3 Criteria to Correctly Classify Employees

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    Please enjoy this guest post from Dominique Molina.

    When your business grows to the point where you need to start hiring people to work for you, you know you’re doing well. It means you’re growing, and it’s a big step forward in terms of just how successful your business can be. It also means you need to spend some time figuring out exactly what those employees are going to do, and how they’re going to do it. Do you need part-time employees? Full-time? Do you need occasional help? How you answer those questions will help determine how classifying employees.
    Employee or contractor?
    Everyone who works for you is going to fall into one of two classifications: employee or contractor. The first thing you need to determine when hiring a worker is whether the individual is an employee or a contractor.
    The IRS looks at three specific areas to determine whether a person is your employee or whether they’re a contractor:

    • Behavioral issues. This has to do with who makes the decisions about how, where, and when a worker performs a task. If you specify exactly what is to be done, when, and where, and you even go so far as to specify which tools the worker has to use to do so, you’re more in employee territory than you are in contractor territory.
    • Financial issues. How finances are taken care of during the course of business matters, as well. For example, a significant financial investment required by the worker puts them more in the contractor category. Whether payment for services is guaranteed, or whether pay is on an hourly or flat basis matters, too. Even the question of whether the worker has the opportunity for financial profit or loss during the endeavor factors in here. The more financial responsibility that rests on the worker, the more likely they should be classified as a contractor.
    • Relationship. Your intent, as well as the worker’s intent, matters too. Things like written contracts, whether you’re paying for benefits like vacation time or a retirement plan, your terms for discharging or terminating the worker, and whether the work that the worker does is integral to your business all determine the relationship. Someone who does a job that can’t be done by others that’s business-critical is probably an employee, as is someone to whom you pay for sick days.

    As you can see, it’s not always cut and dried. While there are some obvious types of workers that are employees, for some it’s more nebulous.

    Which is better?
    From a financial perspective, it’s usually better for a business to classify workers as independent contractors whenever possible. That’s because there are many rules and regulations that apply to employees that don’t apply to independent contractors. For example, with employees, you have to:

    • Withhold payroll and federal income taxes.
    • Pay your share of the employee’s FICA taxes.
    • Pay the employee’s FUTA tax.
    • Provide benefits as required by law, such as overtime pay or even health insurance.
    • Meet any state requirements for employees, such as withholding state taxes.

    These are things that you don’t have to hassle with for independent contractors.

    The penalty for misclassification
    If you classify one of your employees as a contractor without a verifiable and reasonable basis, you can be looking at a number of penalties. You can be liable for the worker’s employment taxes, as well as uncollected Social Security and Medicate Tax. This can create a bit of a tax nightmare, leaving you with a significant tax burden that can be very difficult to pay. On top of that, you’ll likely be looking at penalties and fees.

    What to do when it’s not entirely clear
    If you have some doubt about how to classify a particular worker, you should most certainly talk to your tax advisor. They can help you make sure you get it right.
    Beyond that, you can also work together with the worker to determine their classification. If the worker is amenable, you can develop a contract that explicitly addresses some of those three categories of evidence. That will certainly help you build your case, should the worker’s classification ever be challenged.
    Finally, you can fill out the SS-8 form. This form is sent to the IRS, which will then review your worker’s circumstances and determine whether or not they can be classified as a contractor or must be classified as an employee. It does take about six months to get a determination.
    Getting your employees correctly classified can have an impact on your bottom line, as well as your tax burden. Do it right the first time?

    For more resources, See the Human Resources library.

    Author bio

    Dominique Molina is the President of CertifiedTaxCoach.org, a professional organization that helps tax professionals deliver thousands in tax savings to their clients. Dominique has compiled many resources for members, including powerful accounting templates, a tax-specific engagement letter template, and the most comprehensive tax training in the industry.