When hiring, the crucial question every business must answer is: How should we classify this individual — as an employee, independent contractor, or temporary worker? While finding the correct classification can be challenging, it's essential to get it right. After all, misclassification can have significant legal and financial repercussions for your business.
How can your business dutifully follow the rules established by the US Department of Labor (DOL) and the Internal Revenue Service (IRS)? In this guide, we'll walk you through how to classify workers fairly and accurately, helping you avoid costly mistakes and ensuring your business stays on the right side of the law.
Why Employee Classification Is Crucial for Every Business
Most businesses hire a variety of workers, including employees, temps, interns, and contractors. The issue with classification lies in misclassifying full-time employees as contractors to avoid offering benefits or minimum wage, or labeling non-exempt employees as exempt to avoid paying overtime.
Apart from being dishonest, misclassification can result in serious legal and financial consequences. If a business misclassifies full-time employees as contractors, for example, this can lead to:
- Legal Noncompliance: Misclassifying employees can violate federal and state laws, trigger audits from agencies like the DOL and IRS, and result in hefty fines and penalties.
- Financial Implications: Aside from penalties and lawsuits, your business could also be liable for back pay on wages, overtime, and missed employment benefits such as healthcare, retirement contributions, and paid leave.
- Tax Responsibilities: Businesses withhold payroll taxes for employees, but not for contractors. If employees are misclassified as contractors, companies can be responsible for paying any unpaid payroll taxes, often with added interest and penalties.
- Reputational Damage: High-profile employee misclassification lawsuits and investigations don’t exactly do wonders for employer branding. Businesses might have a harder time attracting and retaining top talent due to the bad press.
Types of Employee Classifications Explained
Independent Contractors vs. Employees
Independent contractors — also referred to as freelancers, consultants, or gig workers — are not employees. These self-employed individuals set their own schedules, work with multiple clients, and handle their own taxes. This makes the relationship more like a business partnership than an employer-employee dynamic. If your business works with contractors, you will need to complete Form 1099-NEC to report payments made to them come tax season.
Employees, on the other hand, work for one employer. In exchange for employees’ services, the company pays them an hourly wage or salary, provides benefits, withholds taxes, and makes contributions to retirement accounts. Employees can work full- or part-time and can be exempt or non-exempt. An employee’s tenure at a company lasts until they resign, are terminated, or the role ends.
Full-Time vs. Part-Time Employees
The main difference between full-time and part-time employees lies in the number of hours they work and the benefits they may receive.
- Full-time employees typically work 35 to 40 hours a week, are eligible for benefits, and may qualify for overtime pay.
- Part-time employees, on the other hand, tend to work fewer than 35 hours a workweek, are less likely to receive benefits (but still can, depending on the company), and often have more flexible schedules.
Apart from the Affordable Care Act, which defines a part-time employee as someone who performs “on average less than 30 hours of service per week,” there is no official legal distinction between these part- and full-time classifications. Because of this, employers should clearly state in their employee handbook how they define full-time and part-time employees, benefits eligibility, and any other key distinctions between the two.
Exempt vs. Non-Exempt Employees
The Fair Labor Standards Act (FLSA) is a US federal law that establishes minimum wage, overtime pay, and other labor standards for both government and private employers. Under the law, employees are classified into two categories:
- Exempt employees are not eligible for minimum wage and overtime pay and typically work in administrative, professional, executive, computer, or outside sales roles.
- Non-exempt employees are subject to the rules of the FLSA and must earn at least the federal minimum wage and qualify for overtime pay.
The DOL has a job duties test that helps businesses determine which category an employee falls into. To be considered exempt, employees must meet specific job criteria and earn above a certain weekly threshold. For more detailed information on this topic, read our article Exempt vs. Non-Exempt Employees: Key Differences Explained.
*Check the DOL’s website for changes to employee exemption thresholds.
Seasonal vs. Temporary Workers
While these terms might seem similar, they have important distinctions:
- A seasonal employee is hired to work during a specific time of year when demand typically increases, and they are usually employed for six months or less. Examples of seasonal employment include hiring lifeguards during the summer, ski instructors during the winter, and retail workers during the holidays.
- A temporary worker is hired to fill gaps in the workforce, like covering for an employee on parental leave, with contracts lasting from a few days to several months. Unlike the more predictable seasonal worker schedule, temporary workers might be hired any time of year and typically remain employed until a specific project is finished or need is fulfilled.
Why is it important to keep these straight? The Affordable Care Act (ACA). The ACA’s employer mandate requires applicable large employers (ALEs) — those with 50 or more full-time employees who work 30 or more hours per week — to offer health insurance to full-time employees and their dependents. Failure to do so can result in penalties.
While it’s less typical for seasonal employees, temporary and seasonal workers may both qualify as full-time under the ACA if they consistently work at least 30 hours per week for more than a few months. That classification would entitle them to health insurance through the employer. For more information on the considerations surrounding ALE status and coverage under the ACA, consult legal counsel.
The Legal Risks of Misclassification
Two key government agencies oversee worker classification to ensure businesses comply with tax regulations, protect employee rights, and classify talent correctly. They are:
- The IRS: Focuses on tax compliance, ensuring businesses withhold and pay employment taxes (e.g., income taxes, Social Security, Medicare taxes). Misclassification can trigger audits, fines, back taxes, and interest from the IRS.
- The US Department of Labor: Oversees labor rights and ensures non-exempt employees receive minimum wage, overtime, and benefits. Businesses that violate DOL rules can face penalties and be required to pay back wages and cover legal fees.
Misclassified employees can also hold businesses accountable, as workers who believe they’ve been improperly classified can file a claim.
Financial Implications for Businesses
While classifying employees as contractors to avoid providing benefits, paying overtime, and meeting a set minimum wage may seem enticing in the short term, misclassifying employees can be a costly endeavor. If caught, businesses must provide employees:
- Any unpaid wages, including missed overtime and sometimes interest
- Retroactive benefits, including healthcare, retirement, and paid leave
- For any unpaid work-related expenses
They may also be on the hook for paying:
- Missed payroll taxes
- Fines and penalties for labor law violations
- Any legal costs from lawsuits and settlements
The largest misclassification case to date? In 2015, FedEx agreed to pay $228 million after the Ninth Circuit ruled its ground division mislabeled more than 2,000 California drivers as independent contractors. It's clear that any perceived savings from misclassifying employees as contractors are far overshadowed by the associated risks.
Employee Classification and Company Culture
Employees, temporary workers, and contractors may all have different expectations for their relationship with your business. To build a company culture that resonates with your entire workforce, consider these key tips:
- Adopt more inclusive policies. Different employee classifications can create silos, especially if contractors or temps feel excluded from benefits, communications, or team activities. A strong culture and inclusive practices — like inviting everyone to team events and all-hands meetings — help ensure all employees feel valued, regardless of their status.
- Recognize everyone. Ensure that employees of all types are equally recognized for their contributions to your company. Celebrating the wins of your entire team can significantly boost engagement and make part-time, temporary, or contract workers feel appreciated by your company.
- Invest in employee experience. Each employee group is different. To identify employees’ priorities, assess how well you're meeting them, and find areas for improvement, consider using employee surveys. Survey insights can help you offer tailored perks and initiatives that foster loyalty across your workforce.
- Treat employees fairly. Misclassification often occurs when employers seek to cut costs in the short term. Proper employment classification ensures that employees receive the rights and benefits they’re entitled to, helping foster a sense of fairness and respect within the workplace.
Best Practices to Ensure Compliance
This step-by-step employee classification guide provides valuable tools to help your business remain compliant and minimize the risk of misclassifying your workers. As with any complex topic, consulting legal experts can help with your specific situation.
1. Understand legal requirements and tests.
There are a few federal and state tests to help you determine the best employee classification for an individual. To determine if an individual is an independent contractor or an employee, businesses can use the following:
- The IRS common law rules
- The FLSA economic reality test
- The ABC test, in some states
Though the above tests each have unique criteria, all examine three core factors: behavioral control, financial control, and the nature of the relationship. These factors assess the degree of control a business exercises over a worker, helping provide a basis for accurate classification.
2. Clearly document work agreements and contracts.
Document, document, document. Create formal contracts or working agreements for every new individual you hire. These should outline the terms of employment or contract work and specify things like roles, responsibilities, and expectations.
For independent contractors, your employment relationship agreements should clearly state that the worker is responsible for their own taxes, benefits, and work expenses to avoid confusion.
3. Regularly review contracts and working relationships.
Roles and responsibilities change over time, so periodically reviewing your worker classifications can help ensure they still meet legal criteria and allow you to make necessary adjustments as changes occur.
4. Consult legal and employment experts.
It never hurts to have an extra pair of eyes looking out for your business. Consider hiring a legal or employment consultant to help your business accurately classify new and existing workers. These resources often specialize in labor law and can provide invaluable advice, especially when faced with more complex cases.
5. Stay prepared for audits.
To keep your business prepared for audits, properly document and maintain comprehensive records of worker classifications, contracts, and payments. A human resources information system (HRIS) like Lattice HRIS can organize your records, track worker performance and projects, and ensure that all documentation is easily accessible in case of an audit.
Protect your business and employees with proper classification.
Get employee classification right the first time. With the tools and insights you’ve gained from this article, your business will be better equipped to classify workers accurately and avoid costly missteps.
The best way to stay organized and protect both your business and your employees? Lattice HRIS. By consolidating all your HR data and processes into one unified, reliable platform, Lattice helps streamline operations, ensure compliance, and improve the employee experience. Schedule a demo to see how Lattice HRIS supports administrators, executives, HR teams, and employees with a system that everyone loves to use.
