Independent Contractor or Employee? What to Know About Misclassification

What are the differences between independent contractors and employees?

Improperly classifying workers as independent contractors when they are actually employees can create a myriad of problems with various federal and state agencies. Employment taxes due to both the IRS and the state governments are a primary concern, but there may also be insurance or labor law ramifications.

Benefits of Hiring Independent Contractors

Why might a company prefer to have independent contractors?

It’s easier and cheaper. When a company pays an independent contractor, no taxes are calculated or withheld and the total payments made for an entire calendar year are reported on Form 1099. The company does not owe any employer tax on the payments made because the independent contractor pays the self-employment taxes himself. Payments to employees, however, must be reported on quarterly payroll tax returns and W-2s. Employee taxes are withheld and remitted frequently, and the company must also pay its employer share of taxes on the wages paid. Also, there are no requirements to offer health insurance or paid time off to independent contractors. However, the preference of a company or a worker to be classified in one way or another has no bearing on the facts and circumstances of the relationship. Merely agreeing to be called an independent contractor does not mean that the classification would be sustained if the relationship were examined by taxing authorities.

How to Determine Whether a Worker is an Employee or an Independent Contractor

In order to determine whether a worker providing services to a company is an employee or an independent contractor, the degree of control the company has over the worker must be considered. There are three categories of control to examine: behavioralfinancial, and type of relationship.

Behavioral control would be demonstrated if the company has the right to control what the worker does and how he does his job. Does the company specify when and where work is to be done and in what order the tasks are to be completed? Does the company provide specialized training for the worker or require him to attend meetings regarding the work? Must the work be done at the company’s office during specified business hours? If the answers to these types of questions are yes, then the relationship is likely one of an employer and employee.

Financial control is indicated by the method and timing of the business aspects of the worker’s job. Does the company reimburse the worker for expenses? Is the worker paid in regular intervals, such as hourly, weekly, or monthly? Does the company provide supplies and tools for the job? If so, these factors would tend to indicate an employer and employee relationship. Conversely, if a worker can hire his own assistant, if he has the possibility of realizing either a profit or loss as a result of his services, or if he makes his services available to the general public, then he might be an independent contractor.

The type of relationship category looks at factors like whether or not there are written contracts or employee type benefits. Is the work performed by the worker a key component of the company’s business? If so, then the worker might be an employee.

A company must weigh all factors when determining how to classify a worker. There is no set number of factors that definitively determines whether a worker is an employee or an independent contractor. The key is to look at the entire relationship. If you are still uncertain, a Form SS-8 can be filed with the IRS to ask for a determination. This review can take several months, but it might be worthwhile if you continually hire the same types of workers to perform particular services and the classification is unclear. For employers who have been improperly treating workers as independent contractors, there is an IRS “Voluntary Classification Settlement Program” that provides partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat workers as employees.

A company can eliminate future financial and legal complications by properly classifying workers when the relationship begins. The desire to simplify reporting and avoid paying payroll taxes does not change the actual substance of a company’s relationship with its worker.

New Jersey’s ABC Test for Employee vs. Independent Contractor

Under the ABC Test, a worker is presumed an employee unless the employer can demonstrate all three components of the ABC Test:

A – The individual is free from control or direction over the performance of the work  (i.e., they are not supervised, compensated based on performance, or compelled to adhere to a set schedule); and

B – The service is either outside the usual course or nature of the business or is completed off the premises of the business  (i.e., the work in question is not an advertised service of your business); and

C – The individual is customarily engaged in an independent trade, occupation, profession, or business  (i.e., the worker has clients or customers in addition to your business).

New Jersey employers need to assess existing independent contractor relationships to verify that they meet all three requirements of the ABC Test. Failure to satisfy any one of these conditions will now result in recognition of that individual being classified as an employee, which could entitle him or her to benefits, minimum wage, and overtime laws. Misclassifying your workforce exposes you to the risk of possible fines, unpaid wages, payroll tax liabilities, employment law violations, and attorney fees’ and costs.

Federal Misclassification Penalties

There’s a lot at stake when it comes to classifying employees. It starts with fines, back payments, steep legal fees, and can end with harm to the employer’s reputation, and even jail time when mistakes are made, unintentionally or not. Penalties can be steep. If misclassification is unintentional, an employer can be charged a $50 fee for each W-2 not filed, 1.5% of the employee’s wages plus interest, 40% of the employee’s FICA (Social Security and Medicare) contributions and 100% of the employer’s matching FICA contributions.

Misclassify on purpose and it gets more serious with greater fees and fines. There could be up to $1,000 in criminal penalties per misclassified employee, and up to 1 year in prison. The person who made the error in misclassification can also be held personally liable.

New Penalties for Worker Misclassification in New Jersey

Classify correctly or pay up. In early 2020, New Jersey Governor Phil Murphy signed a set of bills aimed to hinder the growing trend of intentional worker misclassification in New Jersey. In addition to the existing fines and penalties for misclassifying employees and independent contractors, the new bills introduce the following:

  • Assembly Bill 5838: Allows the state labor department to issue a “stop-work order” against businesses who violate the wage and hour laws by misclassifying workers.
  • Assembly Bill 5839: Update to the fines and penalties for employers, including an administrative “misclassification penalty” ranging from $250 to $1,000 per misclassified employee.
  • Assembly Bill 5840: Both the employer and labor contractor would be jointly responsible for worker classification and therefore equally liable for penalties incurred from evading tax laws.
  • Assembly Bill 5843: Requires employers to post a workplace notice describing misclassification, benefits and protections to which employees are entitled, and remedies under law for workers affected by misclassification.
  • Senate Bill 4226: Allows the state labor department to “name and shame” by posting guilty employers’ information online. Published employers are prohibited from contracting with state government agencies.

Senate Bill 4228: Permits the sharing of tax information between the Department of Treasury and the Department of Labor and Workforce Development.

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