Employee or Contractor? What Tech Startups Need to Know
Originally published on April 30, 2019
Updated on October 27th, 2023
We’ve seen many reasons why startup technology companies use an independent contractor instead of hiring an employee. Maybe you have the occasional need for a worker with a particular skill set. Or perhaps you need more personnel to handle increased business, but you’re not quite ready to permanently grow your staff. You may be hesitant to commit resources to employment when your available capital is uncertain. The gig economy is a natural for startup companies.
Whatever your reason, it’s important to make sure you classify your team correctly. Distinct conditions must be met to consider someone an independent contractor; failure to do so can lead to significant costs, fines and other ramifications.
What’s the Difference?
The U.S. Department of Labor (DOL), the Internal Revenue Service (IRS) and the National Labor Relations Board each have their own rules. However, the basic “common law” standard defined in 1948 focuses on whether the employer is “legally responsible for the acts or omissions of” the worker. The IRS takes it further to encompass three areas of examination:
- Behavioral control – Who possesses the right to direct or control how the worker performs tasks?
- Financial control – Who possesses the right to direct business aspects of the arrangement, such as reimbursement terms?
- Relationship – How do both parties perceive the relationship, whether the worker receives employment benefits, the terms of termination, etc.?
Independent contractors typically set their own hours, scope and other aspects of their work and can serve other businesses in addition to yours. They generally don’t receive employment benefits such as paid time off or insurance coverage, and your company does not have to withhold income, social security and Medicare taxes or pay unemployment wages.
Employees, on the other hand, are generally subject to more rules about their daily work and given the protection and benefits of true employment. While they’re more expensive to hire and retain, they may be longer term and more committed team members due to the financial benefits of being an employee. They’re also more likely to build relationships with your customers, which in turn helps with customer growth and retention.
Follow DOL and IRS Requirements… or Pay the Price
The lower cost of hiring and retaining an independent contractor can be a big benefit to startups. During initial growth (when more help is often needed), these companies don’t usually have much cash or resources to pay for benefits and payroll taxes. Contractors provide a more adjustable workforce solution to support a growing businesses—with the eventual goal of increasing permanent staff as finances permit.
However, sometimes an employer will classify actual employees as independent contractors simply because it’s cheaper or involves less paperwork. It could also happen because the owner (who is often new to running a business) simply isn’t aware of the classification requirements.
When this happens while also providing all the resources needed and perhaps paying by the hour—even with the best of intentions—it is called employee misclassification. Not only does this deny workers their proper protections, it can also result in steep penalties and damage to your company. If the IRS determines that employee misclassification has occurred, the agency could come after your company for any unpaid income tax, Social Security tax or Medicare tax owed on amounts paid.
The Wage and Hour division of the DOL is working with the IRS and several states to combat employee misclassification. To determine whether your company is compliant, you can start by asking yourself a few questions:
- Does my business pay for the worker’s resources (computer equipment, office supplies, etc.)?
- Do I have specific instructions on how tasks are to be performed?
- Is he or she required to work full-time hours for my business?
- Do I pay based on time increments (such as hours or days) instead of for deliverables?
- Does my company pay for business/travel expenses (e.g., visiting a client or attending a conference)?
- Does my company demand that he or she cannot perform similar work for another business?
While there are many additional areas to consider, a “yes” to any of these questions can indicate that the worker should be classified as an employee. Note that having an independent contractor agreement may not provide protection to the company if the other factors suggest employee status. It’s best to consult a human resources consultant or employment attorney to see if any steps are needed to ensure proper classification.
Protect Yourself and Your Company from Liability
Some companies hire contractors because they assume it will protect them from lawsuits regarding the conduct or performance of that person (since he or she is not an actual employee). However, this is not always true.
In liability cases, one test for validity is the customer’s perception about the provider’s employment. Let’s say an independent contractor you hired performs work that results in a lawsuit filed by the customer. If you haven’t made it clear at every stage of the customer relationship that this person is not an employee of your business, the perception is that the practitioner is an employee. Additionally, your liability insurance policy might cover contractors; if it does, the plaintiff’s lawyers often look for such coverage as a source of funding if the plaintiff wins.
How Do I Avoid Misclassifying My Workers?
You can take several steps to demonstrate that a worker is an independent contractor. First and foremost, use a written contract that specifically outlines several aspects of the work agreement. This puts you and the contractor on the same page. Among other things, the contract should:
- Set pricing for work performed or deliverables; pricing should be for results or outcomes, not hours
- State that the contractor can perform the same work for other companies
- Indicate that the contractor decides how his/her work is performed and is not subject to company approval
- Stipulate that the contractor must have his/her own liability insurance (you should also check your own insurance policy to understand how contractors are covered)
Another step is to make sure that resources normally used by employees are not available to the independent contractor. For example, a contractor should not have a company email address, display your logo or use any company-specific materials such as computers, letterhead or appointment cards. He must also bill separately for services rendered.
Additionally, make sure the distinction is made clear to everyone at your company and that they’re using the correct terminology for each person. Even casual references can be misunderstood by customers or used in court to suggest an employer-employee relationship.
Finally, consult an employment attorney. They can supply the correct wording for signs/forms and advise you on the steps to make this important distinction clear to all involved.
As your technology CPAs and HR consultants, we know how tough it can be to staff your growing startup within your small budget. We can help ensure that you’re doing so without violating DOL and IRS requirements.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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