Question: We are currently downsizing as part of our company reorganization and are considering redesignating some of our employees as independent contractors. Are there any potential ramifications for making the change?
Answer: It is possible to change a worker’s status from employee to independent contractor provided that the worker meets the legal requirements of an independent contractor. Whether a worker is an employee or independent contractor is determined through a series of legal tests established by state and federal courts and agencies. For example, for federal tax purposes the IRS uses common law rules to determine whether a worker is an independent contractor. The common law rules examine various facts regarding the degree of direction and control the employer has over the worker and the amount of independence the worker has in regards to performing the work. The more direction and control an employer exerts over the worker, the more likely the worker is an employee. Conversely, the more independent the worker is, the more likely the worker is an independent contractor. It is important to note that there is no single factor that is determinative. The determination is based upon the totality of the circumstances.
While there are other tests at both the state and federal levels, most of them look at the same factors contained in the common law rules and focus on the amount of direction and control the employer has over the worker. The major difference is how many factors the court or agency looks at and how much weight is given to particular factors. For comparison, consider the factors used in the economic realities test, which is used by federal courts and the U.S. Department of Labor (DOL) to determine whether a worker is an employee or independent contractor under the federal Fair Labor Standards Act (FLSA).
Employee misclassification is one of the top enforcement issues for the U.S. DOL’s Wage and Hour Division (WHD). This is because under state and federal laws employees are provided protections and benefits that are not provided to independent contractors, such as minimum wage, overtime, family and medical leave, discrimination and harassment protections, unemployment insurance, workers’ compensation, and medical coverage. By misclassifying an employee, the employee is denied access to benefits and protections to which he or she is entitled. In addition, the employer avoids withholding income tax and paying into programs such as Social Security, Medicare, unemployment insurance, and workers’ compensation.
While making sure employees are properly classified can be a huge task, the consequences for misclassifying an employee can be devastating. If the WHD/IRS perform an investigation or audit of an employer, they will examine all employees and independent contractors for a three-year period.
The ramifications for an employer can vary depending on whether or not the WHD and the IRS determine the misclassification was unintentional or intentional, or even fraudulent. With respect to the FLSA, penalties include liquidated damages (i.e., double back wages) and attorneys’ fees and court costs. In regards to federal taxes, if the misclassification was unintentional, the employer faces at least the following penalties based on the fact that all payments to misclassified independent contractors have been reclassified as wages:
- $50 for each Form W-2 that the employer failed to file because of classifying workers as an independent contractor.
- Since the employer failed to withhold income taxes, it faces penalties of 1.5 percent of the wages, plus 40 percent of the FICA taxes (Social Security and Medicare) that were not withheld from the employee, and 100 percent of the matching FICA taxes the employer should have paid. Interest is also accrued on these penalties daily from the date they should have been deposited.
- A failure to pay taxes penalty equal to 0.5 percent of the unpaid tax liability for each month, up to 25 percent of the total tax liability.
- $50 for each failure to obtain a Social Security number.
If the IRS suspects fraud or intentional misconduct, it can impose additional fines and penalties. For instance, the employer could be subject to penalties that include 20 percent of all of the wages paid, plus 100 percent of the FICA taxes — both the employee’s and employer’s share. Criminal penalties of up to $1,000 per misclassified worker and one year in prison can be imposed as well. In addition, the person responsible for withholding taxes could also be held personally liable for any uncollected tax.
Not to be forgotten, employers may also face tax and other penalties under state laws. For example, in California these penalties include repayment of back payroll taxes, subject to interest and a 10 percent penalty on the unpaid taxes. Failure to withhold and pay payroll taxes can also result in a misdemeanor charge, and the employer can be fined up to $1,000 or sentenced to jail for up to one year, or both. Additionally, Cal. Labor Code § 226.8 imposes penalties of up to $25,000 on employers who misclassify employees.
While employers may choose to navigate the various tests on their own, due to the severity of penalties for misclassification, employers are strongly encouraged to seek counsel when uncertain about the status of certain employees.