Why It Matters to Know the Difference Between Employee and Contractor

When it was all said and done, 97 people were arrested, and James Brantley owed them over $600,000 dollars. Before he could pay them back, however, he would have to serve 18 months in an Alabama prison first. Failing to understand the difference between an employee and contractor isn’t the only thing that got him taken into custody, but he could have avoided a lot of trouble if he had.

It was April of 2018 when a joint operation involving the IRS, Homeland Security, ICE, and Tennessee Highway Patrol descended on Southeastern Provision, a meatpacking plant near Knoxville, TN. It was a story that ended up making national headlines and even became the subject of a Netflix documentary.

Brantley had been hiring illegal immigrants from Mexico and Guatemala for the past 30 years to work in his slaughterhouse, and was paying them under the table in cash. (He was also forcing them to work in extremely unsafe and unsanitary conditions.) Tellers at the Citizens Bank eventually became suspicious of the large amounts of cash he was regularly withdrawing ($25 million since 2008), and it wasn’t long before state and federal agents were headed to Bean Station, TN.

That’s An Extreme Example…

…but there is a principle at the root of it all that every small business owner should pay attention to: it matters how you classify your workers.

The Difference Between Employee and Contractor

Few decisions can have an impact on your business as the one to classify someone you hire as either an employee vs. contractor. There are advantages and costs associated with each one, and small business owners would be wise to be familiar with both…especially since it’s something the IRS and Labor Department pay very close attention to.

Employee: Someone hired by a company to work exclusively for that company on an ongoing basis in exchange for a salary or wages. The owner is able to define not only what is done by that worker, but how it is done as well.

According to an article by the CPA Journal, if you hire someone as an employee you are responsible for:

  • The employer’s share of Social Security (FICA) and Medicare taxes
  • Overtime and minimum wage payments
  • Employee health insurance premiums
  • Employee retirement benefits, vacation, holiday, and sick pay
  • Other employee fringe benefits, such as stock options
  • Federal and state unemployment compensation taxes (FUTA and SUTA)
  • Workers’ compensation insurance premiums

Contractor: An individual hired by a company to perform a specific function for a specific project within a limited scope and timeframe. The individual is responsible for their own taxes, health insurance, and retirement. The owner only pays the fee established in the contract for services rendered. According to the IRS, “Generally speaking…the payer has the right to control or direct only the result of the work, not what will be done and how it will be done.”

Unexpected Employee and Contractor Surprises

Many small business owners end up getting caught off guard when they realize that someone working for them is actually considered an employee, even though they are classified as a contractor. The penalties for making such a mistake can be quite severe, and “I didn’t know” isn’t an acceptable excuse.

In Business Magazine of Madison, Wisconsin recently published an article describing several employment law horror stories. In it, they interviewed an attorney with the law firm Kramer, Elkins, & Watt. They said:

“…clients are frequently surprised upon learning that their “independent contractor” is actually an employee. “I have had several clients who believed that they engaged the services of an independent contractor to perform various types of work, and then lo and behold that client receives a notification from a government agency…alleging that back taxes and fines are owed,” says Elkins.

“The clients are typically shocked when we speak, and state things like, ‘But I have a contract that says the worker is an independent contractor,’ or ‘But this is common in my industry.’

Just calling someone an independent contractor does not make them such, and likewise just because someone else in the industry is doing something one way certainly doesn’t make that action legal.”

The legal ramifications associated with misclassification of employee and contractor can be quite severe depending on the level of the mistake. It is a federal crime to knowingly misclassify a worker in order to avoid paying taxes.

Accidents are not exempt, either. Even if the misclassification is not intentional, once the error is discovered the business can be liable for paying back taxes on whatever wages were paid during the time period of employment for each individual involved.

Additional federal fines and financial penalties can be applied if the IRS determines that the actions were willful or fraudulent. Criminal penalties, including prison sentences, may also be applied for each individual that the business knowingly misclassifies (as James Brantley from East Tennessee learned in 2018).

Once the situation has been dealt with on a federal level, state tax and labor authorities also have the ability to impose penalties of their own. So, as you can see, it is worth your time to get this right.

How to Protect Yourself

What is the best way to ensure that you—the already-stressed small business owner—are doing this right? How do you know when to classify someone as an employee or contractor?

The details of every business are unique. But since the IRS is the government agency likely to be most interested in your compliance, let’s see what they have to say. The IRS’ own webpage on the topic of employee and contractor issues lists 3 criteria:

  1. Behavioral Control – Does the business have the right to tell the worker what to do and how to do it? (when and where to work, which tools to use, ongoing training)
  2. Financial Control – Does the business control the financial aspects of the workers job? (Buying equipment and materials, method of payment, opportunity for profit or loss)
  3. Relationship – How do the worker and the business perceive their relationship with one another? (permanent or temporary, the presence of benefits, ongoing services that are key to the business)

Each of these areas need to be evaluated on a case by case basis in order to determine if someone is an employee or a contractor.

You Need A Good Partner

When it comes to making sure your business is protected, you deserve to have professionals in your corner who understand labor laws and their financial consequences.

Our team at CRS CPAs has been helping business owners just like you navigate murky HR waters for over 40 years. We understand what it takes to keep you and your business compliant and on the right track.

Because we work with so many clients who deal with this issue on a regular basis, we included it as one of the topics in a free PDF we created called “9 Simple Accounting Mistakes That Are Costing Your Business Money.

After you’ve gone through your free PDF, schedule a call with one of our accounting and business experts to find out how we can go further in helping you grow your business…and avoid visits from 3-letter agencies!

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