​For small businesses, misclassifying employees as independent contractors is an easily missed personnel action that can have a big impact. In general, if the employer controls what will be done and how it will be done, the individual is an employee. If the employer controls only what the end result is, then the individual is an independent contractor. How to classify an individual depends on the facts of each situation, and it’s important to get the classification right for each worker.

Why do these classifications matter?

Businesses that have even one employee are required to pay and withhold certain taxes. Employees are entitled to certain benefits covered by these taxes, and if and when the need arises for them to take advantage of those benefits your company could be in trouble if the appropriate taxes have not been paid or withheld. On the federal level these withholdings and taxes include Social Security, Medicare, federal unemployment and income tax. At the state level in Washington, these taxes and withholdings include workers compensation, state unemployment, paid family medical leave, and, starting in 2022, long-term care insurance.

How do I determine the appropriate classification?

To better determine how to properly classify a worker, consider these three categories – Behavioral Control, Financial Control and Relationship of the Parties.

Behavioral Control:  A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised. Behavioral control categories are:

  • Type of instructions given, such as when and where to work, what tools to use or where to purchase supplies and services. Receiving the types of instructions in these examples may indicate a worker is an employee.
  • Degree of instruction. More detailed instructions may indicate that the worker is an employee.  Less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
  • Evaluation systems to measure the details of how the work is done points to an employee. Evaluation systems measuring just the end result point to either an independent contractor or an employee.
  • Training a worker on how to do the job—or periodic or on-going training about procedures and methods—is strong evidence that the worker is an employee. Independent contractors ordinarily use their own methods.

Financial Control: Does the business have a right to direct or control the financial and business aspects of the worker’s job? Consider the following:

  • Significant investment in the equipment the worker uses in working for someone else.
  • Unreimbursed expenses, independent contractors are more likely to incur unreimbursed expenses than employees.
  • Opportunity for profit or loss is often an indicator of an independent contractor.
  • Services available to the market. Independent contractors are generally free to seek out business opportunities.
  • Method of payment. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time even when supplemented by a commission. However, independent contractors are most often paid for the job by a flat fee.

Relationship: The type of relationship depends upon how the worker and business perceive their interaction with one another. This includes:

  • Written contracts which describe the relationship the parties intend to create. Please note that a contract stating the worker is an employee or an independent contractor is not sufficient to determine the worker’s status.
  • Benefits. Businesses providing employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay have employees. Businesses generally do not grant these benefits to independent contractors.
  • The permanency of the relationship is important. An expectation that the relationship will continue indefinitely, rather than for a specific project or period, is generally seen as evidence that the intent was to create an employer-employee relationship.
  • Services provided which are a key activity of the business. The extent to which services performed by the worker are seen as a key aspect of the regular business of the company.

Classification Examples

Example 1: Denise owns a small retail toy store. It is open 6 days a week, 10 hours a day. During the week there only needs to be one employee working at a time, but on the weekend there needs to be two. She hires Damon to work Tuesday and Thursday to give Denise two days off, plus Friday and Saturday to be the second in store. Here are some facts about their situation:

  • Behavioral Control: All the tools Damon will need are provided by Denise. Denise gives Damon instructions on how to ring up orders, how to interact with customers, and how to restock the shelves.
  • Financial Control: Denise pays Damon a set hourly wage on a bi-weekly schedule. Damon does not have any risk of loss because any expenses he should incur to perform his job are reimbursed by Denise.
  • Relationship: Damon is performing a key service of the business. The business could not operate without him there to interact with customers and work the register. 

Due to the circumstances above, Damon would be considered an employee. 

Example 2: Denise realizes she’s in over her head with the bookkeeping of her toy store. She hires Aiysha to do her bookkeeping. Aiysha was recommended to her by another business owner.

  • Behavioral Control: Denise lets Aiysha decide if she wants to use her own computer or the business’s computer. Due to the backlog of paperwork being physically at the office, Aiysha and Denise decide it would be easiest if Aiysha works at the business. Denise doesn’t know much about bookkeeping besides paying bills. She shows Denise what she has done so far and gives her access to her Xero bookkeeping account, but it is largely up to Aiysha to perform her duties. 
  • Financial Control: Denise pays Aiysha a set monthly rate. Aiysha thinks this is fair, knowing that some months it may take her only a few hours a month to complete the tasks and other months it may take longer. Aiysha offers her services to other businesses.
  • Relationship: Aiysha provides Denise with an engagement letter outlining the nature of their relationship. Aiysha also provides her own health benefits. The services Aiysha provides are not a key aspect of the business. 

Due to the circumstances above, Aiysha would be considered an independent contractor.

Example 3: Denise’s business has done well and she now has twelve locations across the Pacific Northwest. Her accounting needs have increased tremendously. She hires a lead accountant to supervise a staff of two additional accountants at their headquarters office.

  • Behavioral Control: Due to the close collaboration and the fact that the accountants need to be available to answer questions from Denise, suppliers, and other employees, all the accountants are required to work in the office Monday-Friday during regular business hours. They are provided their own desk space with a computer and all the office supplies they need to carry out their duties.
  • Financial Control: The accountants are all paid a salary rate on a bi-weekly basis. Any expenses incurred are reimbursed by the company under an accountability plan.
  • Relationship: Denise provides benefits, including a 401(k) retirement plan, a health plan, and paid time off. 

Due to the circumstances above, all of the accountants are considered employees. 

Still Unsure?

If you are unsure about any of your workers’ classifications, consider filing a Form SS-8 with the IRS. Even the process of filling out the form may provide insight on how to classify the individual.
 
If you are ready to reclassify your independent contractors as employees or have general questions about employee classifications, Edmonds Bookkeeping and Tax can help. You can schedule an appointment to ask questions or get the reclassification process started. We can help get your businesses set up with all applicable agencies and set you up with our preferred payroll provider, Gusto.

Originally published at edmondsbookkeepingandtax.com on November 30, 2021.