Contingent Workforce Solutions
Compliance
Over the past decade, the IRS has garnered over a billion dollars in back taxes, interest and penalties from companies who misclassified workers as independent contractors. IRS reports indicate finding wrongly classified independent contractors in more than 90% of the firms they audit. In fact, research suggests 66% of companies surveyed are extremely concerned about employee misclassification. In many of these situations, individuals typically performed the same job function as those performed by a regular employee of the company. There are a variety of tests and conditions that are used by multiple government agencies to determine misclassification for purposes of taxes, overtime pay, benefits and other employment practices. Numerous federal and state agencies have made it a priority to collect this money by conducting an aggressive audit campaign against companies, big and small, who use independent contractors.
It is relevant to note that independent contractors who wrongfully benefited as a result of being paid on a 1099 basis are virtually free from penalties. They are typically held harmless with the main focus being the company for which they worked. In addition to the classic risks associated with misclassifications, there are a number of other areas that are virtually out of the company’s control where they may be exposed if they work directly with independent contractors:
Independent Contractor Fails to Pay Appropriate Taxes
Independent contractors must file for taxes with the IRS on a quarterly basis. As a result of these filings, the contractor is responsible for the full burden of FICA taxes or 15.3% for Social Security and Medicare. In addition, if an independent contractor forms a corporation, they must be treated as a W-2 employee of that company and pay the appropriate statutory costs including FICA, FUTA, SUI and workers compensation.
Independent Contractor Lacks the Appropriate Liability Insurances to Protect Their Client
Independent contractors who have not paid for general liability, errors and omissions, non-owned auto and other insurances put their clients at risk in the unfortunate circumstance of a liability claim. Companies should require copies of certificates of insurance obtained from their insurance carrier for all business insurances and coverage levels.
Independent Contractor Files Unemployment or Workers Compensation Claim
If an independent contractor were to mistakenly file for unemployment benefits or a workers compensation claim, this most likely would trigger an audit by the IRS. These "red flag" events, while out of a company's direct control have a significant impact on the bottom line due to penalties imposed by the IRS for worker misclassification.
Independent Contractor Performs "Work for Hire" That Applies to Copyright Law
The distinction between employees and independent contractors is critical in copyright law to determine both ownership of a copyright and the scope of rights accompanies with such ownership. According to the current copyright law, it is far more likely that the worker will retain copyright if he or she is classified as an independent contractor versus an employee in a "work for hire" situation. Therefore, the company should put the appropriate protections in place or convert the contractor to an employee of a third party to ensure copyright protection from "work for hire".
Independent Contractor Claims Eligibility for Employee Benefits
In several instances, independent contractors themselves have used government imposed penalties and fines as a case to file lawsuits against companies, suggesting they were excluded from benefits, stock options and bonuses in which they would have been eligible for as an employee of the company. Companies need to implement protections against the liabilities of benefits exclusion in direct independent contractor relationships.
Reliance on written contracts with 1099 wage earners that claim their independence from the company is a common and costly error. In reality the onus as stated above is on the company to prove the 1099s are independent. The tax authorities will demand evidence of their independence regardless of the existence of a written contract. A written contract is still a requirement for appointment of 1099 contractors but is no protection in an audit and is in this context worthless.
Fortunately, there are ways for companies to engage with independent contractors legally while mitigating the risks of misclassification. The first step in the process is evaluating the current group of 1099 contractors to determine any individuals who might be misclassified.
Back to TopEmployee vs. independent contractor
Under common law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. In other words, if the payer has the right to control or direct the result (what) as well as the means and methods (how) for accomplishing the result. As a general rule, there are three basic areas to determine employment status:
Behavioral control: determines whether the business has a right to direct or control how the work is done through instructions, training or other means.
Financial control: determines whether the business has a right to direct or control financial and business aspects of the worker’s job including:
- The extent to which the worker has unreimbursed business expenses,
- The extent of the worker’s investment in the facilities used in performing services,
- The extent to which the worker makes his or her services available to the relevant market,
- How the business pays the worker, and
- The extent to which the worker can realize a profit or incur a loss
- Written contracts describing the relationship the parties intended to create,
- The extent to which the worker is available to perform services for other, similar businesses,
- Whether the business provides the worker with employee-type benefits, such ass insurance, a pension plan, vacation pay or sick pay,
- The permanency of the relationship, and
- The extent to which services performed by the worker are a key aspect of the regular business of the company.
Red Flags
Certain actions by independent contractors can cause a "red flag" for an IRS audit:
Individual was both a W-2 employee and 1099 contractor in the same calendar year with the same company
In many cases an retired employee or employees who have been through a layoff are re-hired for short and long-term projects. Appointment as a 1099 contractor will almost always breach IRS and state rules if the retiree is returning in the same capacity as when they were an employee, and offering similar services. Where an individual furnishes the IRS with a W2 and 1099 for the same company, an investigation by the IRS or State authorities will ensue.
An independent contractor files for Unemployment Benefits or Workers Comp
If an Independent Contractor files for Unemployment benefit or Workers Compensation claim, it will almost certainly result in an investigation into the circumstances of that individual's employment with the client company. This type of inconsistency is exactly the kind of lead that is searched for by tax authorities to implement a company-wide compliance audit and is one of the most common triggers. A claim by one independent contractor within the state typically triggers an investigation of all workers in similar positions.
Legal action taken by Contractors for benefits
Contractors have successfully filed charges against their clients claiming coverage as an employee under many labor laws including minimum wage, overtime and non-discrimination laws. The anomalies implied by this action on the part of the contractor will attract the interest of tax authorities to determine the true nature of the agreement between contractor and client company and conditions of work.
Contractor creates a single employee corporation
Although long considered a legitimate means of achieving compliance, more recently tax authorities have broadened their area of concern to include recently formed corporations with a single employee. Tax Authorities will challenge these arrangements on the basis that they were created specifically to reduce tax obligations. However IRS auditors, have recently searched for corporations created by computer programmers and other technology professionals for this purpose. Many such corporations were disallowed for tax purposes on the basis that they were less than 1 year old and had only one employee.
Penalties
In the event of non-compliance, there are several federal and state penalties including back taxes, interest and fines that can be assessed for a period of three years. Estimates suggest that fines per contractor may come to $30,000 per year if the IRS determines that the misclassification was unintentional. If however, intentional misclassification is determines, fines may run up to $63,000 per year for as many years for up to three years.
Back taxes can total:
- 15.3% FICA Tax
- 20.00% Federal Income Tax
- Up to 6.2% Unemployment Insurance
- Total = 41.50% of contractors pay
- Failure to file W-2 or 1099 form
- Failure to file quarterly returns
- Failure to pay taxes
- Average Hourly Wage Rate = $40
- Annualized Wage Rate = $83,200
- Number of Contractors = 10
- Back tax penalties = $34,528
- Back tax penalties (3 years/ including interest) = $111,870
- Total Exposure = $1,118,700
There are also significant fines if the IRS believes you committed fraud or were negligent, plus fines for many other situations.
NOTE: The information provided in this section is for general information purposes only.
