If you’re like a lot of ecommerce business owners we’ve worked with, you’ve probably avoided hiring anyone in your business until you absolutely have to. Hiring strategically is important. However, deciding how to classify your new hires can be ambiguous at times.
Many times, online business owners tend to think hiring contractors is cheaper, easier, and less hassle than bringing on an employee. They’re accustomed to hiring for “projects” and short term assignments, as opposed to managing someone on a regular basis.
If your online business operates exclusively online, you probably don't have an “office” for an employee to go to, making it more difficult to monitor what your hire is doing.
As your business grows, you’re going to find yourself needing more help, more often. Even then, some business owners might continue to designate their hires as contractors in order to avoid payroll taxes and offering benefits packages.
The contractor classification may seem like a convenient workaround. However, it is important to understand what you are putting at risk when you don’t accurately classify your hires.
Common Mistakes in Classifying Hires
The IRS has a whole list of things that will designate your hire to be classified as an employee. News Flash: Getting it wrong could get you in trouble!
The short version of the saga is as follows:
If you as a business owner guide an individual on what to do, how to do it, and when to do it, that makes them your employee.
What If I Make A Mistake?
If the IRS deems you have employees but you've been paying them as independent contractors, you will be liable for back taxes for Social Security and Medicare (15.3%, to be exact, in order to pay both the employee and employer portion). You could also be liable for penalties up to 20% plus interest.
The number of years the IRS could look back and charge you for could be as far back as you started paying them.
There is not much relief here, so make sure you do your due diligence now and make notes and documentation in your files as to why you decided to classify your hire as a “contractor.”
If you’re genuinely unsure, you always have the option to ask the IRS via Form SS-8 and get a ruling from them. It also makes sense to ask someone you trust — whether it be your CPA, lawyer, or business mentor.
How to Classify Your Future Hires
If you have misclassified a hire in the past but haven't been penalized (yet), what should you do?
Correct it now. In addition, document your reasons for classifying your current contractors as such.
I also suggest a contractor agreement that you both sign, detailing those duties and responsibilities of each party.
While I don’t advise business owners to go looking for trouble, if you get a notice in the future, you have proven your intention by correcting the error, and those penalties will be minimal.
If the IRS discovers the past error, you still may be liable for those back taxes, but there’s no sense fretting about that until it happens. Just be aware you are still potentially liable for it.
As you look forward, it’s important to do your research in order to weigh whether your best option is to hire a contractor or a traditional employee.
Consider and document why you believe your new hire is a contractor, versus a W2 employee. Have the person or company sign a contractual agreement to clarify those details. This will help document your decision and will provide a real defense if it is questioned. The agreement should be reevaluated and resigned every year.
I also want to add from experience (my own as well as MANY of our clients) that an employee is much more vested in your business and it's success than a contractor.
When you have an employee, their loyalties are not divided and your control over them and their work is greater. Contractors are fabulous and I'm not knocking them. Just understand the difference, and don't try to build your business on the backs of contractors, as you will most likely get frustrated.
The Bottom Line
While I sympathize with wanting to avoid extra taxes like the plague, you have to make the best decision for the long-term health of your business. Paying penalties on a misclassified hire can be avoided with appropriate due diligence.