Employee Misclassification 101: What You Need to Know

The gig economy has exploded, and now more than ever, contract workers are in high demand. One report showed that month-over-month revenues in the gig economy increased 18% in June 2020 alone. The problem is that many hiring managers are unaware that some freelancers and gig workers may be classified as employees and not freelancers due to the nature of their work, the equipment provided for the company and the # of hours they work per month.

As recently as 2017, Harvard Business Review reported that up to 20% of businesses misclassify their employees. And this was before a global pandemic flooded the market with tens of thousands of additional contract workers. As this trend picks up, federal governments in countries across the world are setting stricter standards and regulations to ensure companies properly handle this growing workforce as they work to build (or rebuild) their organizations.

The problem? Most companies still don’t fully understand the basic differences between their relationships with traditional employees and independent contractors. In fact, most organizational leaders are unaware of the volume of independent contractors working for their organizations, and due to a lack of proper tracking tools and processes, they oftentimes grossly underestimate the amount of freelancers they employ.  This knowledge gap can lead to expensive consequences, including: 

  • Back-taxes at federal and state levels
  • Back pay for “wage theft,” retroactive insurance premiums, and additional penalties
  • Back premiums for workers’ compensation insurance
  • Lawsuits from freelancers and independent contractors

Below, we examine some ways to approach the business of hiring contract workers — and measures to implement to ensure you’re protecting your company from unwanted consequences. 

Who Qualifies as an Independent Contractor?

Who Qualifies as an Independent Contractor?

To qualify as an independent contractor, a worker typically earns income from multiple employers, and does not depend on a single employer for a majority of his or her income. 

Additionally, the amount of control you exert over a worker is the largest factor in determining how he or she gets classified in the eyes of the law. The more control your organization exerts in these areas, the closer you get to crossing the line from contractor status to employee status. However, it’s important to keep in mind that there isn’t a single list of items you can check off that determines whether or not an employee is considered a contract worker. 

“There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination,” says the IRS. “The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.”

Questions to Ask Yourself Regarding Employee misclassification

When it comes to freelancers not only in the U.S., but around the world, there are a few vital questions to ask yourself to get a better sense of where the worker falls on the classification spectrum. The IRS lists three key areas — behavioral control, finances, and a worker’s relationship to the organization — when determining their classification. Below, we’ll explore aspects of each you should keep in mind as you bring contract workers on board at your company. If the answer to most or all of the below questions is “yes,” it’s more likely your relationship with the worker resembles that of an independent contractor instead of a traditional employee. 

1. Determine what degree of independence the worker has

How much control you exert over a worker is paramount in determining whether you can consider them an independent contractor, or if you’re getting dangerously close to the traditional employee threshold. Here are three key factors to consider.

  • Self-supervision: Do they have the power to perform their tasks the way they want to—free from anyone in your company instructing them on process, and also free from discipline, work rules, performance evaluations and other supervision and control?
  • Self-scheduling: Are they free to set their own schedule and work hours, with no attendance requirement?
  • Self-starting: Are they free to determine the order and sequence of their tasks, with no requirement to make regular progress reports to you?

2. What is the nature of their financial situation in relation to your company?

In many countries, it’s important to ensure you’re not the sole or majority source of income for your independent contractor. But how do you determine if this is the case? Here are four factors used to determine a contract worker’s financial setup.

  • Exclusivity and independence: Can they, and do they, have other paying clients — and do they market their services to the public?
  • Supplies and tools: Do they provide their own office and supplies, pay their own business expenses and hire their own assistants? 
  • Task/hourly pay: Do they get paid only for work they actually do, like hourly pay or task pay, with no paid vacations or holidays? Is their pay free from employee-benefit executive compensation elements like bonuses, health/life/disability insurance and equity awards?
  • Business risk: Do they take business risks and bear the ultimate risk of profit or loss? Do they bear the risk of casualty loss (property/personal injury) and do they buy insurance? 

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3. How is the relationship set up?

While it may be tempting to just hire contractors to perform every role in your organization — especially if you’re a small business owner — there’s a lot of risk involved in that, especially when it comes to continuously employing an independent contractor in perpetuity, or on a long-term basis. Below are three factors that illustrate what the relationship between your organization and an independent contractor should look like. 

  • Short-term: Is your relationship with the worker explicitly temporary?
  • Tax/social security: Do they make tax/social security payments and withholdings like a business? 
  • Business cards/letterhead/email/title: Do their business cards and letterhead clarify their independence from your organization, and do they use a title unrelated to the company? Are they kept off of your organizational charts and internal structure documents? Does their email address make clear they are not part of the your organization
  • Core business functions: Is the worker performing specialized tasks that are not a part of your business’s core functions? (Examples of core business functions could include administrative assistant work or, in cases like Uber, could include serving as a driver for a company whose core business function is transportation). 

These questions can help you determine contractor dependence, but they’re not all you need to consider. There are three additional questions it’s critical to ask yourself, and that frequently factor into classification analysis. 

  • Restrictive covenants: Is the worker free from non-compete, non-solicitation and other post-termination restrictions?
  • Training: Does the worker refrain from attending your organization’s training sessions as a student?
  • Organization structure: Does their operation stay separate from your organization’s structure and work procedures?  (For example, including them in your payroll  or HRIS could suggest they are part of your organizational structure.) 

So now with the basics of contract worker classification understood, what can you do to ensure your company stays above-board with the contractors you plan on hiring? First, you should consult the full guidelines laid out by the IRS regarding these matters. Second, you should invest in a workforce management platform like Stoke.

Written by
Stoke Talent

Team

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