Accounting 101: Classifying Your Workers to Prevent Issues


As a small business owner, you have several things to keep track of. As you’re growing, you may even bring on help. Once this happens, a necessary and important step is to ensure you’re correctly classifying your workers.

This crucial step allows you to determine if you are required to withhold income, Social Security and Medicare taxes or if, as an independent contractor, you don’t have to. Also, remember that employees are eligible for benefits, whereas independent contractors are not. This can be a costly mistake if not correctly identified.

Yes, we get it. This isn’t why you got into business. But it’s an important step to take that can save you from a world of hurt. If you’re not classifying correctly, you can get stuck with some harsh fines and penalties. When businesses wrongly classify their workers, they are still liable for the related taxes and payments for those workers, and may even face other sanctions. Correctly classifying your workers helps you avoid this, making it easier for you to run your business.

So where do you begin? Here are the steps you need to take to make sure you’re properly classifying workers:

Determine if you have employees or independent contractors.
The business relationship between the organization (you) and the person performing the services must first be analyzed to determine how payments should be treated.

The employee-employer relationship is generally determined by the “common law” test. The common law test focuses specifically on determining who has the right to control two basic elements:

  1. What must be done – the results of the work
  2. How it must be done – the method by which the work or services are performed

A worker is considered an employee (and subject to payroll tax withholding) if the employer has the right to control both aspects of the test. In other words, the employer controls both the results and how it must be performed.

A worker is considered an independent contractor if they can only control the results of the work, not how the work will be done.

Consider these types of controls.
The IRS uses three categories when determining employee status and the degree of control and independence.

Behavioral Control
A worker is considered an employee when the business gets to be bossy. Okay, maybe bossy isn’t the right word, but the business does have the right to direct and control the work being done. Behavioral control can be broken down into a few more distinct categories:

  • Type of instructions – This can include telling the employee where to work, when to do the work and how the work should be done.
  • Instruction complexity – The higher the complexity of the instructions given, the more likely it is the individual is an employee. When the instructions have less detail, this gives the worker more control to do the job how they see fit, which points towards the worker being an independent contractor.
  • Evaluation – How a business evaluates the work can help determine if the worker is an employee or contractor. If the details of how the work was done are evaluated, then the worker is likely an employee. However, if only the end product is being evaluated, it’s more likely you have a contractor.
  • Training – This one is fairly simple. Would you like someone else telling you how to do your job? If a worker is an employee, the business has the authority to do just that. For independent contractors, they are the experts and generally don’t require training from the hiring company.

Control over Finances
This category looks at what control the business has over the financial and business pieces of the worker’s job. Factors to consider include:

  • Equipment investment – Independent contractors are much more likely than employees to make significant investments in the equipment they are using to get the job done. Employees are often provided equipment from their employer, rather than investing in it on their own.
  • Expense reimbursement – Businesses generally reimburse expenses for their employees, not for independent contractors.<
  • Availability – Independent contractors generally have the freedom to seek out more business opportunities, while employees work is usually contained to the one business.
  • Payment – This one is easy to understand. When you have employees, you usually guarantee them a regular wage. With independent contractors, a flat fee is usually agreed upon and paid on the completion of the work. 

Relationship Elements
What the business or worker offers in the relationship can also determine classification. Some key elements to consider are:

  • Contracts – Written contracts which describe the relationship the parties plan to create are a fairly simple way to determine which type of worker the business has. However, it’s important to note that a contract stating the worker is a contractor or an employee isn’t enough on its own to classify the worker’s status.
  • Benefits – Insurance, retirement, vacation and sick pay are benefits provided to employees. It’s rare for these benefits to be given to independent contractors.
  • Forever or just a fling – The length of time of the relationship can help determine a worker’s status. When an employee is hired, the expectation is that the relationship is long term. For contractors, the relationship isn’t permanent. Instead, both parties enter the relationship with the assumption of a certain amount of time for the work to be completed.

When in doubt, use your resources.
In case you hadn’t guessed, this isn’t simple. No one set of factors is the supreme answer. All the facts and circumstances in a situation have to be taken into account in determining whether an individual is an employee or an independent contractor.

If you need a little extra help, Form SS-8 can be filled out to assist in the decision.

Your accountant should also be able to help you through these details, to ensure you’re classifying correctly and protecting yourself from having to pay for unmet tax burdens or sanctions.

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