Staffing your Business—correct classification as contractor or employee is more important than ever

Published On: August 22nd, 2015

Staffing your business can be a challenge, regardless of size or industry. Hiring independent contractors (1099) rather than employees (W-2) may seem like a smart choice to avoid a lot of paperwork, minimize fixed costs, avoid employment taxes and withholding requirements, and maintain a flexible workforce. An independent contractor workforce may realize these goals, but incorrect worker classification may cost you much more in back taxes, penalties, and retroactive employee benefits. Worker classification is becoming even more important with the Affordable Care Act. Certain parts of the Affordable Care Act that impose health insurance coverage responsibilities and penalties hinge upon the number of "employees" of a business.

How does anyone ever find out whether a worker is correctly classified? A common trigger for a worker classification audit is a so-called independent contractor files for worker's compensation or unemployment and there's no record of that person being an employee.

The main (though not only) factor the government will look to is control.

Prior to 2007, the IRS used a twenty-factor test to determine the difference. According to the IRS, it now uses the following three factors:

  1. Behavioral control: The facts that illustrate whether there's a right to direct or control how the worker performs the specific task for which he or she is engaged (e.g., instructions, training etc.).
  2. Financial control: The facts that illustrate whether there's a right to direct or control how the business aspects of the worker's activities are conducted (e.g., significant investment, unreimbursed expenses, method of payment, opportunity for profit or loss, etc.).
  3. Relationship of the parties: The facts that illustrate how the parties perceive their relationship (e.g., intent of the parties/written contracts, employee benefits, discharge/termination, regular business activity, etc.).

Factors commonly thought to determine worker classification but which actually make little difference include: the amount or way time spent (part-time, sporadic), how the worker's pay is calculated (per diem, per hour), whether the worker formed a corporation. Classification as an employee does not mean that an employer and employee lose flexibility. Employment does not mean a worker must work a certain number of hours or be paid a certain way. It does mean that the employer ensures that the appropriate payroll taxes are paid.

The probability of an audit of your workforce is high because of the ease and likelihood of a worker filing for employment benefits and because of the sheer number of government agencies with authority to review worker classification or issues related to worker classification: federal and state tax authorities, federal and state departments of labor, New York State Attorney General, New York State Workers Compensation Board, and the list goes on. Regulators for specific industries (healthcare, construction, food service) may have authority to review worker classification as part of another type of review.

Regardless of whether you are in the midst of an audit, currently making staffing decisions, or have never been confronted with the issue before, it's not too late or too early to consider correct classification of your workforce and what it may mean financially. Many people and companies may offer advice on this subject, but consultation with one of our employment attorneys is the most reliable, and thus cost-effective investment.