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  • Writer's pictureChris Reel

How To Properly Classify Independent Contractors & Avoid Hefty Penalties In 2021

There is no denying that a growing business is an exciting business. More customers, more revenue, less worry – what could be better?

There comes a time in the growth process that you will need to strongly consider bringing on some additional hands, and by hands – I mean people. You can either hire people as independent contractors or as employees and there is a huge difference between the two. Getting this right at the beginning is vital for a few reasons, not the least of which is keeping you in the IRS' good books. The last thing you want is the IRS or Department of Labor (DOL) dinging you with tax and other penalties attributed to the misclassification of your workforce.

In 2021, the DOL updated its test for determining whether or not an individual was considered an independent contractor or employee. Here are few factors which the IRS and DOL share when determining whether someone is a contractor or employee.

1. Behavioral Control

Whether or not on paper someone is classified as a contractor will make little difference if you are maintaining control over the hire’s conduct while on the job. Do you control the means upon which they are completing a task? Do they follow particular orders and instructions from your business procedures or are they simply meant to serve as a guide? Do you have an evaluation procedure in place to critique the work that person completed?

If you are allowing the person discretion in their conduct and performance you can make an argument that that individual is properly categorized as an independent contractor. If you are controlling what they do, how they do it, when they do it and so on you are likely misclassifying an employee as a contractor.

2. Financial Control

Another element of control is the financial runway you are providing a person. For example, if you require the individual use particular equipment that is provided by the business there is a strong argument that they are not a contractor, but in fact, an employee. What if you have them pay for such equipment or materials and simply reimburse them? Unfortunately, this too will paint the picture of an employee relationship and not one of a contractor.

Additionally, you have to look at your compensation method? Are you paying them biweekly or on a flat fee per project they are part of? If you are paying them biweekly it is likely that they are taking the form of, at the very least, someone being compensated the same way as an employee. It is suggested that you instead pay them on a flat fee basis per project, have them pay for their own overhead to complete the job (if any) and do not reimburse. It is much easier for the contractor to come up with a reasonable flat fee quote that accounts for their overhead, just as an independent business entity would if they were bidding on the same project.

3. Perceived and Demonstrated Relationship

What sort of relationship does the person believe to be between they and the business? While you may think that with all things considered they are undoubtedly an independent contractor, but are they aware of this?

Important here would be having a very clear cut independent contractor agreement in place that specifically states they are being categorized as an independent contractor, free to make reasonable yet independent decisions and are also responsible for their own tax liability. Without this agreement it becomes that much harder to prove their classification as a contractor and not an employee.

Another tidbit to add into the agreement would be a specified length of time the contractor will be engaged with the company. I like to suggest that this timeline matches up with particular projects and is not so much a length of time arbitrarily set (i.e. 6 month contract). Again this is to continue to paint the picture that they are, in fact, properly categorized as a contractor.

There are a host of other factors that come into play with proper classification of a new or existing hire. Let’s chat if you’re unsure where your worker-bees fall on the spectrum.

We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to properly classify employees and independent contractors and develop the proper agreements for both.We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today to schedule a time to chat with our Ohio and Florida business lawyers.

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