A Guide to Worker Classification: 3 Questions Businesses Must Ask in 2022
Understanding the nuances of worker classification can help your business build the right mix of talent — whether it includes employees, independent contractors or both — to achieve your goals and meet the challenges ahead of you in 2022. Here are some important questions to ask.
As the labor market continues to shift and people reassess their ideal work experience, the gig economy is expected to grow to 86 million people by 2027. In fact, 4 million Americans quit their jobs last July, according to the U.S. Bureau of Labor Statistics, after a peak of resignations in April. Studies by the Morning Consult for Prudential also found as recently as this past October that 46% of full-time employed U.S. adults are planning to, or are actively engaging in, looking for a new job. When it comes to bringing on new types of workers, employers need to understand the importance of accurate worker classification. While there are just two main classification types from a legal perspective, there are nuances and complexities to consider regarding the practical deployment of talent in the workforce.
Here are three questions business and human resources leaders need to ask and be able to answer when they're hiring and onboarding new workers.
1. Will they be an employee or a contractor?
Businesses must classify workers as either employees (full-time, part-time, or temporary) or as independent contractors (freelancers, gig workers or contingent workers). This determines, among other things, how the worker will be paid, what benefits the worker may be eligible for, and which tax forms will be used to report that income.
Understanding how the applicable agency defines the business relationship between an employer and a worker is key to determining whether a worker should be classified as an employee or an independent contractor. The determination is made based in large part on the degree of control and independence the worker has in providing the service to the employer.
In general, workers are more likely to be considered contractors if they have more control over when and how they do their work, such as setting their own hours, working offsite, or using their own equipment. The Common Law Test, which is what the IRS uses to determine worker classification, evaluates the degree of control and independence based on three categories of factors:
- Relationship considerations. When it comes to the nature of the relationship between the employer and worker, the IRS does not require a contract stating the worker is an independent contractor. Instead, it is how the parties work together that determines whether the worker is classified as an employee or an independent contractor. Length of relationship, or permanency, if the services are a key business activity and whether benefits are provided (such as paid time off, insurance, pension, or retirement plan) are used to define an employer-employee relationship.
- Behavioral considerations. These include the type of instruction given and the degree of instruction a worker requires to do the work. Factors such as when and where the work will be performed, what tools and equipment will be used, and who dictates the order and sequence in which the work will be completed are considered.
- Financial considerations. These relate to how much control the employer has over the economic aspects of the worker's job, including the method of payment, opportunity for profit or loss, degree of investment, non-reimbursable expenses and whether the worker's services are available to other businesses.
In addition to determining whether the IRS considers a worker an independent contractor or employee, other federal agencies, such as the Department of Labor, and state and local jurisdictions (county or city), may have additional or different rules for categorizing workers. Its important organizations consult with all pertinent agencies, plus connect with your legal advisors to learn which requirements are in place.
2. How do these considerations affect taxes?
Workers classified as employees are compensated through their organization's payroll, and the business must withhold federal, state, and local taxes from their pay. The employer then reports this information annually by filing a W-2 form for each employee.
Independent contractors, on the other hand, do not have any taxes withheld from their compensation and are responsible for paying applicable taxes, including their federal, state, and local self-employment taxes. Businesses that hire independent contractors are required to file a 1099-NEC form for anyone they've paid $600 or more in a calendar year.
Because businesses don't pay employment taxes or provide benefits for independent contractors, hiring independent contractors can be a way for many businesses to save costs. However, misclassifying workers as independent contractors, even if it's done unintentionally, can result in significant penalties and a requirement to pay unpaid employee wages and benefits, worker's compensation coverage, and employment taxes. Because multiple agencies strictly enforce worker classification status, it's best for organizations to consult with legal counsel on these matters.
3. What other factors should be considered?
When onboarding a new worker, there's more than financial implications to consider. Workers who will be classified as employees come with a long-term commitment, can have a greater impact on organizational culture and require growth and development opportunities. Independent contractors provide businesses with flexibility and a shorter time commitment. They also have more specialized or advanced knowledge and require less supervision.
It's best to take into consideration what type of needs the business has and getting clarity on how those needs can best be fulfilled before starting the search for new workers. This will help to ensure a smoother and more accurate worker classification process from the start.
Pinning down worker classification in 2022
There's a lot for businesses to consider when they're bringing on new workers, especially independent contractors. Technology, like a freelance management system (FMS), enables companies to have a total workforce management strategy by streamlining the contractor onboarding process and providing ongoing support that a thriving business need. Automating how businesses manage freelancers, 1099 contractors and contingent workers through WorkMarket® (an ADP® company) allows greater consistency, compliance, and visibility.
Putting in the effort to understand the nuances of worker classification now can help businesses build the right mix of talent — whether it includes employees, independent contractors, or both — to achieve their goals and meet the challenges ahead in 2022.
See how WorkMarket can enable you to better manage your contractors.