There are employees, and there are independent contractors. And as long as your workers get the job done, it doesn’t matter what you call them, right?
Actually, it does matter — especially to the IRS.
If you misclassify an employee as an independent contractor, you could be subject to fines or penalties and may be liable for back taxes, wages, and benefits. That’s why it’s critical to correctly identify the individuals working with you regarding their working status.
According to the Economic Policy Institute, an estimated 10%-15% of employers misclassify at least one worker as an independent contractor. Misclassification is a common mistake, but you can minimize the likelihood of a problem if you’re proactive and know the rules in your state as well as federal laws.
We’ve written this article to help you understand if a worker you hired is more likely going to be classified as an employee or an independent contractor. Keep in mind that this is simply a primer, not a replacement for official legal advice. Seek legal advice if there are any questions and concerns regarding worker classification.
This guide will, however, hopefully give you a basic understanding of the distinctions between employees and independent contractors. Let’s get to it.
In most cases, workers are either employees or independent contractors. When you hire someone, it’s up to you as a business owner to classify them correctly.
So how do you know the difference?
Generally speaking, independent contractors are self-employed . They usually set their own fees and may have more flexibility.
Employees typically perform work that is a regular part of your business and with direction from the company. They aren’t self-employed, and their pay and benefits are generally set by the employer. They usually have regularly scheduled hours, receive training and direction from you, and be on your payroll.
Note: The IRS and your state will assume that a worker is an employee unless proven otherwise. Also, none of the examples described above on their own determine if a worker is an employee or independent contractor. The entirety of the employer-worker relationship must be examined. We’ll get more into this later in the article.
As a business owner, you need to know the federal and state guidelines to help determine your worker’s classification. Start with your state’s labor law test(s). Worker classification tests provide you with criteria that can help you determine whether or not your worker is an independent contractor.
Most states use one of these two tests: The Common Law Test or the ABC Test.
This is the test used currently by the IRS, 18 states, and Washington D.C. The test determines worker status by examining these three categories:
Can the employer control what the worker does and how they do it? Do they have the right to this control?
Are the business aspects of the worker’s job — such as payroll, tools and supplies, and other expenses controlled by the employer?
Type of relationship
Do the terms of employment suggest an employee/employer relationship? For example, does the employee receive benefits such as a pension plan, insurance, vacation pay, and paid time off?
The IRS determines worker status on a case-by-case basis, which usually boils down to the right to direct and control the worker. If the company controls the work the worker does and how they do it, there’s a decent chance that the worker is an employee.
However, making the call of employee versus contractor isn’t a perfect science. If it’s still unclear what factors distinguish an employee from an independent contractor after reviewing the three categories, a worker or employer can file a Form SS-8 with the IRS asking them to make an official determination.
This is the test used in some states to determine workers’ status. Under the ABC Test, a worker is considered an employee and not an independent contractor unless the hiring entity satisfies all three of the following conditions:
Absence of control
The worker is free from the company's control by contract or agreement and in practice.
Business of the worker
The worker performs work that is outside the usual course of the hiring entity’s business; and
The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.
Although several states have adopted the ABC Test as law, other states may use it for specific situations only, such as determining unemployment insurance eligibility. And to make it more complicated, a few states use only the A&B or only the A&C of the ABC Test to determine worker status.
Keep in mind that the ABC test is not used in every state, and is under dispute by the U.S. Department of Labor.
For example, New York State’s Department of Labor offers this guidance on the employer-employee relationship:
“An employer-employee relationship may exist regardless of how the hiring party describes it. For example, if you give a worker a Form 1099 rather than a Form W-2, they still may be an employee. Persons who work for you may qualify as employees under the law, even if, for example:
The South Carolina Employment Security Commission states that an "independent contractor contracts to do a job according to his or her own methods, without being subject to the control of the employer, except as to the results of the work." Neither the Commission nor the courts are bound by the language used by the parties to describe the professional relationship. The parties can’t control the contract’s legal consequence by the language used in it.
And a California amendment enacted in September 2020 includes clearer direction on independent contractor classification, such as contractors must have a separate business address, must carry their own business insurance, can hire and fire their own help, and can receive feedback on work done but are not required to follow it.
Key takeaway: Consult federal and applicable state' rules, and check with your state's employment authorities if you have any questions regarding worker classification.
If you realize that you’ve misclassified an employee as an independent contractor, don’t panic. You can convert the worker to an employee. Converting an independent contractor to an employee will affect how you pay your worker, so you’ll want to do this as soon as possible.
Here’s how to change independent contractor to employee:
Per federal and applicable state guidelines, use the Common Law Test, ABC Test, or another applicable test to make an informed decision as to whether your worker should be classified as an employee. If there is any uncertainty, consult with your state’s employment authorities,the IRS, or an employment attorney.
It’s best to do this in writing, so there’s a documented record that states the date your worker was notified. If you mail the letter, be sure to obtain proof of mailing and keep a copy for yourself to avoid discrepancies.
Create an employee file that includes their contact information, insurance enrollment forms (if applicable), and payroll information. Your employee should fill out a Form W-4, and you and the employee should fill out a Form I-9, which is used to verify an individual’s eligibility to work in the U.S.
When the switch from independent contractor to employee is official, add the employee to your payroll so they are paid on time and can begin to collect wage statements that reflect paid sick time, vacation time, health insurance, and other benefits.
It’s important to address payroll adjustments as soon as possible, since you may owe back taxes due to a misclassification.
As a small business owner, you may want to consider using payroll software to automate your company’s payroll and tax filing. This time-saving solution can process your payroll using time and attendance software that syncs to your employees’ hours.
When you convert an independent contractor to an employee, you must switch from a 1099-MISC Form to a Form W-2 to document your employee’s year-end earnings. You must send this form to your employee by January 31, so they can file their taxes.
Finally, welcome your converted employee as you would any new employee. Ensure that they receive a clear job description, employee handbook, and the same onboarding process as your new hires. Help them get acclimated, and provide them with the tools they need to succeed in their job.
As a small business owner, you already may have business insurance to protect against some losses and liabilities.
If you’ve just hired your first employee, it’s a good time to revisit your insurance needs. Even if you have only one part-time employee, it may be that your small business will require workers’ compensation insurance.
Many states require that employers carry workers’ comp insurance when they hire their first employee. Unfortunately, some business owners may purposely misclassify workers to avoid paying for workers’ comp insurance. This kind of misclassification can result in serious penalties and legal issues.
Why is workers' compensation important?
If an employee gets injured or sick while working for you, workers’ compensation could cover the cost of those claims. Carrying a workers' comp insurance policy can provide your business with much-needed security. Having this coverage in place might also keep an employee from suing your company for workplace injuries.
Visit our state-based insurance hub, where you’ll find recent workers’ comp insurance requirements for your state. And check out this Simply Business® article to learn more about workers’ comp insurance for small business owners like you.
At Simply Business, we can help you find an affordable workers' comp policy. Our licensed insurance agents will take the time to understand your business’s specific needs and help you find a policy that works for you.
And it takes only a few minutes to get a quote online.
While we’re on the topic of insurance, you may wonder if you have to provide your employees with health insurance benefits. Under the Affordable Care Act (ACA), if your business has 50 or fewer full-time or full-time-equivalent employees, you’re not required to provide health insurance. But that doesn’t mean you shouldn’t provide it.
When it comes to benefits, employees rank health insurance coverage at the top of their list. Offering health insurance is one way to attract top talent and keep your employees happy, healthy, and productive.
There’s a lot to consider regarding small business health insurance, so we put together this helpful guide to break it down for you.
At some point, you may need to convert an independent contractor to an employee. Whether it’s due to misclassification or your choice to offer your worker a permanent role, you now know what it takes to correctly identify an employee and make the transition as smooth as possible.
I've always loved to write and have been lucky enough to make a career out of it. After many years in the corporate advertising world, I'm now a freelance writer—running my own show and contributing to Simply Business. Fun fact: I have three desks in my house, but I still do my best thinking walking in the woods.
Susan writes on a number of topics such as workplace safety, customer sales, and workers' compensation insurance.
This content is for general, informational purposes only and is not intended to provide legal, tax, accounting, or financial advice. Please obtain expert advice from industry specific professionals who may better understand your business’s needs. Read our full disclaimer
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