Various work arrangements exist, and sometimes there are even subcategories within each. For example, companies in Raleigh may exclusively hire employees, including part-time and full-time or salaried ones. Other North Carolina businesses may only take on independent contractors (ICs) or have a hybrid arrangement consisting of employees and ICs. As a company owner or member of upper-level management, you must realize that there are notable distinctions between the independent contractor vs. employee classifications. Continue reading below, where we’ll discuss the legal distinctions and implications associated with each.
Understanding the Legal Distinctions Between Employees and Independent Contractors
Simply put, an “employee” (sometimes referred to as a “W-2 worker”) is someone who works directly for and under the direction of a company or a business owner. The Code of Federal Regulations (CFR) and more specifically, 26 CFR § 31.3121(d)-1(c), spells out how the Internal Revenue Service (IRS) views a relationship as an employment relationship when the employer “has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.”
In contrast, an “independent contractor” (sometimes referred to as a “1099 worker” or, incorrectly and problematically, as a “1099 employee”) is described as being free to perform his or her tasks or functions at the individual’s own discretion with regard to means and methods. Given their arrangement with the employer, ICs must report and pay their own income and self-employment taxes as compared to employees, for whom employers are required to withhold deductions from paychecks for taxes income taxes and government programs like Medicaid, Social Security, and unemployment insurance.
Workers Are Commonly Misclassified as Independent Contractors vs. Employees
Employers often misclassify their workers as “independent contractors” instead of as “employees” without the workers’ knowledge, by having the workers fill out the wrong tax paperwork and then not making any withholdings from their paychecks. Although unlawful, employers may do this for a number of reasons, including to avoid common employer obligations, including:
- Having to make payroll deductions: Employers must withhold taxes used to pay for government programs like Social Security, Medicaid, and unemployment, whereas that’s required of them if they have independent contractors.
- Offering health insurance: Per the Internal Revenue Service, under the Affordable Care Act (ACA), employers with at least 50 full-time workers must provide health insurance to at least 95% of their staff. The smaller a company is, the more likely it is that it will solely hire independent contractors or have a hybrid arrangement to avoid providing insurance.
- Complying with minimum wage and overtime pay obligations: The N.C. Department of Labor outlines how a Fair Labor Standard Act- and Wage and Hour Act-compliant role is one where workers must be paid no less than the federal minimum wage, which corresponds with the North Carolina minimum wage, and is currently at $7.25 per hour for up to 40 hours of work and pay and a half for overtime (so hours over 40 in one week); although there are exceptions to this rule for certain exempt employees. There’s little to no oversight for pay for independent contractors.
- Having to offer additional employment benefits: Employers with just independent contractors don’t have to worry about offering paid annual or sick leave or workers’ compensation, the latter of which is insurance that the North Carolina Industrial Commission says all employers with three or more employees must have.
- Making contributions to retirement plans: Employers get out of paying toward a worker’s 401(k) and other types of retirement accounts if they’re not bona fide employees.
Implications Associated With Errors in Classifying Workers
Hiring employees instead of independent contractors involves extra work and added costs as an employer. However, you shouldn’t let that push you into misclassifying your workers thinking that will relieve you of obligations to purchase workers’ comp coverage, pay overtime, or comply with other governmental requirements, as there may be fines levied and back taxes due for doing so. Specifically, since 2017, the North Carolina Industrial Commission has maintained a fully-staffed “Employee Classification Section” whose main purpose is to investigate and then pursue those employers who have misclassified their workers as “independent contractors” instead of as “employees.” Moreover, in the case of a worker getting hurt on the job, your company may be sued for damages without the protection of an insurer to cover the costs if you have misclassified that worker as an independent contractor.
In addition, the IRS tests a multitude of factors to determine whether a worker should be classified as an employee or IC. The U.S. Department of Labor also has its own criteria, which it has recently updated, and we recently wrote about that here.
As a law firm that assists business startups with incorporation and aids existing Raleigh companies with operational matters, Wilson Ratledge supports its clients with a wide range of matters, including workers’ comp defense. We are ready to support you with your company’s needs to ensure you don’t land on the wrong side of the law and incur unnecessary costs. Contact our law firm to schedule a consultation with a business law attorney to discuss your company’s legal needs.