As a small business owner, deciding to expand your team is an exciting undertaking that will hopefully lead to increased productivity and profitability. However, this isn’t the only choice an employer has when growing their business.

Before adding a new member to the team, employers must also determine whether the new hire should be onboarded as an employee or an independent contractor. Choosing the appropriate worker designation has critical legal and financial implications, including rights and entitlements, for both the worker and the business.

This guide will help small business owners identify ahead of the hiring process whether a W-2 employee or a freelancer is best suited for the job.

The DOL’s 'Final Rule' on Employment Classification

The Department of Labor’s “Independent Contractor Status Under the Fair Labor Standards Act” final rule, also known as the “Independent Contractor Rule,” is a proposal to clarify “the standard for employee versus independent contractor under the Fair Labor Standards Act.” Within the final rule, which has a tentative effective date of May 7, 2021, the Department names the following primary pillars for determining worker designation:

  • The potential for worker profit or loss based on their degree of initiative or level of investment made in the work.
  • The type and amount of control leveraged over the work.

In a given hiring situation, if the two foundational worker designation pillars do not signal the same classification status for a given employee, the Department also offers three additional points of evaluation: 1) whether or not the work is considered a component of an integrated production unit; 2) the permanency of the work relationship held between the employee and the worker; and 3) the skill level needed to perform the work.

Solidifying worker designation guidelines protects employee rights as well as freelancers’ independent business ambitions. Of the final rule proposal, former DOL wage and hour division administrator Cheryl Stanton said, "Streamlining and clarifying the test to identify independent contractors will reduce worker misclassification, reduce litigation, increase efficiency, and increase job satisfaction and flexibility."

Related Article: Should You Hire Contractors to Grow Your Start Up?

3 IRS Common Law Factors for Determining Worker Status

In addition to DOL rules, the IRS also evaluates and makes determinations on worker designations. Using IRS Form SS-8, “Determination of Worker Status,” business owners can request that the IRS make a formal decision about whether a specific worker is an employee or independent contractor — because when the IRS says it is imperative for business owners to properly classify their workers, they mean it.

If an employer misclassifies an employee as an independent contractor with no reasonable basis for the determination, the consequences include not only being held liable for employment taxes, but also facing fines and penalties based on a percentage of the worker’s wages.

To help business owners decide how to correctly classify a worker, the IRS asks employers to consider the following common law control factors crucial to understanding the differences in an employee or contractor designation:

1. Relationship

How an employee and a worker engage with each other is key to establishing worker classification. The type of relationship a worker needs to have with their employer in order to perform their duties will help shape the worker’s professional designation.

When to Hire an Employee:

  • If the worker’s services are needed for the long-term or on an indefinite basis.
  • If the work performed is key to the regular operation or success of the business.

When to Hire an Independent Contractor:

Learning Opportunities

  • If requested services can be completed within a specific period of time, having clear start and end dates.
  • If the business does not intend, or does not deem it appropriate, to offer benefits, such as insurance, retirement, paid leave or vacation days, as part of the hiring package.

2. Behavioral Control

The level of control an employer will have over a worker’s processes and workflows is another important factor for determining employment status.

When to Hire an Employee:

  • If the worker will be instructed on how to perform their job, when to work, and what equipment, tools, and resources they will utilize in their role.
  • If ongoing training and evaluation will be provided to measure continued work efficiency and success.

When to Hire an Independent Contractor:

  • If the work can be sufficiently performed under minimal supervision.
  • If the business needs immediate assistance with a project that requires an established, experienced professional with specific expertise, education or skills.

Related Article: Want to Attract and Retain Talent? Consider Offering Remote Workers These Benefits

3. Financial Control

Financial control is one of the most obvious, and important, indicators of worker designation. Yes, onboarding a new W-2 employee means that the employer is responsible for withholding the employee’s taxes, unlike freelancers who pay their own self-employment taxes via a 1099, but the financial implications for accurately classifying an employee extend beyond tax liabilities. For example, freelancers also have the right to pursue other business opportunities within their available markets.

When to Hire an Employee:

  • If the business can invest in equipment the worker will need to do the work.
  • If the employer can reimburse the employee for expenses incurred during the course of the work.

When to Hire an Independent Contractor:

  • If the worker needs to supply their own equipment to perform the job.
  • If the payment for the work is a flat rate, a fixed hourly rate for the duration of the assignment, a project-based fee, or a bid submitted by the worker and agreed to by the business.

No One-Size-Fits-All Approach for Hiring

The decision to hire either a freelancer or an employee cannot be made using a one-size-fits-all approach. While each hiring situation is different, all worker designations should be established using official guidance from the DOL and IRS, as well as with additional counsel from licensed attorneys if necessary.

Small business owners must remember that a single factor, including a work contract, cannot prove freelancer status. You must examine the whole of the working dynamic, especially regarding elements like the employer-worker relationship, behavioral controls including supervision levels, and financial exchanges. When all of these factors are weighed, business owners can confidently make an appropriate employee designation and add a new W-2 employee or freelancer to their team.

fa-solid fa-hand-paper Learn how you can join our contributor community.