Independent Contractor or Employee – The Distinction Aborts Misclassification

Updated: September 21, 2010

Why Misclassification Happens?

To understand this, we need to answer - Why do employers intentionally indulge into the practice of employee misclassification?

Well, the fact is that employers are responsible for paying different taxes on account of the employee wages they give. Social Security taxes and Medicare taxes are two examples of the employee taxes every employer needs to pay.

On the other hand, employers are not responsible for paying any such tax for independent contractors working for their company. So, in an attempt to reduce the tax burden, employers might classify their employees as independent contractors.

Who Are Independent Contractors?

Independent contractors are the individuals, businesses or corporations that sign contract with one or more organizations to provide goods and services to them. Another common name used for these service providers is freelancers. These independent contractors are responsible for paying their own taxes.

For example, a certified personal accountant hired to take care of business accounting is an independent contractor. Another example is that of an engineering consultant hired by an engineering product manufacturing company. Some of the other examples of independent contractors are lawyers, real estate agents, stock brokers, private security providers, translators, trainers and sales representatives.

Common Laws to Avoid Misclassification

Considering an increase in the cases of employee misclassification, the IRS has taken the initiative to help employers classify their workers as employees and independent contractors.

Common laws exercised by the IRS are described below:

  • Right to control the behavior of the worker: If employers have control on things like when and where workers work, what tools and equipments they use, and what order they should follow to perform various tasks, then these workers are classified as employees. Independent contractors, on the other hand, are free to decide these things because they operate their business on their own.
  • Business training: Workers are classified as employees if they are provided training by the organization they work for. Independent contractors, however, have their own methods of training and don't depend upon the training from the organization they work for.
  • Financial control of the employer: Employers pay their employees in the form of regular wages, whereas independent contractors are paid a flat fee. Also, independent contractors make significant investments to have their own business office and other facilities. Besides, independent contractors don't enjoy benefits like reimbursement of expenses, health insurance benefits, vacation and sick leave, etc. On the other hand, employees are entitled to enjoy all these benefits.
  • Relationship shared by the employer and worker: An employer-employee relationship is described by the fact that employees work indefinitely for the employer. An independent contractor is usually hired for a specific project or for a short period; though the relationship might continue after that. The written contracts between the employer and the worker decide the nature of relationship. An independent contractor is free to work for more than one organization at a given point of time.

Need of Classification

Classification of a worker as an employee or an independent contractor is important for the following reasons:

  • For an employer, the classification is important to avoid the imposition of fine or penalty when the IRS recognizes the misclassification.
  • It helps in preventing exploitation of employees by lawfully enforcing every employer to follow and implement this classification.
  • Misclassification may also exploit independent contractors, especially when they are not aware of the rights they have as independent contractors.
  • Classification is in favor of the whole nation. If some employers reduce their tax burden through intended misclassification, the rest of the tax-payers are cheated.

How to Perform Classification?

A compliance officer should be hired to help employers classify their workers as employees and independent contractors. An evaluation of each worker of the organization is done and related reports are prepared. In some cases, an independent contractor might show interest to become an employee for the organization. If the employer decides to hire this person, the related documents must be prepared for the tax audit. If the employer is not able to classify one of the workers to the right category, the IRS form SS-8 must be used.

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