Employer/Contractor Win/Win Turns into a Lose

Question:

Our business was going under because our payroll costs were eating us alive. Worse, our employees were resigning, one after another, and we couldn’t find the right replacements at a salary cost we could afford.

Then, one of our employees offered to contract with us. He said he’d be willing to do his former job as a contractor and we’d save employer taxes, and thus could pay him enough to make it worth his while. We liked the idea and realized we could offer our current and prospective employees more money if we made them contractors.

I’m surprised more employers don’t do this.

Answer:

Although many employers consider using contractors rather than employees, and some current employees propose this alternative, the strategy has risks for employers.

Two federal agencies, the U.S. Department of Labor’s (DOL) Wage and Hour Division and the National Labor Relations Board agreed in January 2022 that they’d collaborate to strengthen enforcement of the laws they both administer. Their agreement specifically mentioned business models that evade legal accountability, such as misclassifying nonexempt or hourly employees as exempt or salaried employees and misclassifying employees as contractors.

Here’s what you need to know. If either of these two regulatory bodies or the IRS learn you’re paying “in fact” employees as contractors, they’ll review how you manage your contractors and decide whether they’re really employees or contractors.

Will you escape detection? Possibly, however, the IRS has been known to look at the 1099s given contractors who formerly received a W-2. Or the IRS may learn one of your contractors doesn’t pay self-employment tax and look further into the situation. Or your contractor might sustain an injury and want compensation. In that case, an individual who was happy to be considered a contractor but can’t work for a time due to an injury may tell a regulatory agency they were really an employee.

Misclassified employees occasionally file complaints against their employers and demand reparations. These include reimbursements for 401K contributions and paid time off not received. That’s what led UBER to pay more than a $100 million settlement to almost 400,000 drivers in California and Massachusetts after it misclassified them as contractors. Later, a federal court decreed the settlement wasn’t sufficient compensation.

The primary guideline the IRS and other regulatory agencies uses to determine whether your contractors are really employees is who has the right to control the contractor’s work. Do you tell your former employees what you want them to do and when and how you want them to do it? Do you give your contractors instruction of any kind, for example, by telling them that you want to work during certain hours?

Other guidelines include whether they work only for you or for other employers, including your competitors. If an employee is “economically dependent” on you for their financial survival, they may be an in-fact employee. Contractors need to have the opportunity for profit or loss based on their initiative and/or investment.

Will your contractors bring their own tools and equipment with them, or do they use yours, for example your computers? Is the work they do the type of work usually done by someone with a specialty who needs no supervisor, or by someone who works under the employer’s manager? How do you pay them, by the projects they complete or by the hours they log? Is the work they handle an integral part of your business?

Here’s what you pay if you misclassify an employee as an independent contractor:

• $50 for each W-2 you didn’t file;
• 1.5% of the employees’ salaries with interest added; if you pay your contractor more than you would have paid your employee, you pay this 1.5% on a higher salary;
• 40% of the employee’s FICA Social Security and Medicare contributions;
• 100% of the employer’s matching contributions.

If you can’t prove to the IRS and DOL that you didn’t label in fact employees as contractors to evade taxes, they may ask you to pay an additional 20% of all employee salaries you’ve already paid; 100% of FICA contributions for both employer and employee, and up to $1000 in criminal penalties for each misclassified employee. They may also order you to serve a prison of up to one year.¹

If you’d like to explore this further, you will benefit from reviewing the DOL Economic Reality Test for determining if a worker is an independent contractor or an employee protected by the Fair Labor Standards Act. You can find this test on the DOL website, and other “is your worker a contractor or an employee?” on the IRS website.^{2, 3}  

¹ https://justworks.com/blog/consequences-misclassifying-workers-independent-contractors

² https://www.dol.gov/agencies/whd/flsa/misclassification

³ IRS reminds business owners to correctly identify workers as employees or independent contractors | Internal Revenue Service