The Importance Of Employee Classification: And why it Really Matters!

The Importance Of Employee Classification: And why it Really Matters!

Regardless of whether you’re an employer looking to hire or someone who’s been offered a job at a new company, you need to know how employment classification as an employee or freelance contractor will affect your standing with the IRS.

Employers who hire new workers need to be aware of how to best classify them either as freelancers or formal employees or later risk paying for the consequences if they don’t satisfy the tax man. Job hunters likewise need to worry about the same since being classified as an employee or freelancer under the wrong circumstances could lead to negative consequences down the road.

This infographic by the people at staffing and recruiting firm Wunderland Group covers everything you need to know about best classification practices whether you’re hiring or being hired. Here is a quick summary of what they have to say.

Employee classification infographic by Wunderland

What does a Name Mean?

Being either an employee or an independent contractor carries both risks and rewards either way. You need to understand what these are so you can make better hiring or employment choices with this quick overview of how both work:

As an independent contractor:

  • You’re self employed
  • Work on a per project basis
  • Often work for multiple agents
  • Use your own resources
  • Receive no training
  • Isn’t generally supervised or fixed to select work hours
  • Have to self-promote
  • Will need to sign a W-9 form in order to work
  • Will receive per project compensation
  • Do your own taxes and tax returns
  • And won’t be eligible for benefits

As an Employee:

  • You’re working as a part of a company
  • Work for just one employer usually
  • Are using company resources for the job
  • Receive training
  • Are frequently supervised
  • Do not do your own marketing for the sake of new work
  • Must sign a W-2 form
  • Are usually compensated hourly or by salary with full tax withholding
  • Need not file a business tax return
  • Can receive company benefits

These distinctions between employees and freelancers are extremely important, because failing to classify yourself correctly as a worker or those you hire correctly as an employer can lead to a number of serious financial and legal consequences.

The Dangers of Employment Misclassification

Employers:

As an employer, you might misclassify workers because you think that making an employee into a freelancer arbitrarily will save time and cut out the work around tax withholding and benefits, but this can be dangerous because:

  • An independent contractor (IC) that you’ve misclassified can report you to the IRS
  • You must report paying your IC more than 600 per tax year through an 1099 form with the IRS. Doing so will trigger their attention and could lead to audits or penalties if you’ve misclassified workers.

Protecting yourself as an Employer:

As an employer who wants to classify properly and safely, you can do several things to protect your company. For one, you have the option of using a staffing firm that lets you unload your workers as employees onto them, thus eliminating the risk of audit and misclassification.

You can also consult with an attorney to make sure that the staffing firm or your workers are in compliance.

Finally, you can simply classify your staff correctly based on how they actually work so that they are fairly compensated, see you as honest and are more committed to working with your soundly run company.

Workers:

Workers often allow themselves to be misclassified because they either badly need a job and are acting out of hurried need (there are some strategies for avoiding this) or because they like the position and company enough to overlook the misclassification. Also, most commonly, they don’t realize they’ve been misclassified.

This can be very risky because it can deprive you of due compensation and benefits:

  • If as a legal employee your employer still defines you as an IC, you won’t be entitled to benefits such as health insurance, paid leave or 401Kcontributions.
  • You will not have the right to overtime pay when you work more than 40 hours in a week.
  • You might be treated differently than classified employees even if you have the exact same job routine.
  • You will be responsible for all your own taxes and if you aren’t aware of this may find yourself slammed with a massive year-end tax bill once theirs catches wind of your IC status.
  • The company will be saving money at your expense and unfairly in many circumstances.

Protecting yourself as a Worker:

However, as a worker you can protect yourself by doing the following:

Be aware of all IRS rules relevant to your status and let your company know of this. They will be less likely to try taking advantage of you.

If you agree to IC classification but are classified as an employee, you can report this to the IRS and possibly be entitled to compensation for benefits and employee taxes you paid by yourself.

Understand that you will not get into IRS trouble if you find yourself misclassified by your employer but want to report it. Not reporting can lead to lost benefits and the need to pay your own taxes with more effort.

Ivan Widjaya

Ivan Widjaya is the Owner/Editor of Noobpreneur.com, as well as several other blogs. He is a business blogger, web publisher and content marketer for SMEs.