Bosses, beware: The employee v. contractor trap

What if you didn’t have to pay employment tax, worker’s compensation, unemployment, payroll processing fees and all the other costs of having employees? 

Sounds good, right?

It’s a risky bet that many employers have taken in recent years – classifying all or some of their employees as independent contractors to avoid employment costs. Maybe it was advice given by their accountant or just a family friend. Maybe they saw one of their competitors reclassify all of their employees and it seemed like a savvy business strategy.  

Whatever the reason, the number of employees misclassified as independent contractors has risen significantly in the past several years, and the federal government has taken notice. In 2011, the U.S. Department of Labor issued a memorandum of understanding with the IRS stating that they would share information and work together to reduce the incidence of misclassification of employees as independent contractors and the employment tax portion of the tax gap.

 There are many risks associated with misclassifying your employees as independent contractors but usually the most costly is unpaid overtime wages. What happens is this:

               You decide to hire only independent contractors to work for your company. Since you incur very few costs by doing this you can afford to pay these workers a higher wage and attract better candidates than if they were classified as employees. You can also hire fewer people and have them work more hours, which saves on overhead. So you hire 30 people and pay them $20 per hour rather than the $14 per hour that you would pay an employee to do the same job. Since they are not employees they are not covered by federal or state labor laws, so all of your “independent contractors” work 60 hour weeks and you don’t pay them any overtime premium.  

               Then one day the U.S. Department of Labor comes knocking and says that your company is under investigation. During the investigation they determine that the people you had classified as independent contractors are actually employees of your company and therefore covered under federal labor laws.  Then they charge you overtime back wages for the last two years (20 overtime hours per week * $20 per hour * 30 employees * 0.5 * 104 weeks = $624,000) and liquidated damages for the unpaid wages owed (an additional $624,000). Voila! You have a $1,248,000.00 bill due in 90 days.

A simple test to determine if you are misclassifying employees as independent contractors is to ask yourself the following questions:

  1. Are my independent contractors doing the same job as any of my employees?
  2. Do I only have independent contractors?

If you answered yes to either of these questions you are probably misclassifying employees as independent contractors and you should fix it immediately to avoid severe problems down the road.

The complete test of whether a person is an employee or an independent contractor is a little more complicated and includes analyzing several employment-related factors. The IRS has a list of factors as do many state departments of labor but they all boil down to the same question. Are they working for you or are they working for themselves?

Here are the criteria used by the U.S. Department of Labor:

1) The extent to which the services rendered are an integral part of the principal’s business.

2) The permanency of the relationship.

3) The amount of the alleged contractor’s investment in facilities and equipment.

4) The nature and degree of control by the principal.

5) The alleged contractor’s opportunities for profit and loss.

6) The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.

7) The degree of independent business organization and operation.

The risks of misclassifying employees as independent contractors are many and costly. Making an informed decision at the onset of a person’s employment with your company can save you from future liabilities.

Categories: Finance, Management & Leadership