Understanding the Risks

Over the past decade the IRS has garnered over $1 billion in back taxes, interest and penalties from companies who misclassified workers as independent contractors (ICs). More than 90% of audited companies had wrongly classified their ICs according to the IRS.

In many of these cases, these individuals performed the same job function as those performed by W-2 employees of the same company. These ICs are not responsible for misclassification and are essentially free from any penalties or related fines; the companies who contracted with these ICs are ultimately accountable for all financial liabilities.

Aside from the conventional risks associated with IC misclassification, there are other factors that can put a company at risk if they work directly with ICs, including:

• IC's failure to pay appropriate taxes. ICs must file quarterly taxes with the IRS. As a result of these filings, the IC is responsible for FICA taxes or 15.3% of their gross pay for Social Security and Medicare. In addition, if an IC becomes incorporated 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.
• IC's lack of appropriate liability insurances to protect their client. ICs put their clients at risk for failing to carry general liability, errors and omissions, non-owned auto and other insurances. Companies should require certificates of insurance from all ICs to verify coverage and coverage levels.
• IC unemployment or workers compensation claims. "Red Flag" events, such as an unemployment benefits or workers compensation claim mistakenly filed by an IC, often triggers an IRS audit. Although the mistake is out of the company’s direct control, it can still impact the company due to worker misclassification penalties as a result of the audit.
• ICs and copyright law. According to current copyright laws an IC will more likely retain copyright than a W-2 employee in a work-for-hire situation. Therefore, the company should have appropriate copyright protection in place or convert the IC to a third-party employee to ensure necessary copyright security.
• IC employee benefits claims eligibility. ICs have used government-imposed misclassification penalties and fines to file lawsuits against companies, claiming they were excluded from benefits, stock options and bonuses since they were not W-2 employees of the company. Companies must implement appropriate measures to protect themselves from the liabilities of benefits exclusion in direct IC relationships.

Dependence on written contracts from 1099 wage earners claiming their independence from a company is a common and costly error. Companies are responsible to prove their 1099s are truly independent. The IRS will demand proper evidence regardless of a written contract between the 1099 and the company. While a contract is still required for appointment of 1099 contractors, it does not serve as protection for the company during an audit.

There are ways for companies to engage with ICs legally while properly mitigating the risks of misclassification. The first step is discovering and evaluating a company's current 1099 population to determine proper classification.