Whether it is your first hire or your 1,000th, you are going to need help to scale and grow your company. The question is whether you hire those individuals as employees or independent contractors.
Why Companies Often Prefer Independent Contractors
The short answer on why companies often (although not always) prefer independent contractors comes down to cost.
Companies have to pay employees a lot more, especially when it comes to payroll taxes and benefits. Thus, it’s very tempting for companies to misclassify workers as contractors instead of employees. And thus various agencies, most notably the IRS, the Department of Labor, and their state counterparts, are interested in classifying more workers as employees than contractors.
Employee Payroll Taxes
When a company pays an employee, they are required to comply with a variety of payroll tax rules – from federal, state, and sometimes local withholding to unemployment taxes and of course, FICA taxes. FICA, or the Federal Insurance Contributions Act, is where we pay into the Social Security and Medicare systems for retirement payments, disability coverage, and retirement age health insurance.
When a company pays an employee, they withhold 7.65% from the paycheck for the combined Social Security and Medicare taxes. The company then pays this over to the IRS, along with a matching 7.65% for a total of 15.3% of the wages. Of course, this is subject to the Social Security wage limit, above which you don’t pay Social Security’s portion of the FICA taxes. For 2024, the Social Security wage limit is $168,600.
When a company pays an independent contractor, though, the contractor is responsible for the entire 15.3% FICA liability. This is what is commonly referred to as the “self-employment tax” that small business owners, freelancers, and contractors are well aware of.
Confused by payroll compliance? We recommend Gusto to make sure that you are withholding all the proper federal, state, and local taxes! Gusto makes payroll compliance easier!
Saving on Employee Benefits
It’s not just the taxes that employers save when they classify a worker as a contractor instead of an employee. Companies also save on the employee benefits when they hire contractors.
Employee benefits can be very expensive. Think about all the paid time off – vacation and sick. Medical/dental/vision insurance. Retirement benefits. Disability and life insurance. Personal development budgets. And whatever else that a company may offer to attract and retain employees.
Contractors Don’t Get Overtime
Typically, contractors are not eligible for overtime wages. Often, overtime wages can be 1.5 or 2 times the normal hourly rate for employees.
Some contractors have caught on to this and have included provisions in their contracts that include a higher rate for excess hours (sometimes even below the standard 40 hours) to compensate for missing out on overtime wages.
Practical Tip: Both parties, the contractor and the company, should carefully review contract provisions for the scope, the hours, and the compensation sections to watch out for the overtime issue!
Onboarding, Training, and Development
When a company chooses to hire an employee, there is often a very high cost associated with onboarding, training, and ongoing employee development. When a company chooses a contractor, the contractor usually requires very little training and development – they come with the skills in a ready to work on day one package.
There may be some time getting them access to systems and showing them the quirks of how you work, but that is limited. In fact, many contractors will have much more limited
Flexibility
It’s not normally considered a cost, but there is a substantial cost when it comes to flexibility, or lack thereof, with an employee. Think about when work slows down – an employee is still going to require you to pay them even if there isn’t enough work. Or you have layoffs, which comes with a great reputational harm (especially if you don’t do it in a way that the employee appreciates and blasts you on social media).
When a company hires a contractor, there is usually no layoff needed when you let them go. You can usually change the hours, subject to the contract you have with the contractor.
Workers Compensation
Another easily overlooked cost for employees is the cost of workers compensation. This includes both the insurance cost as well as the various costs of compliance or handling the inevitable claims after injury.
Contractors generally have much fewer protections when it comes to such coverage for workplace injuries. In fact, many contracts specifically exclude coverage and require that contractors provide their own insurance or self-insure.
Employees are Often Worth the Cost
OK, OK… we get it. There are a lot of costs when you choose to hire an employee instead of a contractor. So why does a company, especially a small company, ever hire employees?
The biggest reason is the control that a company has over an employee versus a contractor. You can set the hours that they work. You can control what they wear (uniforms, dress code) and where they work (in office versus remote). You can even control how they do the job – think assembly lines and company systems.
There’s also a big deal about intellectual property protections – while the IC contracts will cover various intellectual property concerns, it’s a lot easier to protect when the workers are using company computers and systems versus their own systems. Consider: protecting trade secrets on a company computer where you can track which USB devices are attached versus a contractor’s computer that won’t have the same level of cybersecurity that you control.
Also, it can be costly when you misclassify workers.
- Audits: The state and federal tax authorities will conduct audits to determine whether you are classifying workers correctly. This can be a costly and time-consuming process to justify your decisions to third-parties. And then on top of the back taxes that these agencies will collect, they will add on a variety of interest and penalties.
- Whistleblowers: Often, audits and investigations are launched after contractors complain to the agencies that they have been misclassified. In these circumstances, on top of the eventual costs of defending the audits, the complaining contractors/misclassified employees could be entitled to whistleblower rewards.
- Litigation: The contractors themselves can file lawsuits when something happens. Think about those missing workers compensation benefits – they are injured at your office and now they want those protections. Or a variety of other laws where employees generally receive more favorable status.
See Also: Top 5 Mistakes Business Owners Make
How to Determine Whether an Individual is an Employee or Independent Contractor
The tests have been in flux over the years, as the balance between companies and workers changes and political parties swings.
In 2021, the Department of Labor, under the Trump administration, changed the classification rules to what was seen as a more business friendly test. The 2021 rule replaced longstanding analysis with an “economic realities” test that elevated two core factors:
- The nature and degree of control that the company has over the work
- The individual’s opportunity for profit and loss
Meanwhile, it demoted the ideas about the skill, permanence of the relationship, and whether the work was part of the integrated business purpose in the analysis of whether an individual worker was properly classified as a contractor or employee.
2024 Final Rule
Once Biden came into office and the Department of Labor changed to Democrat leadership, they set upon the long process of returning to a six-factor test that looks at the totality of the circumstances.
Now, instead of focusing only on the individual worker’s ability to make money, it looks at the other factors that the business world and courts have long used. Those factors are:
- The opportunity for profit or loss depending on managerial skill
- Investments by the worker and potential employer
- The degree of permanence of the work relationship
- The nature and degree of control over performance of the work and working relationship
- The extent to which the work performed is an integral part of the potential employer’s business
- The skill and initiative of the worker.
This new rule is effect March 11, 2024.
The IRS Rule on Independent Contractors
Did you know that the IRS has it’s own rule regarding classifying workers?
Under the IRS analysis, you’ll look at three categories: behavioral, financial, and type of relationship.
If you think you’ve misclassified workers for tax purposes, you can participate in the Voluntary Classification Settlement Program to reclassify contractors as employees. This program will waive some of the penalties and back taxes that would otherwise be due under an audit if the company qualifies.
It’s a big risk mitigation opportunity for companies that are currently not in compliance with worker classification rules.
ABC Rule
In California, there is yet another rule that companies need to be aware of: the ABC Rule. Under the ABC Rule, which was codified in AB 5 in 2019, a worker is presumed to be an employee unless the company can satisfy each part of the A-B-C Test:
- The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;
- The worker performs work that is outside the usual course of the hiring entity’s business; and
- The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Nice Rules… But Now What?
Are those factors and multiple rules a lot of gibberish to you? Don’t worry, that’s why we are here to work through it for you.
There isn’t a bright line rule of thumb that we can give you that will always make sure that you haven’t misclassified a worker as a contractor. However, here are some questions that we will want answers to as we perform any analysis for you:
- How much control do you have over the worker?
- Do you set the hours that they work?
- Do you mandate HOW the work is to be done?
- Do they have other clients/work for other people too?
- Do you have employees doing the same job?
- Is the work part of your “core business” function?
- Do you provide the tools or systems for the work?
Think about the answers to these questions on a balance that tips between employee and contractor. As the weight adds up to the employee side, the courts and agencies are more likely to find that you’ve misclassified a worker.
And yes, it is possible that an individual will be classified as a contractor under one test and an employee under another.
Need More Help?
Kimberly DeCarrera is here to help you! Kimberly helps companies through these and other employment concerns to stay in compliance, manage risk and costs, and set your company up for long-term success. She can help you analyze your workforce, draft proper contracts and processes, and mitigate any prior misclassifications.
Contact Springboard Legal for more help!