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Difference Between Onboarding Employees vs. Independent Contractors in the US

For both domestic and foreign companies in the US, the decision to use either employees or independent contractors can have many consequences.  Hiring employees entails a great deal of documentation, and requires a payroll and withholding process that can be costly and time consuming for human resource departments.  For this reason, many companies are turning to contractors to perform the same work without the administrative burden and expense.

While the use of contractors can be much more cost-effective, there are strict guidelines used by the Internal Revenue Service to classify employment relationships, and enforcement is an increasing priority where tax revenues are at stake. Given these issues, it is worthwhile to consider the pros and cons of each type of worker, as well as evaluating the potential for misclassification.

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Hiring Employees

If you decide to use employees, there are a myriad of regulations at both the state and federal level.  Eligibility for employment must be verified with an I-9 form, for both citizens and non-citizens.  All companies must have a formal business entity to run a compliant payroll, which includes licensing and obtaining tax identification numbers.  There are withholding requirements for unemployment insurance, workers’ compensation, social security and income tax, and the employer must also make contributions for unemployment and Medicare funds.

If these steps seem burdensome, employers also have to be mindful of the civil rights protections that extend to the hiring, treatment and termination of employees, and any instances of discrimination could result in a lawsuit.  Although most employment is ‘at-will’, some positions will require employment contracts, along with severance terms and other benefits.  When a company evaluates hiring employees, it is easy to see why employees can be up to 40% more costly than an independent contractor.

Hiring Independent Contractors

Contractors or freelancers are essentially self-employed, and will handle most of the withholding and tax requirements on their own.  There is no need for any employer contributions or documentation, except for issuing a Form 1099 each year that will list the amounts paid to the contractor. There are few liability issues with contractors, although some companies in high-risk fields will want to obtain insurance that covers both employees and contractors.

The simplicity of using contractors has an obvious appeal to companies that are trying to manage costs and do not want the task of running payroll and offering benefits to workers.  However, the US Treasury estimated that over $270 million in wages went unreported in 2013, as more companies attempt to use contractors rather than formal employees. Due to this trend, the IRS is becoming more vigilant in classifying workers, and will scrutinize the essence of the work relationship to make the final determination of either employee or independent contractor.

Factors for Classifying Employees vs. Independent Contractors

While there is no one test for classification, there are key elements that will be used by the IRS to define when an employee relationship exists. The agency defines the relationship according to behavior, financial control and type of relationship.

In general, if the worker is under the control or direction of others, is offered training or skills to complete their duties, receives benefits and only works for one company, then they are likely an employee.  A common situation can arise when a company tries to transition an employee into a contractor relationship to save on costs, with little change in the actual work performed or type of position.  This can be a red flag that may spur tax authorities to review all of the business’s work relationships.

Independent contractors on the other hand will have more than one client, have their own business name and record keeping, set their own hours and perform the work according to their own standards.  If the contractor does not meet these criteria, then the IRS may investigate the company’s practices to see if an employment relationship exists. Following recent trends, it may be the contractor who files a complaint with the Labor Department, asserting that they are entitled to employee wages and benefits because of the nature of their position.

The Consequences of Misclassification

If a contractor is re-classified as an employee by the IRS or Labor Department, the company may be liable for back state and federal taxes and unpaid contributions for Medicare, social security and unemployment insurance.  There may also be amounts owed for overtime and wages that were not adequate under the contractor relationship, as well as other accrued employee benefits.  There is also the potential for penalties if the company was using contractors simply to avoid tax liability.

For companies that are in doubt, the IRS offers a free evaluation with Form SS-8 of the worker relationship, a step that may be worthwhile for companies that are considering use of contractors.

The GEO Solution

One way for companies to avoid the classification dilemma is to simply use the services of a GEO, who will become the employer of record and handle all withholding and payroll requirements in accordance with US law.  Obviously, this will entail the payment of employer contributions and other employee benefits, but will minimize the risk of misclassifying contractors and being subject to back payments and penalties.  The GEO can also assist with all aspects of the employment relationship, and save a company the time and expense of running payroll through human resources.  It may offer an ideal solution for small companies that have a need for compliant payroll processes, but do not have the budget for a DIY approach.

Get in touch to find out more about how an Employer of Record solution can help your company

The information in this article is subject to changes in local legislation.

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