Dangers of Misclassifying Employees as Independent Contractors


I once rented an office in an executive suite from a man who classified his receptionist as an independent contractor. He thought that since the woman provided services for many clients, she was employed by all of them and thus not his direct employee. Of course, he was wrong and faced a brutal audit when the woman filed her taxes as if she was an employee.

Small businesses are not the only companies caught up in employee classification issues. While many small business owners are just ignorant of the law, larger ones gamble on classification for a strategic financial advantage.

Uber is the most recent company to fall under the governmental microscope. The startup claims its drivers work when and where they want and used their own vehicles so the drivers are independent contractors. The state of California disagreed and recently passed legislation that would force gig economy tech companies to pay the people who deliver the company’s services as employees.

The United Parcel Service believed they could save up to 40 percent of labor costs by classifying their drivers as independent contractors. The drivers disagreed and in 2006 filed a class action lawsuit. In 2010, UPS had to settle and paid their drivers $12.8 million.

States and the federal government have scrutinized companies that classify their employees as independent contractors for a long time. Lately, the attention is being dialed up as states like California require tech companies like Uber to directly employ workers they had previously considered parts of the gig economy.

Whether you are a tech company using an app to connect workers to consumers or a more traditional company that classifies some service providers as independent contractors, you need to understand employment law and how government officials evaluate whether someone is actually on staff.

Why the Government Cares about Classification

Companies hire independent contractors for a variety of reasons. They may be able to hire them on an as-needed basis, not have to provide permanent office space, and not have to provide benefits like vacation time and retirement. Another reason though is that it saves them money in payroll taxes and insurance.

On the one hand, hiring some staff on an independent contractor basis undermines the social contract established after World War II. Government, voters, worker’s rights advocates, and businesses collectively made a series of decisions that would shape the American economy for decades to come. We reached a consensus that employers would pay a minimum wage, limit worker hours, provide benefits like health insurance, and pay a portion of the employee’s payroll taxes. When employers misclassify their employees as independent contractors, the social contract breaks down.

If the only pressure to change the system came from workers, the government might or might not get involved. But when the social contract breaks down, the resulting system creates new budgetary requirements for the government. When government budgets are at stake, legislators tend to respond quickly.

Independent contractors pay all of their own payroll taxes. Instead of the payments being regularly deducted from paychecks though, the contractors pay them on a quarterly basis. Often though, they do not understand the requirement or have already spent the money when tax time rolls around. Therefore, medicare and social security taxes are more difficult and more expensive for the government to collect.

Companies also do not pay benefits to independent contractors. It affects the government when certain types of insurance becomes decoupled from employment.

Contractors are not routinely covered under workman’s compensation insurance. This means when on the job injuries happen, the worker may have to be covered out of the disability insurance fund.

Health insurance has typically been provided to full time workers. With the passage of Obamacare, companies with more than 25 full time employees have been required to provide insurance. For citizens who cannot get group coverage, the government provides an insurance market. In order to make health insurance affordable, they subsidize low and some middle income families. So, if your company skirts the health insurance requirement by classifying some employees as independent contractors, the government has to provide additional subsidies.

The final area of concern for the federal government is that businesses who want to get around e-verify requirements hire undocumented workers as independent contractors. As the federal government aggressively pursues repatriation policies, employers will feel heat about misclassification.

In 2006, the IRS estimated that employee misclassification cost the federal government $2.72 billion. Since then, the types of services provided by the government and the number of self-employed individuals has exploded.

As you can see, there are numerous reasons why the government might have an interest in proper worker classification. The US Department of Labor estimates that about 11 percent of jobs are staffed by people classified as independent contractors. While some of those people have other jobs, the growing numbers of self-employed workers puts a stress on government resources.

When are Workers Independent Contractors?

Two different US government agencies have developed tests to determine whether a worker should be classified as an employee or independent contractor. The Department of Labor has the “Economic Reality” test. Failing it could result in Fair Labor Standards Act fines. The IRS also has a test to determine whether a company is an employer or is legitimately purchasing independent services. Companies failing this test could be required to pay back payroll taxes and fines.

Neither agency’s tests are based on one specific behavior. They look at a number of behavioral criteria and determine whether, on the whole, the worker is properly classified.

The IRS Test evaluates the following considerations:

Control – If a worker can provide a service in the manner they prefer without direct control of a worker’s time, then that worker may be an independent contractor. But if you require people to work specific hours or do the work as directed by the company, they are probably not independent contractors.

Financial – An independent contractor must be able to realize a profit or loss on the work. This means that if all you are paying for is the contractor’s time or for a completed product, you’re probably safe with the independent contractor classification. However, if you provide office space, computers, supplies, etc., your classification could be considered in violation of the law.

Type of Relationship – When you provide workers classified as independent contractors with benefits typically associated with employment, you jeopardize the independent contractor status protections. While it might seem like you’re doing an independent contractor a favor by providing health insurance, a pension, or vacation pay, it actually increases the likelihood that the IRS will say you misclassified them.

The Department of Labor asks a different series of questions that are based on the economic relationship between the parties. They are:

Are the services rendered an integral part of the company’s business? A graphic designer providing a logo to a law firm is not providing an integral service because the firm’s principal business is providing legal services. But, a construction company that hires a crew foreman is using him to build buildings which is what they primarily do.

Is it a long-term relationship? If a worker is expected to provide services on an ongoing basis, there could be a classification problem. While you could have a contract with an IT company to provide intermittent trouble shooting without difficulty, a marketing company could have an issue if they had a long-term contract with a video producer who makes all of their client’s commercials.

Who has invested in supplies and equipment? An independent contractor has his or her own business and provides tools of the trade. An employee uses the employer’s tools including computers, software, supplies, and equipment.

Who has control? Like the IRS, the Department of Labor requires independent contractors to control their own performance. If you ask a blogger to produce 5 articles a week, but do not dictate when and where they write, you’re probably okay. But, if you require a driver to show up at a specific time and place, drive at a certain speed, and perform specific tasks upon pickup and delivery, you run into difficulties. If the worker is expected to work at your site during a specified time over a long or uncapped period, you probably have a problem.

Can the independent contractor make a profit or loss? Independent contractors have independent businesses and can thus turn an investment into a profit. They can also take a loss if they underestimate the opportunity or invest in the wrong tools. If your worker is going to be paid a set salary, they probably do not have the opportunity to make more or less in the short term based on the choices they make, you are most likely in an employer-employee relationship.

Is the independent contractor operating in a competitive marketplace? We sometimes hire service providers for their specialized and specific skills. But, when you have a real independent contractor relationship with a service provider, their services can be purchased on the open market. This means both you could hire someone else and they could work for someone else.

Are you contracting with another business? In many legitimate independent contractor relationships involve hiring a solo entrepreneur, the degree to which the person is operating a legitimate business is a factor. Does the person have their own business license, company or corporate structure, and employees? A home builder who subcontracts with a plumbing company to lay pipes is generally in the clear. Especially if the plumbing company has its own payroll and compliance systems.

The American Community Survey defined an employee as “an individual who earns income in exchange for time spent working one or more jobs.” A good rule of thumb is that if you could see hiring someone for the job absent any financial or regulatory limitations, they are probably an employee and not an independent contractor.

Keep in mind that state requirements may be more stringent than federal ones. States are also taking a second look at the issue as a result of the “Uberification” of the workforce and are considering additional regulations.

Consequences of Misclassification

Businesses are often caught misclassifying employees when the worker alerts the government of the practice. If someone you’ve classified as a 1099 worker reports the money you paid them on their tax returns as employment income, it triggers an audit. Workers may also file complaints with the state or federal Department of Labor which may investigate. If an independent contractor files a worker’s compensation claim or for unemployment benefits, the corresponding agency may look into what is going on.

The IRS and Department of Labor also conduct random inspections to ensure that businesses are compliant even in the absence of worker complaints.

Penalties are different when a company is seen as having made a mistake in classification vs. when they are seen as willfully defying the law.

For instance, typical IRS penalties for unintentional misclassification include:

A $50 penalty for each W2 the company failed to file.

Repayment of wages plus a 1.5 percent penalty

Repayment of FICA taxes owed by the worker plus a 40 percent penalty

Repayment of FICA taxes owed by the company plus a 100 percent penalty.

Failure to Pay Penalty equal to 0.5 percent of the owed taxes each month – up to 25 percent total.

However, if the IRS determines that your company willfully misclassified the employee, the civil penalties include all of the above plus an additional 20 percent of the wages owed and 100 percent of the FICA payment for both the employer and employee.The IRS can also pursue criminal charges which can result in a $1000 fine and up to a year in jail.

It is not uncommon for small businesses to be assessed six figure fines when they have multiple misclassified employees. Phoenix-based Paul Johnson Drywall had at pay $600,000 in back wages and penalties for misclassifying 445 current and former employees. A wide ranging operation by the US Department of Labor targeting construction companies in Utah and Arizona resulted in recovery of over $700,000 in back pay, damages, and penalties.

How to Protect Your Business

If you are unsure about whether an employee can be classified as an independent contractor or whether the government will consider them a worker, you can file a SS-8 Form with the IRS to get a formal determination. During their decision period, you should treat the worker as an employee and withhold payroll taxes.

Your company should also develop internal processes to determine whether someone should be on the payroll or can be legitimately considered an independent contractor. You protect yourself from government attention and penalties if these policies are followed consistently and across departments.

It can be useful to have an outside consultant help you develop these policies. Their expertise can go a long way in making sure you are compliant. They also provide an independent and holistic view of the situation which is uncompromised by office politics.

An Ounce of Prevention…

Some experts predict that as many as 30 percent of jobs could be in the gig economy by 2025. Others say up to 50 percent of American adults could be working as independent contractors as either their primary or secondary source of income in that same period.

As independent contractors move from the margins into the mainstream, politicians will take a closer look at the work arrangement. Opportunistic politicians could capitalize on “worker rights” as a campaign issue. Other governments may see the penalty opportunity as a way to raise additional funds.

Therefore, it is prudent to review the independent contractor situation at your own company now in order to avoid future issues. Proactive policies can protect you in the long term. Or, as your grandmother might have said, “an ounce of prevention is worth a pound of cure.”

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