As you grow your small business, you will need to bring on new hands to help you handle your increased work orders and other tasks. Unfortunately, it’s not as easy as just pulling someone in off the street or picking a name from a pile of applications. You must also decide whether you want to work with independent contractors or hire actual employees. While this may seem like an insignificant distinction, misclassifying your workers can cost you — big time.

The IRS is not known for showing mercy, and they come down hard on businesses that mislabel workers. After all, how your workforce is classified dictates who handles the taxes and how much is owed. Penalties vary from state to state, but one fact is consistent across the country: Misclassification will cost you and your workers when the tax man comes around. If you are unsure how to label your workers, the IRS has laid out three criteria to consider:

1. Nature of Financial Relationship

First, consider the financial aspect of the working relationship. If the worker bears most of the responsibilities, they are probably an independent contractor.

This includes:

  • Reimbursements: Contractors typically absorb and costs and expenses associated with doing business with your company. Employees, on the other hand, are much more likely to be reimbursed for materials, tools and equipment for their job. For example, if a 3D printer is needed, an independent contractor may have to buy one out of their own pocket, while an employee can likely rely on their company to buy one for them to use.
  • Outside jobs: Independent contractors are usually allowed to advertise their services and seek out new opportunities while still working for your business. Employees, on the other hand, generally cannot. In addition, contractors tend to maintain their own visible business location.
  • Payment: Regular employees are guaranteed a regular wage, whether hourly, weekly or salaried. Contractors, on the other hand, are generally paid either a flat fee or a fee based on hours and materials per project. As such, independent contractors can face a profit or loss, while an employee does not; their employer does.

2. How Behavior is Dictated

The behavioral control over a worker is perhaps the most telling criteria of an employee versus an independent contractor.

For regular employees, employers can dictate:

  • Where and when to work
  • What work must be done by specific individuals
  • Who can be hired for assistance
  • What equipment and tools to use, and where to buy materials
  • How to do the job

Independent contractors, on the other hand, are free to work as they please. They may be given a deadline, but they cannot be told to work certain hours during the day or, for example, what software to use. As long as they complete the job on time and deliver their goods or services in the manner requested, they are free to work as they please.

In addition, contractors typically do not receive training on how to do a job from the person who has hired them, while an employee will.

3. General Nature of the Relationship

Independent contractors are typically hired for a short time period. They may be brought on for multiple projects, but each one is considered a new contract. For instance, if you run a design agency, you may have a pool of independent designers on hand whom you may hire for individual assignments. If you become their sole source of income or they otherwise become an integral part of your business, it would probably be wise to classify them as employees. This also applies if you expect the working relationship to continue indefinitely.

If you as an employer provide benefits, such as health insurance, sick pay and paid time off, it should only be provided for regular employees. Providing these benefits for contractors can be considered misclassification and could lead to an audit from the IRS. You and the contractor should have a written contract that dictates exactly what the nature of the relationship will be, and said contract should be followed.

There are any number of ways your small business could be audited, but misclassifying employees is one of the easiest to avoid. By keeping track of who is on regular payroll and who is an independent contractor, you can ensure your business continues to grow with as little interference from the government as possible.