Independent Contractor Misclassification and the Ever-Increasing Risks of Non-Compliance
In recent years, many companies embraced the practice of using Independent Contractors (IC’s) to fulfill temporary staffing and project requirements. With the potential for significantly helping the bottom line, companies will continue to the trend of using Independent Contractors (IC’s) to free up capital for other investments.
Data from the AFL-CIO point to the continued growth of the gig economy. Between 2003 and 2013, the Independent Contractor workforce made up of professionals and technology workers grew 1.3 percent. In the same fields, the traditional W2 employed workforce grew more than 15 percent.
Certain workers truly prefer to be Independent Contractors. So the arrangement benefits all parties. Occupations with the highest concentration of IC’s include sales, media, engineering, design, and information technology. Licensed professionals- accountants, physicians and lawyers- are also stepping out on their own. We are quickly becoming a portable employer society. Though with every new set of benefits, a set of risks follows.
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Independent Contractor and Employee Misclassification Causes Nightmares
Uber and Lyft experienced the mess of untangling the policies surrounding employment classification. The highly publicized cases brought the painful realization that the evolving gig economy is making it difficult to file workers into one of only two categories.
Current estimates show contracted and temporary labor eventually comprising 30 to 50 percent of the U.S. workforce. Unless employers can fortify their compliance programs to keep up with the explosion of IC’s in the workplace, they will be vulnerable to huge risks. Already as many as 3.4 million employees were classified as independent contractors when they should be W2 employees.
Companies employing independent contractors sometimes fail proper vetting through a sound Independent Contractor Evaluation and Compliance (ICEC) program. Many times this is not a deliberate action, but an oversight as a result of not fully understanding the nuances of IRS requirements, especially the definitions between employee versus independent contractor or A, B, C testing.
Employment Agencies and Managers Can Minimize the Risk of Misclassification
First and foremost, the difference between an independent contractor and an employee must be clarified. This is not as easy as it sounds because employers must comply with multiple federal agencies, namely the IRS and the Department of Labor. In addition, there are state regulations and sub-categories of employment to consider, such as certain types of sales and delivery personnel.
The IRS’s Definitions of Independent Contractor and Employee:
- Workers, such as doctors, lawyers, accountants, dentists, auctioneers, contractors and subcontractors and others engaged “in an independent trade, business or profession” offering services to the public are usually independent contractors (IC). As a general rule, the payer controls only the result of work performed, not how or what will be done.
- If a worker is an IC, he or she is also considered self-employed for tax purposes, with earnings subject to Self-Employment Tax.
- Work by an IC is not directly controlled by an employer, such as what and how any work will be done, even if that worker is given some leeway.
- The employer is responsible for deducting FICA, unemployment and income tax withholding if the IC is not, by rule, an IC.
The Department of Labor’s Definitions:
Under the Fair Labor Standards Act (FLSA) employees are economically dependent on the employer, as opposed to independent contractors who are dependent on their own efforts. Other factors:
- The extent to which work done is a necessary part of a company’s business
- The extent to which a worker’s managerial abilities affect profits or losses
- The relative investments by both company and worker in equipment and facilities
- The permanency of the relationship with the hiring company
The Federal Government is Stepping Up Enforcement
Figures from a 2009 Treasury study show that misclassification of workers cost the US over $54 billion in underpaid tax revenues, and another $15 billion in unpaid FICA and unemployment taxes. The federal government, anxious to recover this huge deficit, is increasing funding for strict enforcement.
The IRS, in particular, recognizes the tendency to misclassify workers so the IRS is cracking down on companies who misclassify workers by imposing fines and other measures. Recent legislation pending in Congress would fine employers as much as $5,000 with other penalties per occurrence to bring employers into line.
Misclassification Consequences for Businesses Are Steep
Companies who misclassify workers as “independent contractors” will, at the very minimum, be liable for the worker’s FICA and unemployment tax, according to Internal Revenue Code, in addition to any state tax laws. Business owners need to be careful about treating all workers performing the same or closely similar tasks alike when it comes to payroll compliance, withholding and so on. A worker doing substantially the same work as a regular employee could well qualify for employee status – with all the entitlements and compensation. The idea of a one-size-fits-all solution is merely a daydream.
As a result of the misclassification errors by employers, more workers are bringing lawsuits against employers, such as Vizcaino v. Microsoft, which resulted in a $97 million settlement. Lawsuits, while rare, can cost a company far more than any government penalties or back taxes owed.
Independent Contractors Lose, Too
The cost to individual workers is lost wages, Social Security contributions, fringe benefits and other forms of compensation. This cost contributes to under-employment, reduced savings, limited buying power, and shaky financial security. It becomes a vicious circle of arrested growth; the employees are not compensated correctly and, when they act as consumers, cannot spend money on services from the companies who misclassified them.
When in doubt, it is best to seek the advice of competent legal counsel experienced in labor and tax laws for clarification on issues pertaining to worker classification. As noted earlier, the federal government is adding manpower to its enforcement efforts. Companies, therefore, must employ compliance professionals in order to keep the IRS off their back and out of their business. In the end, doing so will save time, taxes, and employment costs. It is better to be safe than sorry.