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Worker Classification: What’s at Stake?

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Worker Classification: What’s at Stake?

By BarbaraWeltman, Guest Blogger
Published: June 19, 2014

When you need help to run your business, you have to decide whether to hire an employee or outsource the work to an independent contractor. For the most part, independent contractors are on their own when it comes to taxes, insurance, and retirement savings. In contrast, employees are largely your responsibility for these costs. You’re free to opt for the arrangement that works better for your business. But you can’t simply attach a label to a worker and make it stick; it all depends on the degree of control that you exercise. Here’s what’s at stake for your decisions and actions:

Employment taxes

As a rule of thumb, it costs about 10% of a worker’s pay to cover employment taxes, which include the employer’s share of FICA (Social Security and Medicare taxes) and federal and state unemployment taxes. What’s more, in most cases you have to carry worker’s compensation insurance. So it costs more to have an employee than an independent contractor.

The IRS uses various factors to determine worker classification. These factors are grouped into behavioral control (whether you have the right to tell the worker when, where, and how the work gets done), financial (whether you or the worker controls such matters as when payment is made, if there is reimbursement for expenses, and who pays for the tools of the job), and the type of relationship created by you and the worker (what both envision, whether there is a written agreement, and the permanency of the arrangement).

If the IRS challenges your treating a worker as an independent contractor and you lose (you should have classified the worker as an employee), you face back taxes and serious penalties. However, you can voluntarily reclassify workers as employees using the Voluntary Classification Settlement Program. If eligible for the program, the cost is only 10% of the tax for the most recent year, with no interest or penalty. Or you may be able to rely on a safe harbor (called Section 530 relief).

Employee benefits

If you have employee benefit programs, such as a qualified retirement plan, you must include employees. Independent contractors are on their own for retirement savings. The cost of employee benefit programs can add another 10% or more of compensation to your payroll costs.

At present, you don’t have to offer health coverage to employees, but that may change. Whether you will be subject to the employer mandate depends on the number of your full-time and full-time-equivalent employees. Starting in 2016, if you have 50 to 99 such employees, you must provide health coverage of your full-time staff or pay a penalty (companies with 100 or more employees face the employer mandate in 2015). The IRS explains how to figure full-time employees, which means essentially working 30 hours per week.

Government mandates

Employees are protected by a number of federal workplace laws (some only apply if the company has a certain number of employees as indicated in parentheses), including:

  • Age Discrimination in Employment Act bars workplace discrimination of those age 40 and older (20 or more employees)
  • Americans with Disabilities Act barring discrimination on the basis of a physical, mental, or emotional disability and requiring reasonable accommodations for the disability on the job (15 or more employees)
  • Civil Rights Acts bars discrimination in the workplace on the basis of a variety of factors (e.g., race, gender) (15 or more employees).
  • Equal Pay Act mandates equal pay for men and women performing substantially the same work (2 or more employees)
  • Fair Labor Standards Act for minimum wage and overtime rules (2 or more employees)
  • Family and Medical Leave Act for unpaid time off (50 or more employees)

Companies that violate these laws can be subject to government penalties and lawsuits by workers. Employment laws do not apply to independent contractors.


In figuring the real cost of employment, add 15% and 50% of compensation to your budget for taxes, insurance, and benefits for employees (e.g., a $40,000 employee costs you at least $46,000 and, depending upon the benefits package, as much as $60,000). Think about the cost before you add workers to your payroll. And make sure that if you decide to outsource, you do it right. Work with an employment law attorney so that the arrangements you make conform to law requirements.

About the Author:

Barbara Weltman

Guest Blogger

Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser's Small Business Taxes, J.K. Lasser's Guide to Self-Employment, and Smooth Failing as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and host of Build Your Business Radio. She has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter: @BarbaraWeltman.


I think this is a good advice companies need to understand clearly before deciding whether to sign a new contract
I would like to suggest that hiring employees instead of giving a contract is better, because you don't have to dependent on contractor for any work. Though its a bit costly but its worth having a employee rather than giving out an contract.
Very useful article highlighting ways to handle employees, but the employees holds the key, as every importance needs to be paid to nurture them well & should be made totally responsible towards the companies development.
I think this is a good advice companies need to understand clearly before deciding whether to sign a new contract
Dear Admin Thank you for sharing a good information. nice article. Here's what's at stake for your decisions and actions: Employment taxes ... The IRS uses various factors to determine worker classification.more information click here This post was edited to remove a link. Please review our Community Best Practices for more information about how best to participate in our online discussions. Thank you.
Well, this process is very important for the companies in order to get a better work for themselves. When you are in need ofan employee, you should take the benefit up to everything, it doesn't matter wheather you hire an employee or you are going to have a contract outside, what is the best idea is to get most benefit in this process.
Great post, I come across this issue often in my practice, mostly after people start a business and it begins to take off, they come in and see me to "get more legitimate." I find that many small businesses believe it is overly burdensome to either deal with the tax accounting for employees or pay a service to do it for them. Most try to lean the IRS multi-factor test in their favor after an explanation but my position is that the IRS will always favor employee classification, especially where one does not have solid contracts that allocate virtually all control over the "how" of a job to the contracted party; and, the consequences at risk far outweigh any perceived benefit. I find myself wishing for some middle ground for small businesses but am not aware of any. Nonetheless, thank you for pointing out the voluntary classification settlement program, it will become a standard topic in these conversations in future, hopefully help me to convince people to classify appropriately.

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