Employee vs Contractor

Contractors and employees come with different benefits, but understanding the difference and what is best for your business can be the difference between growing your team and a knock on your door from Uncle Sam.

According to the Harvard Business Review, 10-20% of employers misclassify at least one employee. Believe it or not, misclassifying employees as contractors is actually pretty common. So common, that the Governor of NJ recently signed legislation to crack down on misclassification of employees as independent contractors. 

You may be wondering.. why would New Jersey (or any other state for that matter) care if the people I hire are classified correctly?

When you misclassify an employee (whether intentionally or unintentionally), everyone is impacted including you- the business owner, the employee and the government. Ultimately, the government has a vested interest in making sure that business owners get this right- because misclassification results in a major loss on tax revenue because business owners do not pay social security, medicare and other payroll taxes on behalf of contractors. 

Employees and contractors are treated differently when it comes to benefits and taxes. As a business owner, misclassification of an employee can leave you liable to IRS penalties and fines from the Department of Labor. The employee also gets the short end of the stick from misclassification, because they miss out on many of the benefits of a typical employee/employer relationship including: employee sponsored benefits, unemployment insurance, workers’ compensation etc. 

Employees

An employee receives benefits in exchange for being on your payroll. Their benefits are not only their salary, but any company-managed retirement plans, insurance, paid time off, and the use of company-owned materials like office space and computers. Employees’ responsibilities may change from time to time, and they may switch roles at the discretion of their bosses. However, they are a consistent moving part and integral to the business’s success. They require more training in company values and all of the company dynamics.

Contractors

Contractors are independent workers hired for one specific job or project. They do not get the same benefits as your employees, and you don’t have to pay taxes on the wages you pay them. Notably, independent contractors also have much more flexibility and independence than workers classified as employees. When you hire a contractor, your business has less control over how their projects are completed. Contractors are not as loyal to the business as employees are, they will complete the project, but once they’re done, they’re on to the next gig, not always relying on the company for long-term work. 

So now that you understand the difference between employees and contractors and the importance of getting this right, here are three steps to get you started on making the assessment for your business. 

First things first…

1. Review existing contracts

If you have people who work for you in your business that you have classified as an independent contractor- go back and review their contracts and the facts regarding the nature of their relationship. 

2. Ensure that you understand how your state classifies employees

Be sure to understand your states standard for classifying employees. The state of New Jersey utilizes a stringent 3 part ABC test where an individual is presumed to be an employee unless employer can show that:

• Employee neither exercised control over worker no had the ability to exercise control over the term of the completion of the work. 
• Services provided were either outside the course of business or performed outside of all the places of business of the enterprise.
• The individual has a profession that will plainly persist despite termination of the relationship.

This means that business owners have to meet all three criteria to classify an individual as a contractor otherwise that individual is deemed an employee.

3. Understand the common differences between an employee and contractor

If you already have a team or are looking to start growing your team, it is SUPER important that you ensure your team members understand how they will be classified and ensure their roles stay within the definitions defined by the IRS. the IRS looks at three defining areas- Behavioral, Financial and Relationship. With that, there are some common differences between an employee and an independent contractor that you should consider as you make your assessment.

• Employees work product and hours are controlled by the employer. In contrast, a contractor controls their own work product and “how” it gets done.
• Employee’s typically uses employers tools and resources such as a company issued laptop. In contrast, a contractor provides their own tools and resources.
• Employees are paid an hourly or salary wage and taxes are withheld from their paycheck. In contrast, a contractor is often paid by project or on a flat fee basis- typically triggered by an invoice produced by the contractor and no taxes are withheld.

I cannot stress enough the importance of getting this right. If you classified an employee as an independent contractor and have no reasonable basis for doing so- you may be held liable for employment taxes for that employee.  If you suspect you may have made a mistake and misclassified an employee as a contractor the IRS offers a Voluntary Classification Settlement Program that allows employers to reclassify their workers for future tax periods- with partial relief from federal employment taxes for prior periods.