One of the critical decisions you’ll make when growing your startup is how to classify your workers. Are they employees or independent contractors? It’s not just a question of title — it affects legal responsibilities, financial obligations and worker rights.
Though this article will give you a general overview of the concept, it’s important to seek legal counsel or the advice of a Human Resources professional in your jurisdiction. Laws vary by jurisdiction, and misclassification can have significant legal and financial consequences.
Employee
An employee is an individual hired to perform services for your startup, with you controlling what will be done and how it will be done. Employees have specific rights and benefits, such as minimum wage protections, overtime pay and the right to join a union. As an employer, you have responsibilities, including withholding income taxes; paying Social Security and Medicare taxes; and providing health insurance or paid leave benefits, depending on your location and company size.
Independent Contractor
Independent contractors are self-employed individuals hired to perform a task or service. Unlike employees, you don’t control how these tasks are accomplished; you’re more interested in the final product or service. Contractors typically have more control over their work, provide their own tools and often work for multiple clients. There are fewer employer responsibilities — you’re not required to withhold taxes or provide benefits, and employment law protections typically do not apply.
Comparing Employees and Independent Contractors
The key difference between these two types of workers lies in control and independence. Employees are integral to your business operations and perform their tasks under your direction. Independent contractors, meanwhile, bring their expertise to deliver a service or complete a task with minimal direction.
For example, an employee might be a software developer who works full-time on your product, using your equipment and following your management’s instructions. An independent contractor might be a graphic designer you’ve hired to revamp your logo; they decide how to get the work done, use their own equipment and provide the final design by a set deadline.
These criteria can vary based on the jurisdiction and specific context, but they generally revolve around the same concepts.
- Behavioral Control. This factor examines the degree of control the employer has over the work done and how it is accomplished. If the employer sets working hours, provides detailed instructions, offers training or monitors the individual’s performance, the worker may be considered an employee. Independent contractors typically have more autonomy and control over how they complete their work.
- Financial Control. This involves factors such as the method of payment (hourly, salary, project-based), who provides the tools and resources necessary to perform the work, whether the worker has the ability to work for others, and whether the worker can realize a profit or incur a loss. If the worker has made a significant investment in their work and has the potential to make a profit or experience a loss, they are more likely to be classified as an independent contractor.
- Relationship of the Parties. This includes factors such as whether the business provides the worker with employee-type benefits such as insurance, a pension plan or paid time off. A written contract can also be a factor, although it’s not definitive. The permanency of the relationship is another consideration. If the work engagement is expected to continue indefinitely, rather than for a specific project or period, this is generally seen as evidence of an employer-employee relationship.
- Nature of the Work. The degree to which the services are rendered becomes integral to the employer’s business. If the work is a key aspect of the business, it’s more likely the worker is an employee. But if the work is peripheral to the business, the worker could be classified as an independent contractor.
The “economic realities” test is often used in the U.S. under the Fair Labor Standards Act. This test seeks to determine whether the worker is economically dependent on the employer (an employee) or in business for themselves (an independent contractor).
It’s crucial to remember that the totality of the relationship, and not any single criterion, will determine the classification. In ambiguous cases, most states have their own criteria, and some states like California have very strict criteria for contractors.
Please seek legal counsel or the advice of a Human Resources professional in your jurisdiction. Misclassification can have significant legal and financial consequences, so it’s important to get it right.
Why the Difference Matters
Misclassifying an employee as an independent contractor can have serious implications depending on the jurisdiction and extent of misclassification. Here are some potential consequences:
- Back Taxes and Penalties. If you fail to withhold income taxes, you might be held responsible for the full amount that should have been withheld, plus penalties and interest. You may also owe back taxes for Social Security, Medicare and unemployment insurance.
- Wage and Hour Claims. If independent contractors should have been classified as an employee, they may be entitled to minimum wage and overtime under federal and state laws. The company could be liable for any back pay due, plus additional damages.
- Benefits Claims. Misclassified workers may be entitled to employee benefits, including health insurance, retirement contributions, stock options or paid time off. If the worker has paid for these expenses out-of-pocket, the employer may be required to reimburse them.
- Workers’ Compensation and Unemployment Insurance. If independent contractors are injured on the job or dismissed, they may file for workers’ compensation or unemployment benefits. If the worker is reclassified as an employee, the employer may be responsible for these costs.
- Penalties and Fines. Government agencies may assess penalties and fines for misclassification. In some cases, intentional misclassification can lead to criminal charges.
- Legal Fees. If workers challenge their classification in court, the employer may have to pay legal fees to defend against the claim. If the worker prevails, the employer may also be ordered to pay the worker’s legal fees.
These are just a few examples, and the specific consequences can vary based on the jurisdiction, the nature of the misclassification and other factors. It’s always advisable to consult with a legal professional if you have questions about the correct classification of workers. This will help minimize the risk of legal issues and ensure that you are in compliance with all applicable laws.
Special Considerations for Startups
Startups may prefer independent contractors for their flexibility and lower costs, but it’s essential to accurately classify your workers. Misclassification risks can outweigh the benefits. Conversely, hiring employees can increase costs but provide more control over your product or service and promote a more stable, committed workforce. The choice depends on your startup’s needs and long-term goals.
Correctly classifying your workers as employees or independent contractors is crucial for any startup. It impacts your legal and financial responsibilities, affects worker rights and benefits, and can influence your company’s growth and culture. Always consider your startup’s needs and seek professional advice when needed.
