Remote Employees vs. Contractors: An Important Distinction

7 minutes, 11 links


Updated March 23, 2023

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Companies typically hire employees and engage a mix of freelancers or contractors. Until more recently in the U.S., this was simply a matter of cost and strategy—hiring contractors helped outsource some work, especially to accelerate a specific project or initiative.

cautionFor U.S. businesses, hiring contractors is financially appealing, as companies don’t need to handle payroll and tax withholding, or provide healthcare or other benefits. It might seem like an easy and less expensive way to expand your remote workforce. But there are federal laws about when someone can be considered a contractor vs. an employee, and getting this wrong can be very painful and expensive.

The IRS worker classification rules suggest that companies consider three aspects of their relationship with someone they are employing:

  • Behavioral control. “A worker is an employee when the business has the right to direct and control the work performed by the worker, even if that right is not exercised.”

  • Financial control. “Does the business have a right to direct or control the financial and business aspects of the worker’s job?”

  • Relationship. “The type of relationship depends upon how the worker and business perceive their interaction with one another.”

Here’s set of questions companies can use to help evaluate this relationship with someone they’re going to hire:

  • Do they have control over how their work is conducted? Are they subject to instruction over process or other work rules? Are they under direct supervision?

  • Can they set their own schedule?

  • Do you provide any benefits or holiday pay?

  • Are they paid only for the work they complete?

  • Can they freely work with other employers?

Violation of these laws can lead to a number of financially significant consequences:*

  • $50 per Form W-2 that was not filed.

  • Penalties of 1.5% of the wages, plus 40% of Social Security and Medicare taxes (FICA) that were not withheld from the employee, and 100% of matching FICA taxes that were not paid by the employer. Daily accrued interest may also be added.

  • Penalty under Section 6651 for failure-to-file Form 941 employment tax return, 5% of the tax amount per month, up to 25%.

  • If the IRS suspects intentional misconduct or fraud, there could be additional fines.

In 2015, home-cleaning startup Homejoy shut down after failing to raise enough additional money while grappling with four separate legal cases of employee misclassification based on Homejoy categorizing all of its cleaners as contractors. Around the same time, other startups like DoorDash, Caviar, GrubHub, and Instacart were all grappling with existing or imminent lawsuits from contractors arguing they should be classified as employees.*

newCalifornia recently passed a sweeping new law, AB5, that makes it significantly harder for companies to employ contractors by closing the gap between what constitutes a contractor and an employee. California makes it close to impossible for employers to engage gig workers (for example, drivers for ride-hailing services like Uber or Lyft) and many other types of service providers (such as freelance writers and editors) as independent contractors. If they don’t have their own independent business, are doing the core work of your company, and you exercise direction over what they do, they must be employees.

As of January 1, 2020, for someone to be classified as an independent contractor in California, they must meet all of these requirements:

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  1. The worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact;

  2. The worker performs work that is outside the usual course of the hiring entity’s business; and

  3. The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed.

cautionViolation of contractor classification according to AB5 could result in fines between $5K and $25K per violation.

newThis is becoming more prevalent elsewhere: the New Jersey legislature is debating a law very similar to California’s, and New York is considering one as well.

Other states have similar, albeit less strict, laws and their own variation of an ABC test like California uses. Be sure to check with the state’s employment bureau or department when considering hiring in a new state.

importantThe remainder of this section applies to full-time employees only, not contractors or freelancers.

Once you hire a remote employee, it’s imperative that you pay attention to the federal, state, and municipal regulations for each new location in which a remote employee works. The laws you are accustomed to complying with where you are located, may be applied, interpreted, and enforced in different ways based on where the worker is. This applies even to federal laws.

importantIn general, California, Massachusetts, New York, Delaware, and New Jersey have the strictest rules. So whenever you’re considering state variations, those are the ones you definitely will want to pay attention to.

cautionYou’ll also want to have a company policy established for how you handle variations in things like parental leave or other benefits that may be mandated by state law—in these cases, some employees may have very different levels of coverage based on where they live. Many remote companies handle this by ensuring everyone is brought up to the best level of coverage across the entire workforce*—but regardless of what you do, ensure that all employees are aware of the policy.

By default, the controlling laws include federal, state, and local. The emphasis is on where the employee works, even if temporarily. This applies to most basic employment rights (such as minimum wage, overtime, and safety issues).* For example, Oracle Corporation learned the hard way that California’s overtime rules applied to its traveling instructors when they worked in California, even though they lived in Arizona and Colorado.*

But some state laws only apply to remote employees as long as they report to a worksite in that state (for example, see the Massachusetts Equal Pay Act).

Keeping Track of Remote U.S. Employee Requirements

When it comes to keeping up with all the laws and regulations for remote U.S. workers, you have roughly three options:

  • Track everything yourself. This means that for every location that you have a remote employee, you manage payroll, benefits, and so on with your own internal HR employees or via external accountants, benefits administrators, lawyers, et cetera. This was what many businesses had to do before more recent SaaS-based HR-service providers came on the market.

  • Mix advisors with services. This typically is a mix of contract legal and financial help paired with some form of service provider that handles most of the payroll, benefits, and related overhead (like Gusto, Zenefits, Bamboo, et cetera—see our list of tools and services for a list of all these providers).

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