How to Determine Your Employee Classifications

Manager ensuring proper employee classification while meeting with coworkers

If you use independent contractors or freelance workers on a day-to-day basis, the Internal Revenue Service (IRS) may be interested in how you classify them. Are they really independent contractors or do they actually perform their duties as if they were an employee? Classification determines how your workers are paid, their level of independence, and other important factors.

Employee Classification penalties can be quite severe if your company becomes the target of an IRS audit, even if it’s just an honest mistake. Issues regarding compliance can be complex, but don’t worry. We’ll explain how employees and other types of workers are classified, which can be helpful context as you shape your workforce.

Employee Classification Basics

The two main types of worker classification determine how workers are scheduled, paid, and (in many cases) managed. The first classification deals with types of employees and the second deals with the distinction between employees versus contractors. Here are the classifications:

  • Exempt vs. Non-exempt: Certain employees, particularly those in a management role, are exempt from overtime rules. Non-exempt employees typically include those paid on an hourly basis (as opposed to an annual salary).
  • Independent Contractor vs. Employee: The term “employee” suggests a specific relationship with an employer. An independent contractor, however, is not an employee and should have the final say in their work product and how much it’s worth.

For the purposes of this article, we’ll focus on the second classification above dealing with independent contractors, since it has tax implications (whereas the failure to properly classify a non-exempt employee can lead to legal action). Employers must withhold taxes for their employees, while independent contractors must set aside and pay taxes themselves. So, if you end up treating an independent contractor as an employee, you could end up having to pay back taxes, in addition to other penalties.

Determining Independent Contractor Status

The best way to avoid employee classification penalties is, of course, to properly classify them in the first place. The IRS considers evidence falling into three categories to determine this:

  1. Behavioral Control: Does the business/employer have the right to direct and control the work through training, instructions, etc.? For instance an independent contractor can’t be required to work on the contracting company’s premises or within certain hours.
  2. Financial Control: Does the business/employer have the right to direct and control the financial and business aspects of their job? This may include the extent to which the worker has unreimbursed expenses, investment in the tools used to do the work, how the worker is paid, and so on.
  3. Relationship to the Parties: Was there a written contract establishing the nature of the relationship? Does the business provide any employee-type benefits? Are the services provided by the worker a key aspect of the company’s regular business?

Generally, a worker will be considered an independent contractor as long as they don’t rely on your business as their sole source of income, work at their own pace (or in accordance with an agreement), aren’t provided with benefits, and retain a degree of independence.

Employee Classification Mistakes: Penalties and Consequences

Companies determined to have incorrectly classified employees as independent contractors are liable for employment taxes. If the IRS makes this determination, you may be able to avoid these taxes if you’re able to provide a reasonable basis for classifying them as independent contractors. If you find yourself in this situation, reaching out to your legal counsel is a must.

Also, certain eligible businesses may have the option to reclassify their workers voluntarily and thus receive partial relief from federal employment taxes. But if you fail to take action, you could be opening yourself up to a surprise tax bill. So it pays be proactive.

Whether You Need Independent Contractors or Employees, Monster Can Help You Find Them

With the potential costs of getting it wrong, it’s critical to ensure that your employee classification process meets both your business needs and your legal obligations. But whether you end up needing independent contractors or employees, Monster is here to help. With our free expert insights on recruiting and hiring strategies, and much more, we can help you align your business with success.

Legal Disclaimer:  This article is not intended as a substitute for professional legal advice. Always seek the advice of an attorney regarding any legal questions you may have.