As a business owner in Tennessee, it’s crucial to correctly classify the people working for you as either employees or independent contractors. Misclassification can lead to significant legal and financial consequences, including penalties from both state and federal authorities. This article will help you understand the differences between employees and independent contractors, the relevant laws, and how to ensure proper classification.

Understanding the Basics

Employees are individuals who work directly for your business. They are typically under your control regarding what work is done and how it is performed. As an employer, you are responsible for withholding taxes, providing workers’ compensation, offering benefits, and complying with various labor laws.

Independent contractors, on the other hand, are self-employed individuals or businesses that provide services to your company. They generally have more control over how they perform their work and do not have the same legal protections as employees. As the hiring business, you are not responsible for withholding taxes, providing benefits, or ensuring compliance with most labor laws.

Federal Law: The IRS Test

The Internal Revenue Service (IRS) provides guidelines to help determine whether a worker is an employee or an independent contractor. The IRS uses the “Common Law Test,” which focuses on three main factors:

  1. Behavioral Control: Does your business have the right to direct and control how the worker does the task? Employees typically follow specific instructions about how to do their work, while independent contractors determine how to complete their tasks.
  2. Financial Control: Does your business control the economic aspects of the worker’s job? Employees are usually reimbursed for job-related expenses, receive a regular wage or salary, and have limited opportunities for profit or loss. Independent contractors typically have significant financial investment in their work, incur unreimbursed expenses, and have the opportunity to earn a profit or suffer a loss.
  3. Type of Relationship: What is the nature of your relationship? Employees often receive benefits such as health insurance, vacation pay, or retirement plans. The relationship is also expected to be ongoing. Independent contractors typically do not receive benefits, and the relationship is usually project-based or temporary.

If most of these factors suggest that the worker is under your control, they are likely an employee. If the worker has more control over their work, they are probably an independent contractor.

Tennessee Law: The ABC Test

In Tennessee, the distinction between employees and independent contractors is particularly important for unemployment insurance purposes. Tennessee uses the “ABC Test” to determine whether a worker is an independent contractor. The ABC Test has three parts:

A. Absence of Control: The worker is free from the control and direction of the business in connection with the performance of the work, both under the contract and in fact.

B. Business of the Worker: The worker’s service is performed outside the usual course of the business of the employer or outside all of the employer’s places of business.

C. Customarily Engaged: The worker is customarily engaged in an independently established trade, occupation, profession, or business.

To classify a worker as an independent contractor under Tennessee law, your business must meet all three parts of the ABC Test. If any part of the test is not met, the worker is likely an employee.

Consequences of Misclassification

Misclassifying an employee as an independent contractor can lead to several negative consequences:

  1. Back Taxes and Penalties: If the IRS or Tennessee Department of Labor and Workforce Development determines that a worker has been misclassified, your business may be liable for back taxes, interest, and penalties.
  2. Lawsuits: Workers who are misclassified may sue your business for unpaid wages, benefits, and overtime. In some cases, they may also file claims for discrimination or wrongful termination under employment laws that do not apply to independent contractors.
  3. Loss of Business Reputation: Misclassification issues can damage your business’s reputation, leading to a loss of trust from both employees and clients.

Best Practices for Proper Classification

To avoid misclassification issues, consider the following best practices:

  • Consult Legal and Tax Professionals: When in doubt, seek advice from a legal or tax professional familiar with Tennessee and federal laws.
  • Use Clear Contracts: Clearly outline the nature of the relationship in written contracts, specifying whether the worker is an independent contractor or an employee.
  • Regularly Review Classifications: Periodically review the status of your workers to ensure they are properly classified, especially as their roles evolve.
  • Keep Detailed Records: Maintain records of the factors that support your classification decisions, such as contracts, payment records, and communication.

Correctly classifying your workers is essential for maintaining compliance with both Tennessee and federal laws. By understanding the differences between employees and independent contractors and following best practices, you can protect your business from costly mistakes and legal trouble.