While it is true that hiring an individual as an independent contractor instead of as an employee has the potential to save an employer 30% to 40% percent on labor cost because your do not pay an independent contractor’s payroll taxes or offer them benefits. It is very important that you take some time to consider the hiring of an independent contractor over an employee because misclassifying an employee as an independent contractor can have serious consequences that are both financial and legal.
Some employers loosely call independent contractors 1099 employees- understanding that they are really not employees. 1099 refers to the IRS form that employers are required to issue to independent contractors that are paid $600 or more during the year. The 1099 form is issued at the same time W-2s are given to employees.
This seems fairly straight forward right- I would like to save 30% on my labor cost so I am going to hire independent contractors and over time replace my employees with the contractors. Well not so fast. When you issue 1099s at the end of the year remember you send those to the Federal and State Government and guess what happens to them. The IRS, the Department of Labor and various state agencies review those filings using a variety of criteria. As an employer filing the 1099 forms you are subject to audits by anyone of these government agencies.
If you are audited and it is determined that the company is in violation, the IRS may impose the following penalties in addition to attorney and tax advisor’s fees:
- Retroactive payment of back taxes for the individual
- Interest calculated from the time when payments were due
- Penalty fines of up to 100 percent of the amount due
- Retroactive contributions to the individual’s Medicare and Social Security, federal and state unemployment taxes, and workers’ compensation benefits
So as you can see misclassifying an employee as an independent contractor can be costly.
What to consider when determining Classification
Under the Fair Labor Standards Act (FLSA), the federal courts apply a six-point test to determine whether an individual is considered an employee or an independent contractor. Under the FLSA, federal courts consider the following:
- Nature and degree of control the employer has over the individual
- The individual’s opportunity for profit and loss
- The individual’s investment in the business
- The length of the relationship between the company and the individual
- The skills needed to perform the task
- The amount in which the individual’s work affects the company’s business
In addition to the Fair Labor Standards Act you have to take into account The National Labor Relations Act (NLRA):
- How integral is the task to the business (part of continuous product or specialized assistance)?
- How is the individual compensated (wages versus contracted amount)?
- Does the employer have the right to discipline the individual?
- To what extent can the employer supervise the work?
- What is the nature of the skill required to the complete the tasks? Is this skill specialized and not commonplace within the company?
- Does the individual work for other clients or advertise his or her services as a business?
- Can the individual profit from completing the task?
While hiring an independent contractor rather than an employee can save money and provide some other advantages to companies, it imperative that employers document and update records that can prove an individual’s status as an independent contractor.