to employees, ask your attorney about how to stay well within the law, and check with your accountant about filing all necessary tax forms.

Employee vs. Independent Contractor: The Right Classification

EMPLOYEES…	INDEPENDENT CONTRACTORS…
Do not run their own business	Are independent business people, especially if they are incorporated
Work in your office and use equipment you provide	Choose their work location and provide their own equipment, tools and materials
Work hours specified by you	Set their own hours
Work per your instructions and may receive training from you	Decide how to perform their services, in what order, and usually receive no training
Are paid for their labor regardless of business performance	Can earn a profit or suffer a loss depending on the quality an quantity of services they provide
Work for you on a continuing basis	Manage multiple clients or customers and work for you on an as-needed project basis
Receive employee benefits	Are responsible for their own benefits
Are usually paid by unit of time	Are usually paid a flat rate or by project
Can quit or be fired at any time	Can be terminated or leave according the terms of their agreement with you

When Temporary Employees Make Sense

If you need extra help for a busy time or for special projects, consider a temporary employee. A worker sent to you by an agency is employed by that agency, and therefore payroll, taxes and insurance are covered by the agency. Expect to pay more than if you hired the workers directly. You’re paying for convenience.

When your peak period slows back to normal, you simply end the employee lease—without damaging morale as you would laying off a permanent employee. Some agencies specialize in fields such as office workers, accountants, graphic designers or tech workers. These trained temporary employees can often start immediately, without the learning curve that can come with a new employee.

What’s right for you? Employees or independent contractors

Let’s say you run a restaurant. You must have waiters and cooks who come in on certain days, at certain times, and perform certain tasks (such as waiting on tables). These workers are employees; there’s almost no way that waiters and cooks could be legally classified as independent contractors.

But in other cases, you can make the decision whether to hire an employee or engage an independent contractor instead.

For instance, let’s also say you need a marketing manager for your restaurant. You want your marketing manager to run your website, send out press releases, and call prospects to hold events at your restaurant. Should you hire a part-time marketing specialist or should you engage a marketing consultant who’ll be an independent contractor?

If you hired an employee, you could have your marketing director come in to the restaurant’s office at times set by you and work on your computer. You’d be certain that they were actually doing the work they were hired to do. If you didn’t like the way they were doing something, you could correct them and show them how you’d like it done. Under the law, that marketing director must be classified as an employee. You’d have the extra expenses of payroll taxes and workspace and equipment. But your marketing director would be part of your team; you’d know whether or not she was doing her job; you could call on her for other tasks.

Instead, if you hired a marketing consultant to perform those tasks, and that consultant worked from her own home, at times she chose, using her own computer—and especially if she had other clients—she would certainly be considered an independent contractor. You wouldn’t have to pay her payroll taxes or provide any company benefits. She’d use her own equipment, and that would save you money too. On the other hand, her hourly fee might be higher—perhaps much higher—than if she were your employee. And—importantly—would you be as confident that she was making as many calls or sending out as many press releases as if she were working under your direction? You have more control over employees than you do independent contractors.

Most businesses use independent contractors at some point—especially to do specific projects or tasks. It’s likely you’ll use an independent contractor to help you with your legal, accounting, technology, or marketing needs. In fact, it’s possible to build quite a “virtual” company using many independent contractors—even legally. But some tasks are not appropriate—or legal—for independent contractors.

It’s likely that independent contractors will have less of a long-term (as well as day-to-day) commitment to you. They may choose to stop working for you. While the money-saving upside seems compelling, not all workers qualify as independent contractors and it’s not always the best choice for you.

Advantages of having employees:

1. You have control. Employees work for you; you can tell them when and where you want them to work and exactly how you want them to get the job done. You can provide on-the-job training so they do the work exactly how you want.

2. You—or a member of your staff—can see and supervise employees. That way, you are certain that they are performing the work in the time you are paying them for. You can see how productive each employee is.

3. Employees often feel a deep sense of attachment to their jobs and employers, feeling part of a team. They are more likely to have a sense of commitment to your company.

4. Employees are likely to want to stay long term, adding consistency and legacy knowledge to your team.

5. If an employee creates anything that might be considered intellectual property—whether it’s your company logo, a design, software, website content, or the like—while working on the job, you automatically own the rights to that work.

6. Employees are often far cheaper on an hourly basis.

Advantages of using independent contractors:

1. None of the payroll taxes and employee-related laws apply to independent contractors, so you won’t pay Social Security and Medicare taxes or workers compensation and unemployment insurance, and you don’t have to worry about overtime pay or complying with other labor laws. Paperwork is easier, too.

2. You do not provide benefits—such as health care—to independent contractors. Once again, this can save you a considerable amount of money.

3. Independent contractors tend to bring special skills and experience to the job you’ve hired them for. They generally don’t need training.

4. Independent contractors provide their own supplies and workspace, lowering your overhead.

5. Most independent contractors are motivated to do a good job, since they want to keep you as a client and get referrals from you. Since you typically hire them on a project basis, you don’t have to worry about finding continuous work for them or laying them off if business is slow.

Independent Contractor Agreements

When working with an independent contractor, clarify your project’s scope, goals and expectations by drawing up an Independent Contractor Agreement. You can use this agreement to demonstrate the intended contractor relationship to the IRS, if needed. Include information such as the services to be rendered, the manner of billing, how much and when you will pay your contractor, location of services, the contractor’s tax identification number, and any other information that will help clarify your expectations and your contractor’s role. If they are creating anything for you—such as designs, software, logos—make sure you have a “work-for-hire” clause so that you retain ownership of their work product. An online search of independent contractor agreements will turn up many samples upon which you can build yours.

Exempt vs. Non-Exempt Employees

Once you’ve classified a worker as an employee, the next most important thing you have to figure out is whether—in the eyes of the law—they are exempt or non-exempt from the Fair Labor and Standards Act (FLSA).

The FLSA of 1938 established a national minimum wage, guaranteed time and a half overtime pay for certain jobs, set standards for the employment of minors and prohibited oppressive child labor, and established guidelines for employer recordkeeping. These employment standards apply to employees in the private sector and in Federal, State and local governments.

Non-Exempt: Employees who are covered by the Fair Labor and Standards Act and, by extension, by most state and city labor laws. You must pay them at least the federal (and state) minimum wage, and they must receive overtime pay of 1.5 their regular rate of pay when they work more than 40 hours in a week.