The high cost of worker misclassification

Independent contractors (ICs) offer businesses several advantages. Unlike with employees, you don’t have to withhold income and payroll taxes; make Social Security, Medicare and unemployment insurance contributions; pay overtime; or provide employee benefits.

Treating an employee as an IC has always been risky. But in the last few years, these relationships are being looked at more closely and more often. Revenue-strapped tax authorities are scrutinizing worker relationships and often reclassifying ICs as employees.

What are the risks?

Generally, the biggest risk in worker misclassification is liability for unpaid federal and state income tax withholding; unpaid Social Security, Medicare and unemployment insurance contributions; and penalties and interest. As an employer, you can be held liable for both the company’s share and the employee’s share. And if you don’t have the money, the government may attempt to collect from “responsible persons,” such as certain owners, partners, officers, directors, limited liability company (LLC) members and key employees (such as bookkeepers).

There’s a popular misconception that, as an employer, you’ll avoid liability so long as you’ve filed Form 1099 and the worker has paid all taxes due. But when the IRS concludes that a worker should have been treated as an employee, you can get hit with a 20% penalty even if all the taxes have been paid, among other consequences.

Another serious risk is that employees misclassified as ICs may sue your company to recover employee benefits, overtime pay, unreimbursed business expenses or other amounts associated with employee status.

How can you check if ICs are properly classified?

The first step is to review your relationships with workers who receive Form 1099. Consider that, when assessing worker classifications, the IRS looks at the:

Level of behavioral control. This means the extent to which the company instructs a worker on when and where to do the work, what tools or equipment to use, whom to hire, where to purchase supplies and so on. Also, control typically involves providing training and evaluating the worker’s performance. The more control the company exercises, the more likely the worker is an employee.

Level of financial control. ICs are more likely to invest in their own equipment or facilities, incur unreimbursed business expenses, and market their services to other customers. Employees are more likely to be paid by the hour or week or some other time period; ICs are more likely to receive a flat fee.

Relationship of the parties. ICs are often engaged for a discrete project, for example, while employees are typically hired permanently (or at least for an indefinite period). Also, workers who serve a key business function are more likely to be classified as employees.

The IRS examines a variety of factors within each category. No single factor controls the result, though. You need to consider all of the facts and circumstances surrounding each worker relationship.

How can you protect yourself?

Once you’ve completed your review, there are several strategies you can use to minimize your exposure:

• When in doubt, reclassify questionable ICs as employees. This may increase your tax and benefit costs, but it will eliminate reclassification risk.

• Modify your relationships with ICs to help ensure they’re considered ICs. For example, you might exercise less behavioral control by reducing your level of supervision or allowing workers to set their own hours or work from home.

• Qualify for the Internal Revenue Code Section 530 safe harbor of the Revenue Act of 1978. (See “Worker classification ‘insurance’”.)

Also, consider using an employee-leasing company. Workers leased from these firms are employees of the leasing company, which is responsible for taxes, benefits and other employer obligations.

Handle with care

There’s nothing wrong with continuing to use ICs, so long as they’re properly classified as such. But it’s important to take steps now to minimize your exposure to government claims and worker lawsuits. •