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Small Business

Employee or Independent Contractor Classification for Small Businesses and Why It Matters

June 22nd, 2016

In 2015, FedEx Corp agreed to set up a $228 million fund to pay for claims from thousands of CA drivers that were misclassified as independent contractors while they should have been employees.

Recently, Uber settled a law suit regarding employee misclassification in CA and MA. Uber will continue to treat drivers as independent contractors though it will pay millions of dollars to thousands of Uber drivers as part of the settlement.

In growing a small business, the owner often faces the same choice – should the small business hire employees or get the help of independent contractors?  Misclassification of the help could be costly, like the settlements from FedEx and Uber.

There are 3 parties affected in this issue of worker classification, the company, the worker, and the government.  The impact of the status classification is summarized as such:

  1. For the company, if a worker is an employee, the company needs to follow labor and payroll laws and provide overtime, health, sick leave, and other fringe employee benefits. In addition, the company needs to match social security and medicare taxes, and pay workers comp, unemployment insurance, etc.  With even one employee, the company needs to withhold employee payroll taxes, make employee payroll tax payments, and file employee payroll tax returns to the IRS and State agencies.With independent contractors, the company just needs to pay for the service, then issue and file form 1099-miscs to the IRS at the end of the year.
  2. Being an employee, the worker is often under the direct control of the company management regarding work schedule, tasks, tools, methods and processes. The employee will receive benefits, workers comp, unemployment insurance and other protections and fringe employee benefits defined under the common law rules.An independent contractor has more control of his/her own schedule, methods, tools, financials, and income taxes but do not receive any of the other benefits that employees receive.
  3. To the IRS and State agencies, the difference is in reporting requirements and tax collections. The net difference on taxes collected is minimum.With employees, the company needs to withhold payroll taxes, match social security, medicare, pay unemployment insurance, and other employee payroll taxes to the IRS and the State.  The company basically works as an agent for the government to collect and report employee payroll taxes.With independent contractors, the tasks of reporting and paying taxes fall on the contractors.  The independent contractor needs to pay the company’s portion of the social security, medicare taxes though the taxable income may be adjusted accordingly with the Form 1040 returns (Schedule SE).

In summary, if a company hires independent contractors, the paperwork is simpler (one form 1099-misc vs. quarterly 941, annual 940, W-2, state reports and regular tax deposits) and the costs for benefits and taxes are lower.

An independent contractor, other than being independent, misses all employee benefits and certain labor law protections and may be liable for slightly higher taxes.

The government may be neutral and impartial since payroll tax impact is minimal.  However, the government will enforce proper worker classification to ensure worker rights are protected and employer responsibilities are met.

The most important question, like the one for FedEx or Uber, is really whether the worker should be classified as an employee or an independent contractor?  Learning from these big companies can help protect your small business from the troubles of misclassification.

We are here to help. If your small business is ready to bring on an employee, Paycheck Manager is one of the best small business payroll software, helping you manage employer payroll and employee payroll taxes.

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