Considering whether you need to hire employees or contractors is one thing. It’s another when it comes to correctly classifying those in your workforce.
Incorrect classification is a dangerous hole to fall into. Research teams have determined that up to 30% of employers in the US may be misclassifying their workers, possibly for cost-saving purposes. US tax authorities are clamping down on employee misclassification, which causes state and federal governments to lose billions annually, greatly affecting the economy and law-abiding taxpayers.1
It also means that employees who are incorrectly classified as contractors or subcontractors are being deprived of benefits and protections that are normally offered to regular employees.
This article aims to assist you in ensuring correct classification of your workers, maintaining compliance with labor laws, and ultimately protecting your firm from legal risks.
What Is an Employee?
In simple words, an employee is an individual who is hired by an employer. They sign a written employment contract and agree to perform services for a company on a regular basis. The tasks to be done and how they will be accomplished is subject to their employer’s control.
Employees typically receive a regular salary. They have withheld taxes and are eligible to receive different company benefits. Under law, employees are also entitled to rights and protections like minimum wage, overtime pay, unemployment compensation, and protection from discrimination.¹
What Is a Subcontractor?
Subcontractors are professionals working under an independent contractor. They are usually hired to complete a specific part of a project. Their responsibilities focus on providing their skills and expertise to help finish the project assigned to the contractor who hired them.
Compared to regular employees, subcontractors have more autonomy over how they complete their tasks. They also follow different payment structures and schedules depending on their contracts. Whether they were brought in for a specific project or to provide service to a specific client, subcontractors are independent workers who take control over the services they provide.
Read more: W-2 vs. 1099: A Clear Guide to Employee Classification and Onboarding
Implications of Misclassification
When you classify workers, it’s vital to file them under the correct categories. What exactly would happen in the event of employee misclassification? The following are just some implications you would want to avoid:
1. Legal Consequences
One of the biggest implications of misclassification is the legal challenges that come with it. Labor law violations can occur when workers aren’t given their appropriate compensation. For example, when you wrongly classify an employee as a subcontractor, they can submit a lawsuit since they weren’t given the benefits they rightfully deserve.
Potential lawsuits, whether from a worker or a client, can lead to further issues for the company. Legal disputes over unpaid wages or wrongful termination can be initiated simply because of misclassification.
Moreover, government agencies like the Department of Labor and the IRS may take your misclassification as a reason to audit your entire business. If misclassification or any other issues are found, you may be issued penalties and other sanctions due to non-compliance with employment laws.
2. Financial Risks
Lawsuits can already be quite costly for your company. On top of this, misclassification may also require you to pay back taxes and fines. From Social Security to Medicare, you may be asked to pay for any incorrectly handled cost. Interest charges can add up. All these imply a significant financial burden for your business.
Aside from being unable to claim tax deductions for payments made to misclassified subcontractors, the price of administrative work necessary to resolve legal battles can be expensive. Paying for legal representation and compliance costs can cause a dent in your business’s finances.
3. Operational Implications
Another implication of misclassifying employees lies in the operational side of your business. When you’re unable to classify your people properly, you’re creating a possible disruption to your company’s daily operations and services.
Reclassifying workers from subcontractors to employees often requires adjustments in staffing and project management. It also affects the compensation package you can offer them.
Employee misclassification, if discovered, can also have a massive negative impact on your organization and employer branding.
7 Questions to Ensure Proper Employee Classification
Aside from knowing their definitions, you can ask the following questions to correctly identify an employee from a subcontractor.
1. What is the nature of the work relationship?
This specific question explores the overall dynamic between your worker and the organization. You need to understand whether your professional is being treated as a part of the business or as an independent service provider.
Remember that employees are required to follow all company policies and procedures. They are expected to fit in with the teams they are put into and are given ongoing responsibilities. Meanwhile, subcontractors are generally more autonomous in how they finish their tasks. They can decide how to accomplish the project-based responsibilities assigned to them.
2. Is the relationship long-term or short-term?
The duration of the work relationship is a key factor in classification. Employees typically have ongoing, indefinite relationships with their employers. They don’t have a specific end-of-contract date. On the other hand, subcontractors are often engaged for specific projects or limited time periods.
A long-term, open-ended relationship points to employee status, whereas a relationship with a defined end date or project completion point suggests a subcontractor arrangement.
3. Does the worker follow set schedules?
The level of control over a worker’s schedule is also a significant indicator of their worker classification. Generally, employees have work hours set by their employers. Some work the usual 9 to 5 while others are assigned night shifts based on the needs of the company. This is quite different from subcontractors who have more flexibility in choosing when to work.
If your firm dictates specific work hours, this suggests an employee relationship. However, if the worker has the freedom to set their own schedule within project deadlines, this points towards a subcontractor status.
4. Who provides the equipment and materials for the job?
Another difference between an employee and a subcontractor is where their resources come from. Subcontractors are professionals who use their own tools and equipment in order to finish a job. They are responsible for procuring their own materials if there is a lack.
In the case of employees, their employer has the responsibility to provide everything they need to finish their tasks. They don’t need to worry about securing the necessary tools.
5. Will the worker be provided with ongoing training?
Providing training for employees is important. It improves engagement and overall retention rates. Research even found that around 94 percent of employees would stay with an organization that invests in their learning and improvement.² With that said, workers who undergo training can be classified as employees.
Subcontractors are independent individuals expected to have the necessary skills and knowledge for their tasks. They require no training from the clients they work with.
6. How do you evaluate this worker’s performance?
The method of performance evaluation can provide insights into the nature of the working relationship that was asked at the top of this list. Employees are typically subject to regular performance reviews based on company-set criteria. They can also receive raises or promotions based on these evaluations.
Meanwhile, subcontractors are usually evaluated based on the outcome of their work or project completion. Instead of performance reviews for bonuses, they are evaluated to find out if the agreed-upon standards are met. Employers double-check if the work subcontractors accomplish aligns with the expectations set at the beginning of their engagement.
7. Does an Employer of Record expert agree with the classification?
If you’re still unsure about the classification of your workers, it’s time to consider asking an Employer of Record. These experts are well-versed in employment laws and regulations. They can provide you with an objective assessment of the working nature and relationship between a client and a professional. They can also review all aspects of engagement to ensure proper classification.
By asking this question, you can gain external validation and assurance. It can help your firm further by mitigating any risks of misclassification and demonstrating due diligence in case of audit.
Read more: Employer of Record Services
Partner with Signature Back Office for Assured Compliance
With experience dating back to 2006, Signature Back Office has been providing top-notch back-office services to staffing firms all across America. When you partner with us, you can rest assured that our team of experts is knowledgeable and experienced in any administrative tasks you need to accomplish.
Avoid employee misclassification and all its implications by reaching out to us today!
References
- National Employment Law Project. “Independent Contractor Misclassification Imposes Huge Costs on Workers and Federal and State Treasuries – National Employment Law Project.” National Employment Law Project, 8 May 2024, www.nelp.org/insights-research/independent-contractor-misclassification-imposes-huge-costs-workers-federal-state-treasuries-update-october-2020
- Coursera. “Employee Training: What It Is and Why It’s Important.” Coursera Enterprise, 13 Jun 2024, www.coursera.org/enterprise/articles/employee-training.
