Employee Vs. Contractor: The Costly Issue of Employment Misclassification

Many legal issues can arise from the nuances of business and employment law. It is common for companies just starting out to have more contractor relationships since it means you do not need to provide benefits like vacation, holiday, or sick pay. It is also true that you are not required to pay certain taxes and insurances associated with regular employees nor are you responsible for overtime pay rates.

Other ways an independent contractor (IC) differs from an employee

  • A contractor is considered self-employed
  • ICs are not provided certain protections that employees receive under the law
  • They only have rights as a supplier
  • ICs may or may not retain the rights to their work product
  • Income is reported to the IRS via a 1099 (not a W-2)

Misclassification of Workers

The biggest issue arising from employment law in this area is the failure of the organization to accurately classify their workers. The Department of Labor recently issued an interpretation the FLSA or Fair Labor Standards Act to say that it is the nature of the relationship that matters, not the title and not the contractual (paper) specifications. In other words, if you treat your independent contractors like employees, they will be considered as such, under the law.

The IRS is another government entity which is concerned with the misclassification of workers, particularly since there are specific payroll obligations such as withholding requirements and contributions to FICA and Social Security. According to the IRS,

An estimated 3.4 million employees are classified as independent contractors when they should be reported as employees.

In addition, there are state government labor laws that can impact the rights of employers and contractors.

Serious and Costly Penalties

The ramifications of misclassifying a worker can be costly. If the IRS, DoL or State agency receives a complaint, they will conduct an investigation. If they find misclassification did occur they will seek to determine whether it was intentional/ fraudulent or unintentional.

Penalties for Unintentional Misclassification (In addition to state penalties)

  • $50 fine for each Form W-2 the employer failed to file
  • Penalties of 1.5% of the wages earned
  • 40% of the FICA (Social Security plus Medicare) taxes that were not withheld from the employee
  • 100% of the matching FICA
  • Interest accrued on these penalties is assessed from the date of each violation
  • Penalty for failure to pay equal to 0.5% of the unpaid tax liability for each month (up to 25% of the total liability)

Penalties for Intentional or Fraudulent (Not including state agencies)

In addition to the above fees and penalties, the IRS can impose additional criminal penalties, in the case of fraud.

  • $1,000 per misclassified worker
  • 1 year in prison
  • Personal liability for any amount deemed uncollectible from the business entity.

What IS the Difference Between an Employee and an Independent Contractor?

Because it is such a serious offense the DoL and IRS have sought to thoroughly define the relationship standards it uses to differentiate an independent contractor from an employee. They have designated three categories in which the criteria for an employment relationship is established.

Behavioral Controls

  • Employees – must follow instructions given by the employer as to when, where, and how they perform their work.
  • ICs – set own hours, decide how to perform their job, or complete the project. The business reviews the finished project.
  • The more detailed the instructions are that are given to the worker, the more the relationship resembles that of an employer/employee. This is seen as an exercise of control the business has over the worker.
  • Less detailed instruction, therefore, reflects less control. This indicates that the worker is more fits the role of a contractor.
  • If an evaluation system is in place to measure the details of how the work is being performed, this indicates an employer/employee relationship.
  • If the system for evaluation is just the end result, then you could be either an IC or employee.
  • Employees attend classes, meetings, and may be closely supervised during on-the-job to training.
  • Independent contractors are able to perform the work as they choose to complete the job.

Financial Controls

  • Employees are generally not required to invest in the facility and do not supply equipment.
  • ICs invest in their own workplace, equipment, and supplies.
  • Independent contractors are more likely to have unreimbursed expenses than are employees.
  • Employees may also incur unreimbursed expenses, however, on a more limited basis.
  • The P&L of the company doesn’t change the regular pay that its employees earn.
  • ICs can experience profit or loss based on factors such as time spent working on the project.
  • Employees, in general, have one employer.
  • Independent contractors may provide services to an unlimited amount of companies consecutively.
  • Employees are paid with regularity at specific intervals and may be reimbursed business expenses.
  • The independent contractor and business determines how payment is to be made as part of a contract for services. Expenses may be paid by the business or may be unreimbursed.

Type of Relationship

  • A contract itself is not enough to determine the status of a relationship.
  • The IRS may not follow the contract which states the worker is an independent contractor and responsible for paying self-employment tax — if the relationship bears otherwise.
  • The working relationship of the parties is the single determining factor when deciding whether a worker is an employee or contractor.
  • Employees receive benefits including insurance, pensions, vacation days, sick days, and disability coverage.
  • While independent contractors do not typically receive these benefits, the lack of benefits does not mean the worker is an IC.
  • Employees have ongoing employment.
  • ICs are hired for a specific project. When that job completes, so does the working relationship.
  • Often an employee provides services that are a key aspect of the business, which gives the business the right to direct or control the worker’s activities. This is not typical of a contractor relationship.

For many businesses, hiring independent contractors is an attractive and common sense approach. However, don’t make the mistake of believing it to be a simple way of avoiding certain costs. The government has made it clear that it takes enforcement seriously. Violations can be costly, even devastating to your business. Because this is an issue regulated by several agencies, it can be very complex. It is important to accurately classify your employees and independent contractors. The best practice is having separate approaches to the management of both these valuable asset types. Keep in mind the differences and follow the guidelines for reporting income to avoid the pitfalls that can sideline your growing business.

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