A Simple Way to Classify Workers in Small Business

There's a battle waging regarding how to classify workers in small business.  The Gig economy has significantly blurred the lines between the definitions of employees versus independent contractors.  This blurring has started a war between business owners and the States' Department of Treasury or Taxation.  It's a very important job to set up correctly.

California Proposition 22 - Update 2020/2021

Proposition 22 passed in California, which may give gig employers a breather. But, given the damage COVID-19 has done to the States' Unemployment Insurance funds, I struggle seeing this issue going away anytime soon. Even more so, now that the relief from the Federal Government may be limited.

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That question matters to your small business because there's a war going on over the question of "employee status."  Whether you're a gig worker, service provider, consultant, or one of the hundreds of other kinds of self-employed entrepreneurs, or you hire those kinds of workers, you're a soldier in this war.

USA Today

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In a major win for gig economy companies, CNN projects California voters have passed a costly and controversial ballot measure to exempt firms like Uber and Lyft from having to classify their gig workers in the state as employees rather than as independent contractors.

CNN

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What's the big deal?

How you classify your workers in your small business impacts the taxes you pay.  Employees and employers are subject to employment taxes and withholding.  Employees are also subject to a number of state regulations and laws, such as family leave, sick time, etc.  In contrast, employers of contractors are not.  Employers are required to file a form at the end of the year for each contractor.  After which, the employer's tax obligations end.  So, it is easy to see the appeal to small business employers.

What's the catch?

If this is such a great deal to employers, you might ask, why don't we classify all small business workers as contractors?  Some companies, like Uber try, but here's the catch.  The biggest losers in this war are the States, and they're not happy about it. 

Contractors have to pay their own Federal and State Income taxes but are not subject to paying into workman's compensation, unemployment, and other state employment taxes.  The Federal Government is getting its money, so the IRS isn't the agency you need to worry about.  It's the States. They are losing millions in lost revenue to their workman's compensation and unemployment funds.  So, they are furious. Therefore, they have been very aggressive in challenging how small business workers are classified.

Why should you care?

If a State deems that you are misclassifying your workers in your small business, they will bill you for the back taxes.  Also, these taxes also come with some hefty fines.  The burden is on you to prove the state is wrong.  So, unless you have a staff of lawyers on hand like Uber, it's a costly and time-consuming battle.  Thus, you could stand to owe your back taxes, but also your lawyer's fees, etc.

A simple hack to help with classifying your small business workers

While this is a very grey area in the law, as a fellow businessman, I tell my clients to follow this simple rule: If YOU direct the work, play it safe. Classify the worker as an employee (W2).  Conversely, if THEY tell you how they will do the work, they are more likely a true contractor. 

The easiest way to avoid misclassify workers in your small business is to clearly have a statement of work (SOW) from the contractor prior to the job.  The purpose of the SOW is to have the contractor specify his or her methods, timing, and check-in points. The important distinction is that the contractor through the SOW specifies how and when the work is done, not the contractee.  The contractee can agree or disagree on terms, but once signed, it's set.  Contracts can be altered, but there is a clear paper trail when changes are made. 

This is not a foolproof method, but it does reduce your risk of getting tripped up in this grey area. Â We have some tools that can help.  Ultimately, if you have any specific concerns about your own business, you should probably seek the advice of your attorney.