Being a business owner takes grit. Drawing on your hard work and creativity, you do your best to brush up on your financial savvy and make informed decisions—all while running your business.

And your business may just be you—until suddenly it’s not. Hiring employees or partnering with independent contractors marks an exciting time as your business grows—and it presents a whole new set of tax rules and pitfalls to learn about.

In Texas, it’s common to misclassify employees—and that’s bad news! Business owners who misclassify employees can be subject to increased taxes, interest charges, and fines. If you think you’ve misclassified an employee, consult your business attorney—they can help you figure out what’s going on and how to remedy the situation.

Misclassification of employees

An employee is a worker who receives a W2 and an independent contractor is someone who you sign a contract with, right? The answer in Texas is “not necessarily.”

First, it’s important to understand that different states have different ways of determining who’s a W2 employee and who’s an independent contractor. And the Internal Revenue Service (IRS) has its own set of rules.

As a business owner, you need to meet standards set out by the IRS, the Texas Workforce Commission (TWC), and the state in which the employee resides if they don’t live in Texas. (Yes, the upheaval wrought by the pandemic keeps throwing us all for a loop.)

Why misclassification happens

Growing your business to include employees is an exhilarating experience for any business owner, but it also comes with financial burdens. W2 employees receive benefits, must be paid overtime, and necessitate unemployment insurance. Business owners are also liable for their employees. The costs stack up quickly. 

So instead of relying on W2 employees, many business owners prefer to hire independent contractors—people who do work for the business but aren’t employees. It’s easy to assume that so long as the worker signs a contract and you issue them a form 1099 at the end of the year, everything’s good.

But the truth is a lot muckier. Even if you and the worker refer to their work as contract labor, and even if you issue them a 1099, the state of Texas may still classify them as a W2 employee—which can cost you in taxes and interest.

Definitions in Texas

In Texas, determining if a worker is a W2 employee or independent contractor is decided by state standards—not what the worker and the business have decided amongst themselves.

Instead, a broadly inclusive test established by the TWC is used to determine if someone is an independent contractor or not. Of particular importance is the concept of “direction or control.” In other words, the law looks at how much control the business has over the worker.

Does the business owner determine many aspects of the worker’s day-to-day labor? Are the terms of the work decided in a take-it-or-leave-it fashion by the employer or does the worker have the opportunity to negotiate terms?

For all of these questions around control, the measuring stick isn’t how much control the employer typically exercises in practice but how much control they could exercise if they chose to.

Some of the considerations of the Texas common law test in distinguishing between W2 and contract labor are:

• Independent contractors decide when, where, and how the work is done
• Employees receive training, but independent contractors are already trained
• Contractors can hire their own help and support
• Contractors are usually paid by the job, and employees are paid by the hour
• An employer furnishes an employee’s tools and equipment, but an independent contractor provides their own
• Contractors have an independent business and can realize profits or suffer losses; they can also work for more than one business at a time and make their services available to the public
• An employee can be fired, or quit without liability, but a contractor can only be let go if their work doesn’t meet contract terms

Depending on your business, not all of the factors of the full, 20-item common law test may apply—but the test should give you a starting point for determining how the state of Texas might classify the workers who provide services for you.

Staying on the right side of the law

In Texas, workers are presumed to be employees. If your business is audited, it’s up to you to prove that the worker is an independent contractor. Failure to do so can, unfortunately, have financial consequences in terms of taxes and interest.

If you’re unsure about the classification status of your employees, talk with your business lawyer. It’s better to discover a misclassification for yourself and pursue legal remedies now than find out in the course of an audit.

We know you’re working hard. Keep at it—and keep informed.

If you have questions about employee classification or other aspects of Texas business law, contact us. Our experienced Texas attorneys can guide you through the process.