Classifying employees and contractors correctly is crucial to optimizing your payroll tax position while staying compliant. It can also save your company from costly penalties, fines and back taxes. While employee classification seems black-and-white, there are a few shades of grey that can get you into trouble with the IRS or a worker. Here are five IRS-approved tips to help you classify your workers properly:
Flexibility
Whether a worker is considered an employee or contractor determines how payroll taxes are paid and withheld, eligibility for benefits and company policies like onboarding and training.
While the distinction between contractors and employees seems obvious, companies should know many nuances in the classification process to avoid legal issues. Misclassification of workers can result in back taxes, fines and penalties.
It can also put your company at risk of lawsuits and worker exploitation. The good news is that most employers know the distinction between independent contractors and employees and use tax forms (W-2 for employees and 1099 for contractors) to reflect this.
However, some employers incorrectly classify gig workers as contractors when they should be classified as employees. This is often a result of miscommunication between the company and the worker about their status or because the company’s hiring practices need to match up with local regulations on employee/contractor classification.
Individuals who suspect they’ve been misclassified should contact their local government agency for assistance. The IRS provides a form (SS-8) that individuals can use to request an official determination of their status from the IRS.
Control
Many people work freelance or as contractors, meaning your company does not technically employ them. That’s not necessarily bad—but you need to understand the difference between 1099 vs w2 to correctly classify them at the start of the relationship and throughout its duration.
Misclassification can have serious financial or legal consequences. It can cost your business back employment taxes and associated penalties or lead to lawsuits from workers or government agencies that have been denied benefits or protections.
Classifying workers as either employees or contractors affect payroll tax withholding and reporting, workers’ compensation, meal and rest periods, and reimbursement of business expenses. These rules vary from country to country, so you must know your local laws and keep up with changes.
If you need help classifying a worker, contact your country’s labor office or check Remote’s comprehensive Guide to Global Payroll Management.
Employee misclassification is a major problem in many countries. It deprives workers of important rights and benefits and denies governments crucial revenue. As a result, more governments are cracking down on misclassification and ramping up enforcement.
Some are even introducing new laws that make it easier for workers to report companies that have wrongly classified them. These laws can also increase fines and penalties for businesses that intentionally misclassify workers.
Payment
Determining whether someone is a contractor or an employee can take time and effort. Often, it’s less about the person’s intentions and more about how the company interacts with them. If workers are paid a regular salary, have set hours, and receive consistent training, they are likely employees.
On the other hand, if the company hires workers to complete specific projects and pays them for their results, they are potential contractors.
Keeping up with local laws regarding worker classification is essential to avoid misclassification fines and penalties. And as laws change, businesses must perform regular employee classification audits to ensure compliance.
Mistakes can happen even if a company does not intentionally misclassify its workers. And the consequences can be costly. For example, if a business incorrectly classifies a contractor as an employee, it may not be paying payroll taxes (including federal income tax and self-employment tax) and unemployment insurance. It also might not provide its employees with benefits like health insurance and paid time off.
In addition to financial penalties, misclassification can damage a company’s reputation. Customers may refrain from using a company known for mistreating its workers. And in some cases, companies that are found to be misclassifying their workers face public backlash and boycotts.
As a result, businesses need to understand the differences between W2 employees and contractors to be confident that they comply with the law.
Taxes
While there are quantifiable cost savings to hiring contract workers, this staffing option also comes with challenges. For example, independent contractors are not covered by company-sponsored benefits such as health insurance or paid time off. And if you misclassify employees as contractors, it could cost your business thousands in fines and back taxes.
To avoid these penalties, review all the facts and details regarding a worker’s status generally. They’re likely employees if your business controls how, where, when, and why workers perform their work.
On the other hand, independent contractors typically work for one specific client or project and are responsible for their taxes. This includes submitting their form 1099-MISC and paying their employer payroll taxes.
Many businesses mistakenly misclassify their workers to cut costs and evade employment laws. However, the IRS and Department of Labor will impose costly financial penalties on employers violating these rules.
The best way to avoid these penalties is by clearly defining each worker’s relationship with your business and maintaining a clear working relationship with them. That will help you avoid the common misclassification mistakes that cost companies billions yearly.
