Classifying workers is one of the important decisions small business owners must make. It’s common for certain company contributors to fall under the “independent contractor” title, including consultants, writers, web designers, search engine experts, secretaries, janitors, machine operators, painters, electricians and other service providers. However, misrepresenting employees as contractors could cost companies big-time, so one must know the definition and the costs of an employee vs. an independent contractor.
DefinitionThe Internal Revenue Service (IRS) looks at three factors to define an employee or an independent contractor: behavioral control, financial control and relationship. Employees are told when, where and how to work. They are given set hours and paid an hourly wage or salary. By contrast, independent contractors work on a project-by-project basis, taking as many hours as they need to complete the task for one set fee. Employees traditionally have most of their tools and financial expenses covered for them by the business, whereas independent contractors may have to purchase their own equipment without reimbursement.rnrnEmployees usually receive benefits that include pensions, health insurance, vacation days and disability insurance, and contractors pay their own way. Independent contractors are also responsible for paying all of their own taxes, as opposed to employees who share the cost with their employers. Generally, employees are hired on a more long-term basis compared with independent contractors.
Employee CostsIn April 2010, the Bureau of Labor Statistics estimated that employer costs for employee compensation averaged $29.71 per hour, with wages accounting for 69.6 percent and benefits averaging 30.4 percent of the total employee cost. They found that civilian employer costs, including private industry and government workers, averaged $2.62 per hour for life, health and disability insurance or 8.8 percent of total compensation. Legally mandated benefits, including Social Security, Medicare, unemployment and workers’ compensation, totaled $2.30 per hour or 7.7 percent. Benefits that include paid leave, vacation, holiday pay, sick days and personal leave amounted to $2.06 per hour or 6.9 percent. Retirement and savings plans cost employers $1.32 per hour or 4.5 percent. Supplemental pay, such as overtime, shift differentials and bonuses, average 73 cents per hour or 2.5 percent.
Contractor CostsAccording to Businessweek Magazine, employers can save up to 30 percent by hiring an independent contractor because they avoid paying payroll taxes, unemployment insurance, workers’ compensation and disability, as well as benefits that include pensions, sick days, health insurance and vacation time. Because independent contractors are considered self-employed, they must pay the federal government 15.3 percent for Social Security and Medicare, as well as any state or local taxes themselves. Classifying regular employees as contractors also gives businesses the freedom to evade minimum wage requirements and overtime mandates as well.
Hidden CostsHowever, the cost of misclassifying employees is steep. The New York Times reports that California Attorney General Jerry Brown won a $13 million judgment against two companies that misclassified 300 janitors. The Illinois Department of Labor was awarded $328,500 in penalty fees from a home improvement company that misclassified 18 workers. In New York State, commissioner M. Patricia Smith says her task force has identified more than 31,000 instances of misclassification, bringing in $11 in unpaid unemployment taxes and $14.5 million in unpaid wages since late 2007.
Many small businesses rely on independent contractors and freelance workers because they’re more flexible — not to mention cheaper. However, the IRS warns that employers may end up paying more in the long-run for this game of dodging the system. “Bloomberg Businessweek” magazine reported that the IRS launched a three-year program in February 2010 that will examine 6,000 companies to look for permanent workers misclassified as independent contractors. President Barack Obama’s 2011 budget includes 100 new positions for caseworkers to pursue litigation if necessary. Most of these actions will target small businesses and the self-employed, says the General Accountability Office. If found guilty of misclassification, employers will be responsible for all past payroll taxes, unemployment taxes, plus interest and penalties. Although many business owners object that the legal definitions aren’t clear enough, the crackdown suggests that it may be better safe than sorry in this case.