Employee? Independent Contractor? Somewhere in between?
With healthcare costs rising and mandated benefit requirements either already in play (e.g. Seattle Sick and Safe) or just around the corner (e.g. ObamaCare), employers are contemplating their staffing decisions related to the use of Independent Contractors compared to W2 employees. While most independent contractors typically earn more per hour than do their W2 counterparts—and can for that reason seem more expensive at first glance—employers have historically operated on the belief that by the time all costs associated with W2 status are factored in, the independent contractor is frequently the best way to go.
Our rule of thumb is that W2 employees cost somewhere between 20-35% more than their base pay. In other words, an employee earning $30/hour actually costs the company anywhere from $38-$45/hour. The additional costs are made up by the employers requirement to match the employees Social Security and Medicare tax, to pay state and federal unemployment tax, to provide workers comp insurance, liability insurance, and premium based benefit costs—plus to pay for PTO benefits; holidays, health and personal time off.
Employers have long valued the fact that if you contract to have work performed by independent contractors, you automatically eliminate those expenses PLUS you only pay for time actually worked/billed—no PTO. The added value of “just in time” access to targeted “hard to find, harder to develop” skills and talent pools is a benefit that has driven considerable growth in the 1099 marketplace over the last 20 years.
Unfortunately, risks are now beginning to surface around the independent contractor option that is changing the staffing landscape. The IRS has put the employer community on notice that “employee classification” will be a primary focus for the next few years and there are a growing number of cases where the independent worker category has been challenged and subsequently reversed to employee W2 status. If workers formerly categorized as independent, turn out to be employees, employers have been subject to back payroll taxes, penalties and fines—often with considerable financial impact.
What employers are learning is that just because you and the worker agree to consider the working arrangement “independent,” that doesn’t make it so under the law. If an “independent contractor” gets injured on the job and applies for workers compensation, or the project ends and they file for unemployment benefits, employers run the risk that either the IRS or the impacted state agency will step in to award benefits to someone who they have reclassified as a W2 employee. It is estimated that 75% of all “audits” are triggered by independent contractors applying for certain mandated benefits and when an audit is triggered the unpaid payroll taxes, interest and penalties can actually put some companies out of business.
As a tool for employers to do their own self audits, the IRS has developed a list of 20 factors it uses to determine whether a worker is an employee or a subcontractor.
THE TWENTY POINT TEST
1. Does the business require the worker to follow their instructions on how work is to be performed? If yes, this indicates employee status. An independent contractor will generally decide how the project should be completed and use his own methodology.
2. Does the business provide training to the worker? If you’re hiring a person for a job they are not trained for and providing them with the training to carry it out, that person is probably an employee. There can be exceptions based on the facts and circumstances, but if you fail this test you might lose no matter how many of the others you pass.
3. Are the worker’s services a substantial or integral part of the business? This indicates employee status because business maintains direction and control over the worker.
4. Does the business require the worker to perform all services personally? Independent contractors may have their own employees or at least should have the option of hiring other contractors to perform their work. Agreements for personal services indicate employee status.
5. Does the business hire, supervise and pay the worker’s assistants? If so, this is a strong indication of employee status—let the independent contractor pay his or her own assistants.
6. Does the business have an ongoing relationship with the worker? This one is a stretch since many businesses maintain lifelong relationships with contractors whose work they like. However, the IRS views this as an indication of employee status.
7. Does the business set the worker’s schedule and hours? Independent contractors generally set their own work schedules. If the contractor must work certain hours because of required interrelationships with your employees or to take advantage of down time for computer-related work, document these facts.
8. Does the business require the worker full-time? This is an indication of employee status because the business controls their availability and prevents them from working on other clients.
9. Does the business provide the workspace? Contractors who work off-site are more likely to be classified an independent contractors.
10. Does the business determine the order or sequence in which work is completed? If yes, this indicates employee status. If specific schedules are required, document them in the contract with the reasoning for doing so.
11. Does the business require oral or written reports? The IRS believes regular written or oral reports detailing the work completed indicate employee status. In reality, this is and should be expected from independent contractors as well.
12. Does the business pay by the hour, week or month? This indicates employee status. See our comments at the end of this article on this issue.
13. Does the business pay expenses? This is an indication that the business is directing the independent contractor’s business activities. Make sure the independent contractor pays the expenses and bills you for reimbursement.
14. Does the business provide tools and equipment for the worker Independent contractors would normally provide their own tools and equipment.
15. Does the worker have a significant investment in their own facilities? If the contractor maintains his own office space, computer equipment, tools, etc., this is a good indication that they are an independent contractor.
16. Does the worker have profits and losses independent of the business? This is an indication that the contractor is running his own bona fide business and is an independent contractor.
17. Does the worker have multiple clients? Working with multiple clients generally indicates independent contractor status.
18. Does the worker market their services to the general public? Employees do not generally market their services to the general public.
19. Does the business have the right to discharge the worker at any time? This suggests employee status. An independent contractor would only be discharged for failure to meet contract specifications.
20. Does the worker have the right to quit at any time? An independent contractor is under contract and cannot quit until the project is completed.
The IRS uses these questions to determine whether the employer has the right to control the worker (i.e. how, when and where the work is performed) and the amount of investment the worker has in his own business. The higher degree of control an employer has over the worker, the more likely the IRS will classify the worker as an employee.
A growing trend is for companies to reduce or discontinue the use of independent contractors either by policy or practice. The downside to these decisions is the company oftentimes loses access to that type of high level workforce talent who prefer to work “independently.” Additionally, if they choose to employ these workers directly, they obligate themselves to benefit packages and administrative requirements that completely change the competitive landscape. They simply cannot afford to provide full W2 benefit packages on top of independent contractor “bill rates.”
Some of the solutions being tested involve employers relying more and more on third party staffing agencies to source, evaluate and dispatch contract employees. In those models the worker often gets paid less and the employer more, many believe nobody wins.
A third solution that is becoming more and more popular in the marketplace is called “Employer of Record” services, which allows an employer to reconfigure their former 1099 workers into W2 workers, but instead of employing them directly, they use the pay and HR services of a third party “employer of record.” The Employer of Record service model allows the client to retain control of how work is performed (when and where), but involves an outsourcing of the “employer function” to an employer of record service provider.
The fees for Employer of Record services are substantially lower than for traditional third party staffing services, eliminating that portion of the service fee normally attributed to the costs of sourcing, evaluating and dispatching workers. In the Employer of Record service arrangement, the client does all sourcing and candidate selection, while the services outsourced are reduced to a payroll agent package, plus a menu of HR support.
For more information on the “Employer of Record” product line or a complimentary consultation on the many ways we have helped clients avoid the risks involved with Independent Contractors, contact our email@example.com and enter Employer of Record Services in the subject line.