misclassification of independent contractors in USA
independent contractor misclassification in USA

Despite the challenges that business owners have endured in the pandemic, the year of the entrepreneur is in full effect. Many people have decided to take the journey into self-employment in various areas of the workforce, and have become what is known as independent contractors. 

Who is an Independent Contractor? 

An independent contractor is someone who has full ownership of their business. Unlike an employee, an independent contractor is in control of every aspect of their work – from determining how long they work to who they work with. Independent contractors are also financially responsible for every aspect of their business. Expenses that employees do not have to worry about paying – business expenses, Social Security and Medicare taxes, income taxes – are paid by Independent Contractors. 

Differences Between Independent Contractor and Employee 

An employee is defined as an individual who voluntarily agrees to work for an employer in exchange for pay (SHRM Essential Guide To Employment Law, p. 16). One of the main differences between an employee and an independent contractor is how much control and influence an employer has over a worker. Where an employee is concerned, the employer has a right to control an employee’s manner of work, whether the employee exercises that right or not. A Sales Associate being monitored during his or her shift, for example, would be a case of an employer exercising that right to control the employee’s work. While an employer can hire an independent contractor and has the right to critique or dismiss the contractor’s work, the employer does not have the right to supervise or manage how the independent contractor gets their work done. 

Another difference between independent contractors and employees is the amount of liability both workers do or do not possess. Due to public policy, employers are vicariously liable for injuries or property damage caused by their employees while the employee is under their employment (SHRM Essential Guide To Employment Law, p. 18). If an independent contractor is negligent or responsible for property damage while working, that independent contractor is personally liable and subject to many lawsuits. This is why, depending on the field, many independent contractors are advised to obtain liability insurance.

What is Misclassification? 

Misclassification occurs when businesses classify independent contractors as employees or employees as independent contractors.  Because independent contractors cost less than employees, it’s very tempting for some employers to classify their employees as independent contractors. If the Internal Revenue Service (IRS) finds out about the mistake, however, it can have costly consequences for both the employers and independent contractors. 

Consequences of Misclassification of Independent Contractors

If the IRS or another government agency audits a company and determines that an independent contractor was misclassified, that company is liable for several penalties. The company may be forced to pay back several expenses that employees are entitled to, such as federal and state income tax withholding, unemployment insurance, which requires the employer to pay premiums, and benefit plans such as health insurance and retirement plans. The penalties can become quite expensive to pay.  

Although independent contractors will not be fined by the IRS or any other government agency, there are still some unfortunate consequences that independent contractors can face due to Misclassification. Independent Contractors use the Form 1099-MISC to report their income to the IRS. If an independent contractor becomes reclassified as an employee, he or she will have to refile their income under Form 1040 and report that income as wages. They will also lose any deductions they reported while they were self-employed, such as business expenses, business travel, equipment, mileage, health insurance, or retirement plans.  

How to Avoid Misclassification of Independent Contractors

Even though the differences between independent contractors and employees had been vague in the past, the IRS has now established a standard called the Right of Control Test to determine whether a worker is an independent contractor or an employee. The basis of the Right of Control Test is to determine whether a company has the right to control a worker, essentially making that worker an employee. The primary factors that IRS auditors search for are a worker’s behavior on the job, a worker’s finances, and a worker’s relationship with the company. 

Behavior on the job 

One of the main characteristics of a company having control over a worker’s behavior is giving that worker instructions on how to work. Employees are usually given instructions on how to perform their job in the form of training. Because independent contractors have full control over their work and the way they perform their work, independent contractors do not have to receive training from the company or receive instructions from the company. 

Finances 

Financial factors such as reimbursement of business expenses, establish a worker’s status as an employee. Independent contractors can help establish their status by paying for all their business or travel expenses and having an opportunity for profit or loss. Because employers provide equipment for their employees and pay employees by the hour, employees do not have to worry about having profit or loss or pay for business expenses. 

Relationship between worker and company 

An employee is a worker who receives employee benefits from a company and performs services that are part of the company’s core business. Independent contractors can help establish their status by signing a written client agreement, making their services available to the public, provide their own benefits, and show that you have multiple clients. A written client agreement can serve as evidence that the worker is an independent contractor and the company does not have the right to control the way the independent contractor works. Having multiple clients and making services known to the public also help to show that independent contractors are not relying on that one single company for their livelihood.  

Conclusion

Although there is an additional responsibility involved with self-employment, the ownership and freedom associated with it are worth it. That is why it is important to preserve the independent contractor status as much as possible. It would truly be unfortunate to break away from the employee realm only to be forced to pay the same taxes as an employee.  

To avoid misclassification, Skuad can help organizations hire full-time employees as well as independent contractors in over 169 countries with clearly drafted employment contracts that are locally compliant. To know more, talk to a Skuad expert.

 

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