Monday, January 2, 2012

The Independent Contractor Trap: Don't Misclassify Your Employees

Many start-up and expanding companies prefer to engage the services of a independent contractor rather than hire an employee because of the high costs relating to employment taxes, health insurance and other benefits.  Recognizing the cost savings of hiring a contractor, businesses will often seek to classify a new hire as a independent contractor believing all that is needed is a few revisions to their standard contract that identifies the person as an "independent contractor" and just like that the company has saved thousands of dollars.  In reality, the company may have created a huge red flag for a potential audit that could result in the obligation to pay susbtantial taxes plus penalties.  To avoid the Employee/Independent Contractor trap, consider the below guidelines for determining whether in fact you have hired an employee rather than engaged an independent contractor.

I.  Why do Businesses Often Prefer to Classify a Person as an Independent Contractor?

Whether because a company may be a start-up or an emerging or larger company is concerned about the difficult economic environment, businesses often prefer to classify a person as an independent contractor for the simple reason of cost.  Hiring an “employee” means the company has to withhold taxes and pay social security, and will have to offer health insurance and possibly other benefits (i.e., vacation/maturity leave, etc.)

II. Can't I Just Label the Person an Independent Contractor?

No, it is a common misconception that employees/companies can avoid the "employee" label by simply stating the person is an independent contractor in a services agreement between the parties.  Moreover, the fact that the person waived any rights as an employee, signed a statement asserting he/she is an independent contractor or is issued a 1099 instead of a W-2 does not give the employer any cover.  The tax authorities (and courts) examine the nature of the relationship between the person and the company, look at the facts as to how the person provides the services, and does not care about labels or other efforts made to classify an employee as an independent consultant.

III. What Distinguishes an Employee from an Independent Contractor?   

There is no single factor distinguishing an employee from an independent contractor.  Instead, courts examine all the facts to determine the degree of supervision, direction and control the company exercises over the services.  If the company controls the manner and means by which the person provides the services, the worker is likely an employee rather than an independent contractor.

      A.  An Employer-Employee Relationship May Exist if the Employer:

            1.  Controls when, where and how the services are to be performed
            2. Provides the tools to perform the services (facilities, equipment, tools, supplies)
            3.  Engages and requires the person to work exclusively for the employer
            4.  Exercises supervision over the person, requiring reports, setting the work schedule, establishing the pay rate, retaining the right to review and approve the work product and/or evaluate the person's performance

            5.  Offers compensation in the form of a salary or an hourly rate, and/or reimburses expenses
            6.  Engages the persons who are unskilled or casual workers (therefore requiring supervision).

    B.  Independent Contractors Generally Supervise, Direct and Control the Performance of their Duties.

            1.  When performing the services, the independent contractor is not supervised or subject to the direction of the company, instead controlling its performance of the services.

            2.  The independent contractor generally offers his/her services to the public, operating their own business separate from the company engaging the services.

            3.  Indicia of independence include:
                  (a)  Using own tools, equipment and supplies   
                  (b)  Operating under a business entity (has a business) that assumes risks
                  (c)  Seting fees, project schedule, paying own expenses
                  (d)  Offering services to other companies
                  (e)  Marketing the services
                  (f)   Engaging own employees or third parties to assist
For additional guidance, see the following IRS publications:,,id=99921,00.html

IV.  What if a Company Misclassified an Employee as an Independent Contractor?

If the IRS determines that your company has misclassified en employee as an independent contractor you need to be prepared to pay substantial taxes and potentially interest and penalties, especially if it was not an honest mistake.

Where the IRS finds that the misclassification was an honest mistake on the part of the employer, and the employer filed proper returns, the employer will be liable for (a) the employer FICA obligation that should have been paid in the first instance, (b) 20% of the employees FICA that should have been withheld, (c) 1.5% of the total compensation paid to the person, (d) any amounts due for unemployment tax, and (e) possibly interest and penalties.

If the employer fails to file proper returns and cannot demonstrate reasonable cause, the liability can be doubled.

But, if the misclassification is found to have been intentional, then look out because the above limits do not apply, and the exposure can run to the individual officers/directors of the company.

Now, on top this, add your state tax liability, and the fact that there may have been obligations under other laws (including relating to health care benefits) that the company violated by misclassifying the employee as an independent consultant.

The classification of an employee as independent contractor is carefully scrutinized by Federal and State tax authorities and is a common red flag giving rise to an audit.  Do not let the potential savings lead you into the independent contractor trap as your company will pay dearly for misclassifying its employees.

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.



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