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Employee Misclassification: What Happens When You Mistake an Employee for an Independent Contractor

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When you have a new hire, there are a few pieces of information required before running payroll. You’ll need their pay rate, pay frequency, cost center assignment (if applicable), personal information, their preferred method of payment, and a classification. Understanding whether you have an employee or an independent contractor is vital when paying the individual for their hours worked. Misclassification of workers can result in penalties by the Social Security Administration or state governments. 

Employee or Independent Contractor?

Typically a contractor will set their own schedules and use their own equipment, while an employee is told when they will work, at which location, and what they will use to perform the job. If you determine the schedule and location, it’s more than likely you have an employee. When dealing with an independent contractor, the employer can control the results of the work, but not what or how it will be performed. 

If you are unsure if you have an employee or an independent contractor, visit the IRS website for guidance. You can also check their status using the Common Law Test.  The Common Law Test states that if an employer has the right to control what work will be done and how that work will be done, then an employer-employee relationship does in fact exist and that individual is, by definition, a common-law employee and not an independent contractor. 

Types of Control 

Another way to make the determination of whether or not your worker is an independent contractor or an employee is through understanding control. There are three main areas of control to consider:

  • Behavioral control: the right to control the details of the work being done. The amount of instruction given, such as when, where, and how the work is being done, is included. Another key aspect of behavioral control is whether or not the person performing the work has regular training by the person receiving the work. If training occurs regularly, you are thought to have an employer-employee relationship. 
  • Financial Control: the IRS wants to see if the business has the right to direct and control the financial components of the job being performed. An example is if the person you’ve hired tells you they’re going to charge $25 an hour and send you an invoice at the end of the week, you’ve got an independent contractor. If you decide to pay your new hire $16 an hour and cut them a paycheck on a biweekly basis, that’s indicative of an employee. 
  • Relationship control: an independent contractor will sign a “terms of relationship” agreement. This records a specific date the job will be completed or a specific length of time. By contrast, an employee will sign an employment agreement that outlines benefits available to them, such as medical, dental, and PTO. These two documents are important because it provides evidence that an employer-employee relationship does in fact exist.

The Impact of Misclassification 

The IRS handles misclassification differently based on whether they can prove it was done intentionally or unintentionally. For more information, you'll want to reference the Miss Classification of Employee of this IRS link.

Converting an Independent Contractor to an Employee

If you discover you need to switch your independent contractor to an employee, the process is relatively simple. It is recommended to check the US Department of Labor guidelines to be sure that you are choosing the right classification.

Begin by notifying the independent contractor in writing of your intent to convert them to a current employee. Then, you’ll want to set up a new employee file within your database and indicate whether they will be salary, salary exempt, or hourly, and set up a pay frequency for this employee. You must have the employee fill out a W-4 form so that you have their tax withholding information. 

It is important as an organization to know whether you have an independent contractor or an employee. To avoid penalties, complete the Common Law Test and stay up-to-date on changes the Department of Labor or IRS may make.  Using payroll and HR software can make it even easier (and more efficient) to track, document, and edit employee and pay information. 

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