Many employers are moving work towards independent contractors, rather than hiring traditional employees. This arrangement is particularly attractive for federal government contractors who often need to staff projects of short or indeterminate duration….and on short notice. One common circumstance that C2 addresses with its contracting clients is how to handle workers who are “inherited” from a predecessor contractor. Frequently, the predecessor’s workers will be comprised of both employees and independent contractors, and the new contractor taking on those workers automatically assigns these workers the same designation. That misclassification can be a huge mistake for employers. A contractor bears the same responsibility (and same potential misclassification liability) for workers it inherits from a predecessor as it does for workers it hires off the street. So, it’s important to know not just the advantages and disadvantages of using independent contractors, but also the rules surrounding their legitimate use and classification.
A. Advantages and Disadvantages
When hiring an employee (sometimes called a “W2 employee”), the company has more control over the position and classification requirements and the worker’s performance. Employers are allowed to direct employees as to how, when, where, and what to do while on the job. In addition, Employers can provide employees with job specific directions, set work place rules, require particular work schedules, and outline performance expectations, all while having the employee report to a supervisor that directly manages the employee’s work. Employees can grow to become an integral part the corporation, and may even have the opportunity to grow into a more permanent leadership role within the organization, replacing existing managers and leaders that leave for other roles or retire.
On the other hand, some employee responsibilities are better served by hiring independent contractors (sometimes called “1099 employees”). These are workers who are experts in their field and can provide the service independently, without much direction or control by the employer. This role is best suited for a job-specific, temporary, service-oriented task that is not directly related to the company’s core business. Easy to misclassify the contractor’s role. There can be several cost saving benefits for employers who hire independent contractors. Unlike full-time employees, independent contractors are not eligible for employer-provided benefits (e.g., health-care, vacation, sick leave, etc.), and employers are not responsible for providing unemployment and workers compensation insurance. In addition, employers do not have to withhold Social Security and Medicare taxes (FICA) for independent contractors, like they do for their W2 employees.
B. Correctly Determining “Independent Contractor” Status
Unfortunately, deciding which type of worker would best fit your company’s needs is only half the battle. An “independent contractor” relationship can lawfully be established only in limited circumstances. Employers are constrained by the requirements published by the U.S. Department of Labor (DOL) and the Internal Revenue Service (IRS). While the two agencies’ independent contractor “tests” are slightly different, the crux is that employers cannot exercise the same type of control over an independent contractor as they can an employee. Independent Contractors cannot be given company resources (tools, company car, uniform, company computer, company business cards, etc.), cannot be given a specific work schedule, cannot be told when to take lunch, or when to take vacation time, cannot be “supervised” by a company employee, and cannot typically perform the same job that other W2 employees are performing. In addition, the agencies will look to such factors as whether the independent contractor has their own workers’ compensation insurance, performs work for different clients, or is governed by a written independent contractor agreement.
Unfortunately, no one factor stands alone to make the determination, and every situation is different, requiring its own analysis. The IRS suggests that employers examine the entire “work” relationship, consider the extent of the employer’s right to direct and control, and document each of the “test” factors used when classifying workers. One common misconception is that employers and workers can voluntarily choose to enter an independent contractor relationship by simply utilizing a written agreement. A written “independent contractor” agreement is not, by itself, determinative. Rather, the totality of the relationship as compared against the IRS and DOL tests will dictate the correct classification.
C. Legal Ramifications of Worker Misclassification
The classification process is not just imprecise; it may also subject employers to serious legal ramifications for mistakes. Misclassifying workers as independent contractors can result in the IRS demanding payment for unpaid employment taxes, and the DOL demanding that you compensate the worker for statutory minimum wages or unpaid overtime and pay fines for your initial classification errors. In addition, employers can be sued civilly by the worker(s) themselves, often in the form of class actions.
In recent years, the government has been cracking down on companies who deliberately misclassify employees. A report in 2006 by the Government Accounting Office estimated that the federal government lost out on about $3 billion in Social Security, unemployment, and income taxes due to workers being misclassified as independent contractors. States report similar tax losses, which is why government agencies are now taking steps to hold employers responsible. The DOL has partnered with twenty-nine (29) states to share information in order to identify companies and industries where misclassification is a problem…one such industry being government contractors. In 2015, DOL collected more than $74 million in back wages for over 102,000 workers who were misclassified.
D. Employer Best Practices
To avoid getting bogged down in the misclassification morass, be proactive. Regardless of whether you are hiring an individual to fill a vacancy or taking on new workers through a contract award or an acquisition, the best practice is to evaluate the role(s) and make an individualized determination regarding whether each worker is appropriately classified as an independent contractor or an employee under the IRS’ and DOL’s respective tests.
Many classification decisions are a “close call,” with the worker having some characteristics of both an employee and independent contractor. Employers who are unclear about the correct classification may file a SS-8 form with the IRS, where the agency will review the facts and circumstances to officially determine the worker’s status. Unfortunately, it can take up to 6 months for the agency to respond. Therefore, another option is to call the DOL office located in your state and ask to speak with a representative who can assist.
C2 provides strategic HR outsourcing to clients who want to develop optimal workforce strategies and solutions to allow them to be more competitive and profitable. C2 blog posts are intended for educational and informational purposes only.