Employee or Contractor? What Small Businesses Need to Know

If you are a small business owner who pays other people to work for your business, it’s critical to have them correctly designated as an employee or a contractor. Here is help determining which category applies.

While paying someone as a contractor can be far simpler for the business owner, the government has an interest in ensuring employees — covered by years of employment law that fought for their security and protection — are treated fairly and benefit from the provisions they are due. 

But as a small business owner, in some cases it can be confusing or unclear to determine how your workers should be classified. In order to avoid serious penalties for misclassification of employees as contractors (Rhode Island general law allows for a fine of $1,500-3,000 per employee for a first offense, and up to $5,000 per employee for subsequent offenses, split 50/50 between the state and the employees), it’s worth it to make a correct determination at the start of a working relationship.

How to tell if a worker is an employee or an independent contractor

Joe Degnan, Assistant Director of Workforce Regulation and Safety in the RI Department of Labor and Training, helped us gather some resources to help small business owners make this important determination. Rhode Island’s policies do not differ from federal policies, so one of the first places to turn remains the US Department of Labor (DOL) guidelines. The guidelines parse the relationship into three categories: behavioral, financial, and type of relationship. 

  1. Is the work performed integral to an employer’s business? A contractor who performs the work that a business owner is in business to do (e.g. painting houses, designing software) is more likely to be an employee than, say, someone who performs an ancillary service such as designing a business’s website or providing accounting services.
  2. Do the worker’s managerial skills result in opportunity for profit or loss? Employees are compensated for their time no matter what, whereas contractors take on some risk. For example, a contractor risks losing money on flat-fee projects if the project takes longer than anticipated. 
  3. Relative investment in facilities and equipment. While employers are not responsible for all costs for their employees, in general an employer will cover a vastly larger share of the investment costs related to an employee. Contractors, on the other hand, are likely to cover their own expenses related to office space and equipment required to do their job (computers, etc.).
  4. Skill and initiative. While overall skill level is not indicative, in itself, of a worker’s classification, the level of initiative they take relative to their skill is taken into account. Do they exercise independent business judgment or are they economically dependent? Are they in open market competition with others, for example bidding on their own projects?
  5. Permanency of working relationship. An indefinite working relationship (rather than a time-bound or project-bound relationship) may suggest an employee classification rather than independent contractor status.
  6. Nature and degree of employer control. This subjective category governs categories including wages, work schedule, and the manner in which work is performed. Employees are subject to more control from their employers, while independent contractors generally have more freedom to determine how and where they work, which projects to accept, and whether they are free to work for others either within or outside of a competing industry (for example, an accountant who works with many similar firms within one field because they are well-versed in the regulations and specifics of that industry).

Degnan confirmed that the six guidelines above can be subjective, and are not listed in order of importance. The RI DOL often has to look at the bigger picture that the combination of all guidelines paint to come to a final determination, if they are required to investigate. He also reported that when a DOL representative is tasked with investigating a possible violation, in order to protect employees there is often a presumption that a working relationship is an employer/employee situation, and the burden of proof falls on the business owner to clearly show otherwise. 

If, after evaluating these six criteria, a business owner still feels split, another gauge to help determine status is to think about who would be held responsible for negligence in the current working relationship. If an employee makes a mistake, generally the business itself is held accountable. However, when a contractor is negligent, they are generally responsible for mistakes they make.

Still unsure? 

IRS Form SS-8 can be filled out and sent to the IRS to help with a determination. The IRS also provides helpful instructions for filling out the SS-8

Why does it matter?

Employees are subject to benefits and protections that contractors are not. Generally, employers are responsible for withholding income taxes, withholding and additionally paying Medicare and Social Security taxes, and paying unemployment taxes for any wages paid to employees. Employers may also be legally responsible for some actions of their employees, and are subject to employment law related to hiring employees, letting them go, and providing access to benefits like health insurance and paid time off.

In return, as an “employer” you have more control over what will be done by the employee, when it will be done (including the hours they work), and how it will be done.

Few businesses can be successful without collaboration, support, and delegation. Determining the status of your workers is an important component of setting your business up for long-term success and of treating others fairly, which should always be a priority of the small business community.