Many startups do not have employees. They have contractors.
Benefits of hiring contractors over employees include saving time and paperwork. Another benefit is significantly lower operating costs.
According to an evaluation report from the Office of the Legislative Auditor, State of Minnesota, “mandatory costs, including federal employment taxes, workers’ compensation insurance premiums, and state unemployment insurance taxes […] cause hourly rates that are 26% higher than the employer’s cost if the employee was misclassified as an independent contractor” (2007).
However, according to federal law, treating a contractor as an employee with job requirements (or even by having a very long term or indefinite term relationship) means you may have legal obligations such as overtime pay and withholding taxes. You may also face an audit from the Department of Labor (DOL), Social Security Administration, Workers’ Compensation Offices, or Internal Revenue Service (IRS). Results of an audit include fines and penalties. Misclassifying employees may also mean you are denying the individual legal rights, benefits, and protections.
In addition, by misclassifying employees as contractors, you may lose:
- Ownership rights to a contractor’s work
- The ability to reprehend poor performance
- The right to ask the individual to work certain hours, to complete tasks in a specific order, or use certain tools or programs.
- Benefits of having employees at your company, such as better terms and investor interest
What is a Contractor?
A contractor is technically a self-employed individual who has control over when and where he or she completes a job. A contractor also has control over how a job is completed, including which tools he or she uses. Rather than employee relationships, contractors have client relationships.
Other employees/contractor differences include:
- Typically, companies can provide job training to employees but not contractors.
- Employees are usually not free to explore other business opportunities. Contractors are.
- Employees can expect the at-will employment relationship to continue until separation, rather than for a specific project or period as is common for contractors.
- Contractors receive IRS Form 1099 whereas employees receive Form W-2.
- Employees receive employer benefits such as health insurance, whereas contractors do not.
- In Texas, you may not even allow a contractor to provide services in your company’s office.
If you are unsure whether a contractor is misclassified, you can complete IRS Form SS-8. This form is the Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
Keep in mind that your contractors or employees can also complete a Form SS-8 to determine proper classification, and if they are found misclassified, you can be liable for a lawsuit under FLSA or other laws and regulations.
Transitioning a Contractor to Employee Status
When hiring a contractor, you have him or her complete a Form W-9 to Request a Taxpayer Identification Number and Certification. As the employer, you complete a Form 1099 to report payments made to the contractor. You also provide a copy of the Form 1099 to the contractor by the end of the year.
To transition a contractor to employee status, you must file the appropriate forms and associated taxes. Rather than a Form 1099, you file and provide a Form W-2. The IRS outlines employer/employee tax obligations here. You may need to pay back taxes depending on the situation and the amount of time that has passed.
The transition period may be difficult and expensive for the employer, so it is very important to properly classify workers from the start of the professional relationship.