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Converting Contractors to Employees

If your business uses independent contractors, you may eventually need to change one to an official employee. There are several reasons why this can happen—you may want a more permanent arrangement, for example, or the original contract may no longer reflect updated labor rules requiring proper employment. It may even be that the “contractor” has already been treated as an employee as defined by law, requiring a change of status to avoid misclassification penalties. Whatever the reason, we’ll show you how to convert an independent contractor to an employee in this guide.

How to Convert a Contractor to an Employee

There are a few steps you’ll need to take in order to change a contractor’s status to an employee. You should consider the effect the expense of a new employee may have on your company finances, then draw up new contracts, get the necessary personal information needed to file your paperwork and update your payroll.

Determine Costs

You’ll first need to determine if your business can afford to make the contractor an employee. You can approximate a new employee’s salary by multiplying their contractor rate by 2,080 hours (the normal number of hours a full-time employee works in a year).

However, bear in mind that independent contractors’ rates usually reflect the extra expenses and taxes that must be paid as a self-employed person. As a result, the salary you offer may not need to be a straight conversion of their hourly rate when you’ll also be paying employer taxes and likely offering benefits that a freelancer would pay for out-of-pocket.

Make an Offer

Notify your contractor that you plan to make them an employee. Providing them a dated memorandum in writing is useful for record-keeping in the event of an audit. You may have to pitch the contractor with a proper job offer, especially if they are accustomed to freelancing and need an attractive offer as motivation to drop other clients.

When the contractor has agreed to becoming an employee, you’ll need to provide them with a new contract to sign. The contract needs to specify job duties and responsibilities, plus:

  • Schedule and working hours
  • Salary and benefits
  • Time off policy, including sick time and vacation policy
  • Termination policy
  • Privacy terms

Get Employee Information

Start filling the employee’s file with the information you need for taxes, payroll and benefits. You’ll probably have some of this material already from contractor invoices, but you’ll still need to give them Form W-4 for employee tax withholding and Form I-9 to verify US work eligibility. Also collect their information that is relevant to benefits, if necessary, such as number of family members when providing health care.

Update Your Payroll

Add the new employee’s pay rate and frequency to your payroll to ensure they’re paid correctly and on time. Mark them as exempt if they are to be salaried, nonexempt for hourly with overtime. You’ll also need to ensure that the new employee has been included in systems measuring time and attendance, and has access to a time clock, if your business uses one.

After the Conversion

Once the contracts are signed and paperwork is filed, your new employee is ready to get back to work. Depending on the nature of their previous contract work, they might already understand the company culture and the job that they will be doing, or they may require onboarding and orientation. Be sure that the former contractor receives the same treatment and benefits you give other employees under your policies.

After the end of the year of conversion, you’ll also need to provide the employee with Form W-2 (reporting their wages and tax withheld) by January 31. Be sure to also send a copy to the Social Security Administration.

Contractor or Employee?

It’s important to be sure if your worker has the right status as an employee or independent contractor. Frequently changing a worker’s status from employee to independent contractor and back is a good way to flag your business for an audit from the Internal Revenue Service, so be sure you have it right before you file paperwork.

When determining if a contractor should actually be an employee, its helpful to consult the guidelines laid out by the IRS. Essentially, what dictates a worker’s classification is whether a business has behavioral or financial control over them, and the type of relationship the worker and business have. These factors include:

Behavioral controls – Businesses have the right to control and direct employees’ work, while contractors’ work is more self-directed, regarding cases like:

  • Instructions on where, how and when to work, with more specific and detailed instructions usually indicating a worker is an employee.
  • Systems measuring work-in-progress and how it is accomplished vs. evaluating the final result alone.
  • Workers who received training by the business to do a job are highly likely to be considered employees. Independent contractors usually already have training in the skills required.

Financial controls – Whether the business controls financial or business aspects of the worker’s job, as with employees—or not, as with independent contractors, such as:

  • Investment in the equipment the worker uses
  • Reimbursed expenses
  • Freedom to seek out other business opportunities.
  • Regular wages or a flat fee.

Type of Relationship – How do the two parties perceive their interaction:

  • Does the worker receive benefits insurance, vacation or sick pay which are usually provided only for employees?
  • What is the duration of the relationship—is it ongoing indefinitely, or only for a specific project or timeframe?
  • How central are the services the worker provides to the key activities of the business?

What happens when an employee is misclassified?

Since contractor wages aren’t taxed on the side of the company that contracted them, employers are liable for underpaid employment taxes if the IRS finds an employee was misclassfied as an independent contractor. Interest and penalties might also be imposed on the employer.

I may have misclassified a contractor, what do I do?

If a worker was given the wrong status, it’s important to change it as soon as possible. File IRS Form SS-8 to get confirmation of their proper status, and follow the steps above to implement the change, if necessary.

  • If you can prove a reasonable justification for not previously treating a worker as an employee, you may be able to avoid paying extra employment taxes under the rules in Publication 1976, Section 530 – Employment Tax Relief Requirements.
  • The IRS also offers a Voluntary Classification Settlement Program to give employers partial relief when reclassifying workers. With this program, an employer is only required to pay 10% of the employment tax liability that would have been due in the most recent tax year, in addition to waiving liability for interest and penalties.
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