In the face of stiff global competition and tight operating margins, a growing number of organizations have begun to restructure their hiring practices to accommodate more flexible talent. Data from Intuit suggests that by 2020 more than 40% of American jobs will be held by these contract workers. This shouldn’t come as a surprise. Over the past decade, companies like Uber have clearly demonstrated the benefits of employing contingent workforces. In a lawsuit filed against the ride-sharing company, claimants alleged that Uber had saved around $500 million a year by classifying its drivers as independent contractors rather than employees.
While other companies are keen to reduce payroll expenses in the same manner, the IRA and Department of Labor (DOL) have other ideas. In recent years, these federal bodies have worked to identify and punish instances of misclassification across a wide range of industries including: construction, transport, trucking, and dining. To date, over $79 million in fines, back taxes and unpaid wages have been retrieved from offending businesses. State regulators have also begun to implement harsher penalties in an attempt to crack down on unfair labor practices. In California, each case of purposeful misclassification is subject to fines of up to $15,000 while repeat offenders can be fined anywhere from $10,000 to $25,000.
Civil lawsuits could pose an even greater concern, as there is no limit to the amount that a company might be ordered to pay as a result of labor code violations. In Uber’s case, federal courts ruled that a settlement of $100 million was unsatisfactory compensation for the 400,000 employees they had misclassified across Massachusetts and California. Alongside these payments you will have to bear the cost of a full-time litigation team while accounting for the negative publicity that may arise due to an unfavorable verdict.
The Difference Between an Employee and an Independent Contractor
Employees are generally hired for an undetermined length of time. Their scheduled hours, working processes, and places of work are strictly defined by their employers. If employees require any specific equipment, supplies or training for their job then this must be provided by the employer. In cases where employees incur job-related expenses, they will usually receive commiserate compensation from their employers. Employees will also be entitled to paid time off and other benefits such as health insurance and retirement contributions.
Employees are subject to state and federal labor laws that govern issues such as minimum wage, overtime rates, hiring, and termination. Employers must ensure that they abide by these laws when hiring employees.
Before an employee receives their wages, the employer will deduct relevant taxes. These withholdings cover Social Security and Medicare as well as other federal and state-specific payments. These contributions are then matched by the employer. Payments made on behalf of employees are reported in the W-2 tax form while compensation for independent contractors is reported on the 1099-MISC tax form
Independent contractors are self-employed professionals who provide services to your company as part of a defined contract. Obvious examples of independent contractors include private doctors, dentists, lawyers, consultants, and accountants. These individuals are not subject to any of the laws governing employees. So you will not be required to contribute a portion of their wages towards Medicare, Social Security, unemployment insurance, and workforce disability insurance. Nor will you be required to provide them with health insurance, overtime payments, or any additional benefits that arise as a result of their employment.
Hiring 1099 workers will not place any additional tax burden on employers, as these individuals are responsible for filing and paying all of their own taxes. The simplified reporting requirements also reduce payroll processing and distribution costs for employers. Employment data shows that independent contractors can reduce payroll costs by up to 30% compared to employees.
With this in mind, it’s easy to see why many businesses are keen to classify their workers as independent contractors, which creates the possibility of labor exploitation. In order to protect against this, the IRS has developed strict guidelines to distinguish 1099 workers from W-2 employees and ensure that employees are compensated in accordance with the reality of their working situation.
An individual’s working status can be determined based on their level of control. In order to remain compliant with IRS rulings, you must ensure that your workforce is correctly classified according to this metric. To do so, you must assess three key factors in your professional relationship.
Who Exerts Behavioral Control?
- Is the worker able to decide where or how they work?
- Have you provided any additional training to ensure that the worker is able to perform according to your requirements?
- Does your worker have employees of their own?
- Are you responsible for determining the order or sequence of tasks that the worker must complete over a given period?
- Is the worker required to report their progress in any specific way?
Who Exerts Financial Control?
- Does the worker cover their own business expenses? If not, are business expenses paid out of pocket and compensated at a later date, or are they covered directly by the company?
- Does the worker submit invoices for work completed?
- Who owns the tools and equipment that are required to complete the job?
- Who bears the potential profit and loss arising from a work project? Regardless of the success or failure of a project, the employee will still be entitled to the same compensation.
Who Exerts Relationship Control
- Does the worker own their own business? Do they advertise their products and services publically? Are they exclusively contracted to work for your business? An employee will generally fulfill none of these terms.
- Does the worker maintain their own insurance?
- Do the terms of the working contract specify whether the worker is an employee or independent contractor?
- Is the worker actively engaged in other projects for your business? Are they contributed to your overall operations in any other ongoing capacity?
- Is the worker currently receiving benefits?
- Is the worker providing a core service to your business (i.e transport is Uber’s main service so drivers are providing a core service).
- Is there a defined end-date to your working relationship?
All of these factors must be considered when determining whether a worker should be classified as a 1099 independent contractor or a W-2 employee. While some of your answers may indicate that a worker falls under the former classification and other may suggest the latter category is more appropriate, you must assess the overall balance of evidence before making your final decision.
Identifying Cases of Misclassification
Both the DOL and the IRS treat misclassification as a serious matter, and they are committed to investigating all potential breaches. There are a number of triggers that can incite an audit from one or both of these federal agencies.
- An internal payroll audit might turn up instances of misclassification.
- The IRS might single out your business for auditing due to discrepancies in your financial reports, or simply because of the nature of your business (cash-intensive businesses are a particular target. In this case they will examine your payroll records over a three-year period to determine whether there have been any cases of misclassification.
- If a terminated worker attempts to file for unemployment and they are classified as independent contractors then this may well trigger an external audit. The same will apply in cases where an independent contractor attempts to file a compensation claim due to workplace injuries.
- In some cases independent contractors may feel that they are entitled to the same benefits as employees, or they may be disgruntled at the fact that they are forced to file their own income taxes. In these scenarios, the worker can ask the IRS to intervene and resolve the issue. The resulting audit could extend to encompass your entire workforce. Similar complaints can also be filed with the Department of Labor under their Employee Benefit Security Administration (EBSA).
- All of these conditions can also be applied to state tax and labor agency audits. Information from state bodies shows that up to 20% of employers misclassify at least one of their employees.
The Penalties of Misclassification
If the IRS determines that your business has misclassified employees as 1099 workers then you will be required to pay all relevant taxes as well as Social Security and Medicare contributions that were due to the employee. Penalties will also be applied depending on the specific nature of the misclassification.
If the breach is unintentional then the employer will be required to pay $50 for every unfiled W-2 form. All outstanding wages will be fined at a rate of 1.5% an additional penalty of 40% will also be charged on pending Social Security and Medicare payments. A 100% penalty will be levied on all outstanding employer contributions. Interest will be charged on all due taxes from the initial date of expected payment. This is charged at a rate of 0.5% of the total unpaid amount for each month up to 25% of the outstanding amount.
Additional penalties will be imposed if intentional misclassification is identified. These penalties can range from heavy fines all the way to criminal penalties which include prison time for the employer.
How to Deal With Misclassification Issues
If you have identified cases of potential misclassification in your business then you have a few options available to remedy the situation.
- As mentioned above, a worker’s classification is largely based on subjective factors. If you can adjust your employee’s working conditions to accurately reflect a 1099 worker then this will allow you to retain this classification. For example, you may choose to afford the worker more autonomy in terms of where, how or when they work. You can also reduce their volume of work and level of oversight of their tasks.
- If your business has proactively identified incidences of misclassification then you can choose to correct any tax and withholding concerns voluntarily. In order to do this, you must correct and file all relevant W-2 and 1099 forms and pay back taxes for all periods of misclassification. Voluntary tax contributions will generally fall under Section 3509 of the IRS tax code, which entitles you to reduced assessment rates.
- If you are able to prove the consistency and reliability of your reporting and show substantive basis for your choice of classification then you may be able to claim Section 530 tax relief from the IRS. This will absolve you of any backtaxes that are due because of misclassification. This relief can only be claimed if you are currently the subject of an IRS tax audit. Substantive basis is determined based on prior case law.
- If a worker is seeking compensation for current and prior benefits (retirement plan, dental plan, health insurance) foregone due to misclassification then the potential payments can significantly exceed any tax-related penalties. In these cases you can attempt to limit the amount of damages by submitting notice of the issue and a proposed resolution to the IRS/DOL. If your statement is considered adequate then the Federal body may apply a lesser penalty.
Do You Need Help With Your Payroll Classifications?
We’re always ready to talk. Get in touch with us online via our contact form, or call us at (732) 458-3800 to get $100 off on your payroll services. If you’re unsure about our service rates, check out the comprehensive breakdown on our site, or reach out to us directly for a quote.