This post has been edited to include new information about a stricter standard of employee classification recently adopted by the California Supreme Court.
There's no shortage of advice and warnings about the many pitfalls along the path to small business success. But there's a good reason why so many of these warnings recently have focused on the issue of employee classification.
Employee classification errors are a common problem for small business owners, according to the U.S. Small Business Administration (SBA) and can put a business at risk of serious penalties or even criminal charges. If workers treated as independent contractors are later determined to have been misclassified, a business can be on the hook for back taxes, back wages and benefits, in addition to penalties.
Meanwhile the number of independent contractors, sometimes referred to as the "gig economy," continues to grow. There may be good reasons to use these contractors for short-term projects or to save on payroll expenses, but it is important to understand the distinction between those workers and "employees" for whom withholding state and federal taxes and other rules apply.
Avoiding Employee Hire and Classification Errors
The IRS offers guidance on how to distinguish between an employee and independent contractor that gives significant weight to the concept of control. If a business has the right to control the work process or the financial aspects of the worker's efforts, the worker is likely to be construed as an employee and not an independent contractor. The perceived relationship between an employee and a worker is also relevant, and can be ascertained from a variety of factors, including:
- The existence of written contracts
- Benefits provided to the worker
- The permanency of the relationship
- The degree to which the services provided are key aspects of the business
Understanding how to classify hires accurately not only reduces the risk of penalties for noncompliance, it can also allow a business to accurately assess the tax and business advantages of outsourcing versus keeping work in-house.
Further information is also available in a guide created by the Equal Employment Opportunity Commission.
California and the ABC Standard
Some states, however, including California, have adopted a narrower standard that presumes a worker to be an employee unless an employer can satisfy each condition of a three-pronged standard known as the ABC test. The ABC test establishes that a worker is an employee unless the employer can show the worker is:
A. Free from the control and direction of the hiring entity
B. Performing work that is outside the usual course of the entity's business, AND
C. Customarily engaged in an independent trade, occupation or business
Under the ABC test, if an employer fails to establish any one of these, the worker is considered an employee.
Avoiding Payroll and Tax Payment Processing Errors
Relying on outdated methods of payroll processing can also expose a small business to costly and time-consuming errors and inefficiencies. Accurate and efficient timekeeping and payroll processing are essential no matter how your workforce is classified. Inefficient payroll practices can be a source of significant revenue leakage.
How Efficient Are Your Payroll Processes?
SBS offers a free, no-obligation “payroll check-up” designed to root out inefficiencies and find where you could be using your resources more effectively. Our check-up will show you how you can leverage technology to reduce errors and create more time for focusing on business growth. To schedule your check-up, call or click on the link below to speak with one of our experts. After the consultation, you will receive a printable PDF of your report to keep and share.