Business Advice

Small Business Payroll: 5 Myths of Employee Classification

There has been a lot of talk lately about small business payroll and the misclassification of employees. With the IRS launching a concerted effort to crack down on misclassification, employers are finding it necessary to make sure their payroll is on the up and up. The need for compliance is underscored by an IRS initiative aimed at encouraging states to work with the Department of Labor’s Wage and Hour Division to fix misclassification errors.

The federal initiative may seem to be yet another federal overreach into state affairs. But five pervasive myths of employee classification clearly demonstrate that the initiative is necessary. The issue of misclassification is a big problem because employers do not understand the law. The Department of Labor initiative is designed to correct that.

Here are the five pervasive myths previously mentioned:

#1: All Federal and State Laws Treat Classification the Same Way

It is generally assumed that someone classified as an independent contractor for purposes of paying income tax is also classified the same way under all laws regarding payroll and taxes. That is simply not true.

For example, a person classified as an independent contractor for general payroll purposes may still qualify as an employee under the Fair Labor Standards Act or the Family and Medical Leave Act. It is up to the small business payroll department to know how to classify under each law that affects the way the company does business.

#2: Receiving a 1099 Means One Is Classified as an Independent Contractor

The law defines independent contractors by the work they do, not the means by which they are paid. This means that just because an individual receives a 1099 does not make that person an independent contractor. The 1099 is simply an instrument for recording how workers are paid in order to comply with federal tax law. A 1099 is not evidence that the employer has correctly classified the employee receiving it. At the heart of the matter is how much control the employer has over the individual’s work.

#3: Independent Contractors Are Not Eligible for Unemployment Insurance

Oftentimes, employers and contractors assume that unemployment insurance is not available to independent contractors. That may be true in some cases, but not all. Unemployment insurance is the domain of states; they all regulate it in whatever way they see fit.

#4: Employee Classification Depends on Payroll Status

For the purposes of administering small business payroll, an individual worker may be paid separately from the salary or hourly wages earned by other employees. But not being officially on a company’s payroll does not automatically classify a worker as an independent contractor. Once again, employee classification is determined by the work being performed and the amount of control the employer has over that work. Employment classification is governed by the legal definition of employment, not by how workers are paid.

#5: Once an Independent Contractor, Always an Independent Contractor

Some legitimate independent contractors maintain their independent status for extended periods of time, perhaps five or 10 years. But their status can change if the nature of their work and who controls it changes. Any time an employer or contractor proposes any sort of change in their working relationship, the change should be scrutinized to determine its effect on employee classification.

Small business payroll is governed by complex rules and regulations as evidenced by the employee classification issue. The IRS and Department of Labor are cracking down on employee misclassification, so it behooves business owners and their payroll services to make sure they are doing things correctly.