For small and mid-sized businesses, every decision about payroll and staffing carries extra weight. One area that often gets overlooked, but can cause major headaches down the road, is worker classification.
Whether someone should be treated as an employee or an independent contractor isn’t just a matter of preference. It’s a legal distinction with real tax and compliance implications. Misclassifying workers has been a hot-button issue for the IRS and the Connecticut Department of Labor (CTDOL) for a while, and enforcement efforts continue to ramp up.
Why Classification Matters
Getting worker classification right touches almost every corner of your business. Employees require payroll tax withholding, employer contributions to Social Security, Medicare, and unemployment insurance, and in many cases, access to benefits like health coverage or retirement plans. Independent contractors, on the other hand, are responsible for their own taxes and benefits.
That distinction may sound straightforward, but if a worker is misclassified, the consequences can be serious. Businesses may find themselves facing audits, back taxes, penalties, and even lawsuits. In short, getting this wrong can drain both your finances and your time.
What Counts as an Employee vs. Contractor?
Both the IRS and CTDOL use a combination of tests to determine classification, often focusing on control and independence. If you dictate how and when the work is done, provide the tools, and expect the worker to be around long term, that person is more likely to be an employee. Contractors, by contrast, generally control their schedules, bring their own equipment, and often work with multiple clients.
It’s worth noting that Connecticut applies particularly strict standards for independent contractors. While the IRS uses a multi-factor test that weighs behavioral, financial, and relationship factors, Connecticut relies on what’s known as the “ABC Test.” Under this standard, a worker is presumed to be an employee unless the business can prove all three of the following:
- A — Autonomy: The worker is free from direction and control in performing their work, both under the contract and in practice.
- B — Business of the Worker: The work performed is outside the usual course of the company’s business, or it’s performed outside of the company’s places of business.
- C — Customarily Independent: The worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed.
If the business cannot satisfy all three prongs, the worker must be classified as an employee. This means that someone who might qualify as a contractor under the IRS’s looser standards (say, a bookkeeper working part-time on projects from home) could still be considered an employee under Connecticut law if their work is integral to the business’s operations.
The Risks of Getting It Wrong
The financial costs of misclassification can quickly snowball. Back taxes and unpaid payroll contributions are just the beginning. Interest and penalties add up fast, and you may also be liable for benefits such as retirement contributions or health insurance that misclassified workers should have received.
And the risks aren’t limited to money. Workers who believe they’ve been denied the rights and protections of employment may bring legal claims, which can damage both your bottom line and your reputation in the community.
Industries like construction, professional services, hospitality, and seasonal shoreline businesses are particularly vulnerable, since contractor arrangements are common and often misapplied.
How to Protect Your Business
Fortunately, there are steps you can take to reduce your risk:
- Put it in writing. Use clear contracts with independent contractors that spell out the scope of work, project duration, and independence of the relationship.
- Review regularly. A role that starts as an independent project can easily evolve into an employee relationship as responsibilities grow.
- Check both state and federal standards. Connecticut’s tests are narrower than the IRS’s, so confirm compliance in both arenas.
- Don’t guess. If you’re uncertain, reach out to us for guidance before making classification decisions or changes.
It can be tempting to rely more heavily on contractors to save costs or simplify payroll. But the short-term savings often pale in comparison to the risks of an audit or lawsuit. Getting classification right not only shields your business from penalties but also helps build a stable, loyal workforce that sees value in the benefits and security of true employment.
If you’re not sure whether your current arrangements are compliant, now is the time to review them. A proactive check-in can save you from costly surprises later.