Independent Contractor or Employee? The Wrong Answer Could Cost You


If all goes according to plan, your startup should be looking to expand and grow. The necessity to hire someone is often inextricably attached to a startup’s growth and expansion.  Startups looking to add additional workers may elect to hire someone who is classified as subcontractors, temporary agencies, labor brokers, franchising management, or licensing and third-party management as either an employee or an independent contractor.

There are legal and taxable differences between an independent contractor and an employee which is determined by the economic realities of the working relationship between the employer and the worker.  It is the duty of the startup to differentiate between the two. Failure to do so can result in the startup up being assessed by either the state and/or federal penalties. Moreover, failing to correctly label a worker may expose the startup to legal proceedings brought forth by the worker.

What are the Differences Between an Independent Contractor and an Employee?

A startup cannot simply decide how to label a worker. Rather, specific definitions for each exist at both the state and federal level. At the federal level, IRS and Department of Labor definitions control the classification of a worker as either an employee or independent contractor. The IRS’ rules exist for purposes of payment taxation and the DOL makes the distinction to protect workers under wage and hours laws. A startup will be required to pay and/or withhold taxes from its workers according to the corresponding classification. Generally, the IRS uses tests to distinguish between the two classifications:

  • Independent Contractors are more commonly considered those individuals which a startup hires for labor, but ultimately has little control over “the right to control or direct only the result of the work and not what will be done and how it will be done.” The IRS may look beyond the startup’s job control and look at factors such as financial control—this includes manners of payment and reimbursement—or relationships between the parties such as benefits and vacations provided. This definition is more of a balancing test; not one factor is wholly determinative of the business relationship.
  • Employees are considered to be those workers who the startup has hired and over whom it maintains a control over what will be done and how it will be done; the details of the services provided by the worker are much more defined. The startup maintains significant control over its employees and their manner of work.

Startups will be required to comply with state laws regarding the definitions of the employee or independent contractor. Because business laws vary by state, startups should always consult with an experienced employment attorney.

Federal Tax Obligations – an Employee or an Independent Contractor

Whenever a startup hires an employee, the startup is responsible for withholding earnings for purposes of FICA and income tax withholdings. Other tax liabilities in areas such as payroll and health insurance may also be required.

Whenever a startup hires an independent contractor, the tax obligations most often fall on the independent contractor. An independent contractor’s earnings are often subject to self-employment taxes.

Guarding Against Improper Classification

Startups may face federal and/or state penalties from improper classification. Startups should work closely with employment attorneys to help clearly define roles and internal classifications that are consistent with both state and federal definitions.

Likewise, startups that consult knowledgeable employment lawyers are able to better position themselves against potential worker-initiated lawsuits. Startups who misclassify workers could face lawsuits for failing to provide benefits, compensation, or other privileges that would typically be provided to an employee.

Contact a California Employment Law Firm Today

Startups should, from the outset, do what they can to plan their growth and expansion in a manner that minimizes the potential risk of penalties or lawsuits. The skilled and knowledgeable employment attorneys at Startup Company Counsel can work with your startup to clearly define the roles of those it hires in order to guard against risk. Schedule a consultation with one of our experienced startup lawyers by calling 408-441-7555 today or fill out our online form.

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