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Contractors vs Employees: Understanding The Risks and Requirements

This post was written by Emily Martin, Owner of Ally HR Partners LLC

Have Contractors instead of Employees? Make sure you know the risks and requirements.

Deciding to have an army of contractors vs. employees isn’t necessarily a business “preference” decision, but one that can have very real legal and financial implications if not made in an educated way. This is especially so as the political winds have again changed at the Federal level, which is going to make this subject less favorable and more risk-prone for businesses, as the Biden administration has already rolled back a more lenient Trump test for deeming a worker a “contractor” vs. “employee”. Businesses need to understand that there are standards that need to be met in order to take someone on as a contractor vs. employee, and also all the implications that come with these distinctions- including penalties if this is not done correctly. 

What’s the current “test”?

There are actually multiple agencies that are interested in the classification of the people working for you. The one most in flux and changing is the Federal standard. NYS has their own test, as well as the IRS. Although each agency slightly varies in the factors it considers, in general, all “tests” focus on the level of control the Company/Employer has over the work being done, as well as the economic independence and freedom of the worker. We will very briefly summarize these factors as they exist under the current federal standard below. As a cautionary point, often the assessment is much more nuanced than the broad strokes listed here, so we recommend discussing this with a professional if you have concerns about the status of your people and want to proceed with maximum peace of mind.

The current Federal assessment is often referred to as the “economic realties test”. The primary focus of this test is how economically reliant the worker is on the Company/employer, which depends on few key factors. 

  • The nature and degree of control you have over the work. Here consider how much freedom your contractor has in getting the work done, including things like their schedule and hours, what they work on, and how they do the work.  If you are controlling most of these factors, chances are this person should be an employee. 
  • Related to the above, another key question is whether your contractor is “allowed” to work for others. First of all, do they have their own registered business, even if sole proprietorship? Can they apply their skills and knowledge to work for others, even in your same field? If you directly or indirectly require this person to work exclusively for you, even for just a certain part of the day, or in a certain industry, it’s likely they should be classified as an employee.
  • The extent to which the person as the opportunity for profit or loss under their own control. Considerations here include whether the person can subcontract work, purchase or use equipment or other resources to do the work, etc. A lot of this may depend on how you pay the contractor- if it’s a fixed hourly rate instead of a flat rate based on delivery of services, which gives them less control of their profit/loss control, then it’s likely your person should be an employee. 
  • Finally, if the above factors are conflicting or the situation is unclear after examining these factors, there are other elements that might be considered when assessing the validity of a contractor relationship. Some other considerations include the permanence of the relationship, whether the person is doing work similar to others who are employees, if the work is directly tied to the deliverables of the business, and how much specialized skill is required for the work being done. 

What does the future hold?

It is widely expected that the Federal DOL will be making a move to make it more difficult for businesses to justifiably classify workers as contractors- wanting to make a push to have business hire employees for tax collection, unionization, and other agenda purposes. For this reason, businesses should keep an eye on this moving target, but also continue to assess their model and really weigh the risks and rewards of going this route vs. hiring, if that is the decision being made. Between Biden’s nominee to the head the DOL, who has a previous history of having a passion for this subject, as well as writing on the wall from the PRO Act, it’s clear that in the next four years, we will see the definition of “employee” broaden, and the scope to have contractors “safely” working for you narrow. Audits and claims on this subject are also likely to increase. States like California already have stricter tests, so even if Federally changes cannot be passed, it’s also possible this could happen on the state level, especially living in NY.  

Why is this important?

There are real implications if someone working for you is deemed to be misclassified. Remember, each agency at both the state and federal level have their own motivations for making sure employees are being classified as employees, and most of it is financially motivated. It’s important you understand what the consequences of each classification are, but also what the penalties could be if you’re found to be in the wrong. 

  • Employees vs. Independent Contractors come with a lot more rules and requirements. When someone is classified as an employee, unlike a contractor, you are now required to comply with all state and federal employment-related laws and rules when it comes to their employment. This means minimum wages, income taxes, unemployment taxes, time off and leave requirements- the list goes on and on. Having employees also means the federal and state DOL agencies have the ability to audit and investigate claims (and collect money) from you for violations of these rules. If you do end up converting workers to employees, make sure you know what these new requirements are (we can help). 
  • You could face serious penalties and back payments if your people are found to be “mis-classified”. This includes three years of back due taxes at both a federal and state level (FICA, unemployment, etc.), criminal penalties or convictions for tax evasion, DOL requirements to pay back due wages and penalties for labor law violations, past due insurance premiums and penalties for worker’s compensation and disability, potential ACA fines- the list goes on. 
  • Audits are likely to be up at both the federal and state level with the changing political winds. So now is the time to take a look at this. 

Tips and Take-Aways 

  • Take a look at your agreements with you independent contractors and consider changing the method of payment if it’s hourly. Also consider specifically defining projects or initiatives that your contractor is being tasked to accomplish, vs. a general contract which buys their time or skill to be applied directly to business deliverables (like an employee). Don’t have a written agreement? You should really get one. 
  • If you’re setting hours, schedules, or work locations and methods in a specific way, consider loosening this control.
  • Finally, there are other advantages to having employees, even if it is more costly to do so (add 30-40% to the base salary for taxes, insurances, etc.). Having a more engaged, inclusive, and collaborative set of individuals working for you has upsides to productivity, efficiency, and profitability that could potentially far outweigh the additional costs of payroll. This is something to consider as well as you weigh all the factors in how to proceed with your current workforce makeup. 
  • Consult a professional if you’re uncertain at all if you could pass the “test” (hi, nice to meet you). If they don’t and you need to hire, we also have all the info you need on how to do that. 


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Have a question about this information, a tough situation you’re unsure how to handle, or just looking for some reassurance? We can help! Ally HR Partners helps HR people, business owners, and other people leaders who are overwhelmed or unsure tackle their problems, and strategically plan to prevent them in the future! Reach us at Emartin@AllyHRPartners.com

This post was written by Emily Martin, Owner of Ally HR Partners LLC, a Buffalo-based HR consulting firm that helps small businesses identify and implement custom solutions to their people problems and opportunities. Often a business’ #1 expense, Ally HR Partners believes your people should be your #1 asset. Through an integrative partnership approach, Ally becomes your internal expert on all things HR including compliance assurance, performance management, and strategic HR initiatives designed to make the most out of your Human Capital. For more information about how Ally can work for you, visit AllyHRPartners.com.

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Step Out Buffalo Business

Step Out Buffalo Business is a business focused publication featuring tips and tricks for entrepreneurs and small business people in Buffalo & Western New York. We write what we know and when we don't know, we ask an expert in the field. We've gained our knowledge through experience growing businesses in various industries.

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