Hi, folks, one of the most common questions I get is should I classify this work as an employee or an independent contractor? In this blog, I'm going to dive deep into both the IRS rules and the state-related rules plus all the potential business implications of choosing one or the other.
This Complete guide will be in three parts, so let's jump right to it we're going to cover why this matters for the motivations of either an employee or a business to be classified as Part 1. The other IRS rules when I talk about some state rules we'll specifically talk about California a new b5 rule which is important just came into existence on January 1st, 2020 as Part 2.
We're going to talk about the business requirement when working with an independent contractor. Then some of the tips I give to my clients about how to deal with independent contractors. This would be Part 3.
An independent contractor typically is there for the short term and does not represent the business itself. Now there are certain business transactions, maybe you're doing construction for the government or something like that and the specific contract will require you to use an independent contractor or to use an employee.
You have to consider, are there legal implications of using an employee or an independent contractor? based on your business or based on a specific transaction we also have a tax for cost implications probably. The most typical one where a business has to pay payroll taxes and have the administrative burden of having to run payroll.
I'll have to deal with all that so that's an important tax and cost implication another one is risk or insurance implication. As I mentioned earlier if you have an employee the business itself has a bit more risk but also does the employee have risk. What if the employer of the worker gets hurt on the job?
I mentioned earlier, not just paying the payroll tax but keeping up with timesheets paychecks requires all the documentation, you have to keep on the employee administratively. It's a bit more work to work with employees versus independent contractors. Which is just basically a check for an invoice type of transaction than we have operating implications.
So, for example, independent contractors work per contract they work short-term. So it's more difficult to manage long-term labor with independent contractors versus having employees in who they're pretty much there working full-time.
They're available for you as a business to do whatever it is that you need them to do an independent contractor. Might be relatively speaking might be a bit more restrictive of what they can do? when they can do it? and the type of work that they're going to do then?
we have unemployment implications right if you have an employee. You have to displace them they're going to go straight to the unemployment compensation office, try to get an unemployment check before they find the next job.
I'm a businessman, if you are having employees you have to understand that's going to happen. If you have independent contractors an independent contractor doesn't know or understand. They are not an employee; they might also walk into the unemployment office and claim to be an employee just so they can try to collect an unemployment check.
They'll be a whistleblower and then you're going to have the State Department Labor Department IRS in any other compliance office add your business trying to figure out why is this independent contractor that you quote fired trying to get an unemployment check? when they're classified as independent contractors but the worker is claiming to be an employee.
It can get messy so just keep that in mind because most employees are going to try to do what's best for them not what's best for the business. Especially if they get fired or this place and lastly we have potential penalties so you can get penalties from the IRS.
The state especially if your state payroll taxes you can have the Department of Labor potential penalties for not paying overtime or not giving enough breaks or not giving enough paid time off. Whatever the state requirements are the permanent labor typically enforces that.
Their other compliance entities law local government entities that try to enforce that most of the time depending on the state some states are a bit more employee-friendly. The site with the employee if there's a discrepancy of any sort so make sure to consider that as well let's talk about the motivations where the specific motivations a business.
Where a business owner may have to classify their workers as an employee but one of the most important ones is exclusivity. I want that employee to work full-time for me. I want them to grow inside of our business. I want them to keep our trade secrets
I want them to sign a nondisclosure. I wanted to sign a non-compete that often is not enforceable in the court of law but generally speaking, I want an employee that knows. What we do is the unique things that we do and it's not going to go out there.
Repeat it and do it for the competition. You also want to attract or retain talent ten people might want to work for a company that's going to give them job security that will give them long-term career path training.
So if you have unique training if you have unique know-how you want these people to be employees. Because you want them to take that training and work exactly as you want them to work to fit into your business or corporate culture.
Not necessarily what's best for the business. So if you wanted to use your tools and use them in a specific way that you need them to use them then they might need to be an employee.
Motivations for Business
Now let's talk about motivations for a business to classify the workers as an independent contractor so the other side of the coin here so.
Saves on payroll taxes right so I don't have to pay IRS state payroll taxes on employment taxes. Every state has its type of local payroll type of tax that businesses have to pay. You will save that because independent contractors just write them a check for the amount that you contractually agreed to pay. That's versus employees they get a bit more expensive.
Now we also have employee benefits so you might have four or five employees that get health insurance 401k whatever type of benefits you have. You don't want those independent contractors to fall into that group. So you want to separate the independent contractors from the employees to pay benefits.
Also, worker’s compensation insurance so most of the time most businesses will give workers comp insurance to their employee’s in-house employees but not to their independent contractors depending on the industry.
In some states you as a business if you contract someone you might have to cover them unless they have their insurance or they have an insurance exception. This varies by state but pretty much workers’ compensation can get pretty expensive and owners want to avoid paying that whenever possible.
So that might be a motivation to classify them as also being able to terminate the worker with ease right away. The contract not to hire them again right in some states is a little bit harder; you may have to keep more documentation to fire or get rid of an employee.
So it's important to understand that as an independent contractor or a short-term, you can get rid of them fairly quickly without having to pay overtime. It's kind of an important perk so it's not having to pay x and a half or whatever the contractual amount is.
Because they're an independent contractor, not an employee. It's a big feature of having an independent contractor also having casual or temporary Labor and not having to pay a full paycheck each month.
Just pay them when you need them to pay them whenever you have more work when you have capacity or capacity goes down bring some extra help some extra casual labor. That's another motivation to have independent contractors also having them bring their equipment to provide their training, in other words.
Independent contractors come ready or they should come ready they should have their equipment. They should be trained to the jobs that are not an additional expense that the business owner or the business has to incur.
Finally, the illusion of paying a bigger paycheck so a lot of independent contractors like getting the bigger paycheck quote-unquote because there are no payroll taxes.
The businesses themselves want to give the illusion that the pain that person more than they would otherwise be paying them as an employee so that's kind of a strange motivation but it's out there I've seen many business owners do that.
Motivations for an Employee
Let's talk about motivations for an employee to be classified as such so why would an employee want to be an employee.
job security fixed schedule guarantees hours, that sort of thing is probably the most important one that comes to mind.
Is getting the benefit many companies offer benefits mostly to keep employees and attract that talent right so health insurance 401 K whatever those benefits might be.
That might also be a motivation for the employee not to become independent to stay as an employee of the business also having a career path so having a clear future about how you can get better and better get paid more and grow inside of a business gets trained by that employer perpetually.
One of the reason employees wants to become an employee or maintain staying as an employee also being able to provide all the equipment all the tools most employees don't buy or bring their tools or some industries like Mechanics.
They typically have their tools, or chefs they're going to have their knives. This is more of a personal preference but they're not required to do so so they don't have to make the out-of-pocket expense typically when they're an employee.
Now, what about half of your payroll taxes so generally especially your IRS taxes. They're paid half of the payroll taxes paid by the employer. When you're an independent contractor you're going to be paying a bit more taxes. Because you're going to be paying the full portion of payroll taxes, which is typically fifteen point three percent of your salary regardless of your salary grade or your salary level.
You're going to pay at least fifteen point three percent of the salary taxes and typically like a split between the employer and the employees. Then we have simplicity right so I'm an employee, when I file my tax return I have a w-2. I will probably get a refund of some sort. That I have to keep up with my mileage, my expenses, business deductions.
Finally, if I get fired I can and possibly get unemployment benefits until I find my next job so that's a sort of a hidden benefit or a potential benefit of being an employee being able to get an unemployment check if you lose your job.
Motivations for an Independent Contractor
Now, what are the motivations for an independent contractor to be classified as such so I’m a worker and I want to be an independent contractor I don't want to be an employee what will motivate me?
Now the ability to deduct business expenses from income in my schedule see in my tax return so typically employees like a w-2s can deduct that many things from their taxes. so independent contractors that have vehicle expenses cell phone home office expenses. Those things typically can be deducted from that gross income and reduced by that taxable amount.
Even though they might be paying more in payroll taxes, they could be possibly paying a lot less in income taxes. Because they have all those business options. You can also check out section 162 and the IRS tax code which specifically speaks about what is the doc double to reduce your taxable business income.
Now getting a larger paycheck as I mentioned earlier the illusion of a larger paycheck by not getting federal withholding state withholding payroll tax withholding. It will give you a bigger paycheck amount so a gives you the illusion of that bigger dollar amount now this could work to your detriment as an independent contractor.
If you don't keep up with expenses or don't have any expenses but at least at the moment you get paid you sort of feel. That you getting paid more versus being an employee now a flexible schedule are independent contractors.
Typically have a bit more flexible schedule most of the time the business or the employer will tell you the deadline or specific times that you can work in but generally speaking there's a lot more flexibility with schedule versus a typical w2 nine-to-five job now.
We also have multiple clients, having multiple income sources. Typically, independent contractors don't work full-time for one entity. They have multiple entities that work with or they have multiple types of income sources.
So if you want that might be your motivation as well. Now being able to use your tools and equipment if you prefer being able to invest in whatever type of training that you want being able to determine.
What does being productive mean from your perspective as an independent contractor? Could also be a typical motivator for a worker to be an independent contractor. Lastly, the independent contractor might want to build a business or a brand around that specific skill set.