With the rise of the gig economy, the proper classification of workers has never been more important to understand—nor more complicated. Many of today’s businesses are getting caught up in the tangle of information available on whether they can classify a worker as an independent contractor or whether the person is legally an employee.

To help, our team at LBMC Employment Partners has unpacked all the important details a business should know when it comes to determining which bucket an individual providing services falls under.

How to Correctly Classify Your Workers

The popularity of freelance work and independent contractors has risen in recent years. While the national discussion has revolved around the emergence of rideshare services and other app-based businesses, more traditional business models have also been affected by the change. Remote workers have become more common, as has contracting specific work to third-party companies.

As the work environment has rapidly changed, it’s blurred the lines of who is considered an employee and who is considered an independent contractor. Because of this trend, the IRS and other government agencies have started paying special attention to employee classification and are making regular changes to their laws and criteria.

Here’s a quick overview of how the Department of Labor classifies the three types of workers and what distinguishes them from each other:

  1. Freelance Workers. A freelance worker is someone hired on a per-project basis. They report and withhold their own taxes, and they typically itemize their deductions.
  2. Independent Contractors. Independent contractors can work similarly to freelancers, but they typically work more with one or two companies for an extended period of time (the contract) and are paid by the hour.
  3. Employees. An employee is someone hired by a company for an indefinite period of time. An employee is expected to work a certain number of hours each week (typically 40) in exchange for a salary and benefits.

Complicating matters even further, each state can also make its own rules for classifying employees. In the last year alone, states like New Jersey and California made new sweeping changes to their rules for classifying employees.

The Legal Difference Between Contractor and Employee

Because the distinction between an independent contractor and an employee has important implications for both parties, the IRS has outlined several definitions to test a person’s status. Here are a few different examples of how the government defines employees vs. freelancers and contractors:

  • Employees typically don’t set their work hours; contractors usually do.
  • Employees often receive training; contractors typically do not.
  • Contractors typically receive flat-rate payments or hourly rates on an as-needed basis; employees work more-regular hours for hourly pay or a salary.
  • Freelancers and contractors have a higher exposure to profit/loss than employees.
  • Contractors typically invest heavily in the tools they need to conduct their business; employees rely on employers to foot the bill for their workstations, equipment, etc.
  • Employees usually receive payment on a regular basis (weekly, bi-weekly, monthly); freelancers receive payment after the delivery of services.

For businesses, there are many practical differences between employees and contractors. While businesses must pay payroll taxes and provide benefits for their employees, they do not have to do so for contractors.

Why Knowing the Difference is Critical

Knowing whether an employee should be categorized as an employee or contractor is important for several reasons. First and foremost, the IRS levies severe penalties against businesses that misclassify employees. Recent lawsuits have resulted in multi-million-dollar penalties for violators, and class-action lawsuits from workers have become a common occurrence. Beyond the legal implications, it’s important to consider how each type of worker would impact your ability to achieve your greater business objectives.

Whether you’re trying to determine how an employee should be classified or considering what type of hire you should make, our team at LBMC EP can help. Our HR services can ensure you’re classifying workers appropriately and building your team in a way that optimizes your ability to grow your business.