Employee or Contract Labor: How Do You Classify Your Employees?

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I’m an employer.  In addition to paying wages, I also have to pay payroll taxes and unemployment taxes as well.  I’ll be honest with you.  It can be a pain in the behind.


I’m guessing that a lot of employers feel that way.  Some hate dealing with payroll so much, that they don’t hire “employees” they just make everyone be “contract labor”.   Here’s the thing—misclassifying your employees as contract labor is illegal.


Seriously illegal!  Did you know that employers in Missouri who misclassify their employees as contract labor face penalties between $50 and $1,000 a day per worker and/or up to six months in jail per violation?  In addition to that—yes, there’s more—the employer could also pay a penalty of 25% of the amount that the state was defrauded.  (Yeah, they consider misclassifying employees to be a form of fraud.)   If the employer has no basis for classifying the worker as contract labor, he’ll also be held liable for the employee’s unemployment contributions.


Here’s the big one though:  Knowingly failing to insure workers’ compensation liability under the law is a class A misdemeanor, and is also punishable by a civil penalty of up to three times the annual premium the employer would have paid had it been insured or up to $50,000, whichever is greater.  (You got an extra $50,000 lying around?  I don’t.)


Do I have your attention yet?  If you mess around with labeling employees as contract labor when they should be employees, you’re risking huge fines and jail.   Suddenly, paying those payroll taxes doesn’t seem like such a burden after all.


So how do you know the difference between whether the person you hire should be a contract laborer or if you need to put him on the payroll as an employee?


Here’s a very over-simplified answer:  control.  Who has control of the employee’s work?   Do you set the time and location of the person’s work?  Do you provide all the tools and materials?  That sounds like you have an employee.  Does the worker also work for other companies doing a similar type of work?   That sounds like contract labor.  The quick and dirty analysis is—if you’ve got complete control over the person’s work—then that person is an employee.  If the person does the same work for other people, controls pricing, etc., then they’re contract labor.


It’s not always easy to determine.  Like I said, I just gave an oversimplified answer.  The state of Missouri has a free booklet out that explains it pretty thoroughly.  Here’s a link to get it:  http://www.labor.mo.gov/DES/Forms/M-INF-310-AI.pdf .


If you have any questions about whether your contract laborer should be reclassified as an employee or not, then you need to read the whole booklet.   It’s not a hard and fast “rule book” but rather guidelines of twenty areas that you can look at to see whether your worker falls into the employee or contract labor category.   If you read the pamphlet and you’re still unsure about how you should classify somebody, call the Missouri Department of Labor and talk to one of their representatives.  The main switchboard number is:    573-751-3215.  I had to call them and they were friendly and helpful.


It’s really important to classify your employees properly.  Missouri has the tools you need to make sure you do it right.  If you’re still confused, they’re willing to help.  There’s no excuse for messing this up.

Small Business Owners: Are Your Workers Employees or Contract Labor?

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The biggest issue you’re going to face as a small business owner this year is whether or not the people you hire to work for you are employees or contract labor. This is such a hot topic with the IRS right now that they’re currently running a Voluntary Compliance Program—giving businesses a chance to “change their minds” about how their workers are classified. It’s called the Voluntary Classification Settlement Program (VCSP).

Basically, with the VCSP, if a business has been calling workers contract labor when they really should have been labeled as employees, you get a chance to go in and change your employee’s status before the IRS nails you instead.

So how do you know if you’ve got an employee versus a contract labor situation? That’s a really tough call sometimes and the law isn’t very clear. It’s all based on what’s known as “common law,” which means the issues have been settled in court cases instead of legislation spelling out the rules for us. The basic common law rule that defines an employee is that the service recipient (in English that’s the boss) has the right to direct and control how the service is performed.

Let me use an example: let’s say you hire me to do your taxes for you (Good idea, actually). In this case I would be contract labor to you. You will tell me what you need done, and supply me with the information to do it, but I’m going to use my software programs, my office, my stuff in general. I’m going to do it my own way, when I want to, and wear my pajamas at work if I want. That’s contract labor. (By the way, I never wear pajamas to work but I sometimes wear a St. Louis Cardinals jersey.)

But I used to be an employee at a large tax company. While I was working there, I used my boss’s software, I had certain hours that I had to be in the office, I arranged the paperwork for the files exactly as I was instructed (with the staple in the top left hand corner horizontal to the box in the big numbers in it) etc., etc.. My Cardinals jersey would have been a dress code violation and I would have been sent home. I could have even done your taxes while I was working for that company, but you weren’t really hiring me, you were hiring that company that I worked for.

You see how those two examples are different? Even though there isn’t an absolute, defining definition of what makes a person an employee, it’s sort of like Justice Potter Stewart’s famous quote about obscenity, “…I know it when I see it.”

I work with a lot of clients who are classified as 1099 contract laborers but should be labeled as employees. Most of them will never file a complaint with the IRS for fear of losing what jobs they do have, so employers have been pretty safe up until now. But the IRS isn’t stupid (Yes, I put that in writing). If I can look at a 1099 MISC and figure out that the person is really an employee instead of contract labor, the IRS is able to set up a computer screen and they’re going to be able to target suspicious 1099s as well. Did I mention, they’ve been updating their equipment? Faster, stronger, better—it’s like the $6 million man but more expensive.

So how do the people you hire stack up? If you’re paying people as employees, and properly paying your withholding taxes, then you’ve got nothing to worry about. If you’ve got employees but you’re paying them as contract labor it’s time to take a good hard look and decide if you’re doing the right thing. Using the common law test of “direct and control” are these people really contract labor or should you reclassify them as employees? If they should be called employees, you’ll want to find out more about the Voluntary Classification Settlement Program.

The VCSP has a whole list of requirements and there will be costs attached. Although that’s a little scary, it’s much better than the costs associated with an audit over your worker classification. To find more information about the VCSP, here’s a link to the IRS website: http://www.irs.gov/businesses/small/article/0,,id=246013,00.html

It’s perfectly legal to hire contract labor—it’s a very normal, regular part of business and many businesses couldn’t function without it. When you cross that line, when you’re really hiring employees but you’re just calling them contract labor to avoid paying payroll taxes– that will get you into trouble.

Employee or Contract Labor

With the economy being in turmoil, a lot of people are turning to contract labor jobs. That’s where the company doesn’t hire you as a regular employee, even though you work for it. You won’t receive a W2 at tax time, but you will receive a form 1099MISC and you will be expected to pay tax on that.

Contract labor is good for employers who are a little gun shy over hiring. It’s also good for employees who may need to work to put food on the table, but don’t want to commit to a job that they wouldn’t ordinarily take.

If you’re thinking about accepting a contract labor type job, here’s a few things you should know. First, when you receive a form 1099MISC, the IRS treats that as self employment income. That means, at tax time you’re going to have to file a Schedule C along with your 1040 long form. You will be required to pay your own Social Security and Medicare taxes, in addition to paying what your employer would normally have withheld.

Let’s use an example: Heather and Melanie are both high school seniors looking for summer jobs. Heather gets a job at McDonald’s making $10 an hour. Melanie gets a contract labor position also making $10 an hour. They both work 20 hours a week. Since this is the only income the girls will make all year, we’re not even going to look at regular income tax (they won’t owe any) we’re just going to look at their take home pay and self employment taxes.

Since Heather works as an employee, McDonad’s is required to withhold her Social Security and Medicare taxes (FICA). Heather makes $200 a week, but she’ll only take home $184.70 because McDonald’s will hold back $15.30 to pay her FICA. What most people don’t realize is that in addition to the money McDonald’s holds out of Heather’s paycheck, McDonald’s also pays an additional $15.30 towards Heather’s FICA. At the end of 12 weeks, Heather will have $2,216.40 that she was paid by McDonald’s. She will owe no income tax at the end of the year.

Now let’s look at Melanie. As a contract laborer, Melanie has no FICA withheld from her pay. For one week, she gets a check for $200. At the end of 12 weeks, she’ll have been paid $2,400. The difference here is that Melanie will have a tax bill of $339 that she’ll owe at tax time. After paying her taxes, Melanie will only have cleared $2,061.

[Geek alert: if you checked my math, you’d say. “but 2400 times 15.3% is $367” -and yes, you’re right. The first $433.13 of self employment income isn’t taxed so the actual equation is income x .9235 x .153.]

In our example here, it’s better to be hired as an employee because the company pays half of your payroll taxes. But that doesn’t mean that you should not take that contract labor job. For one thing, you may be able to write off some of your job expenses, which would reduce your self-employment taxes. Or, you might negotiate a higher hourly wage rate. An increase of 7.65% would basically cover the additional tax paid by the employer. Knowledge is power. Knowing how you’ll be taxed and how much you’ll be taxed let’s you make smart decisions.