Independent Contractor, W2 Employee, can you afford to blur the difference?

Independent Contractor, W2 Employee, can you afford to blur the difference?

by Jeanne Knutzen | May 16, 2013

0 Blog, Human Resource Roles 1099 workforce, Employer of Record, Employer of Record Service, Independent Contract, Kyle Fitzgerald, PACE Staffing Network, Seattle Staffing, W2 Employee, W2 Workforce, Workers Compensation

The world of work is changing rapidly, creating new ways of working, new ways for employers to get work done.

For both companies and employees, the need to have quick and easy access to talent and work, has created a new way of working outside the traditional employee-to-employer relationship.  Independent contractors, often called 1099’s, are people who work assignment to assignment, project to project. Currently, this workforce is estimated to be 16 million folks, and by 2015 is targeted to be 21 million.

Unfortunately, the legal and financial ramifications of this growing new workforce have not escaped the attention of taxing agencies who want to protect the revenues generated from a W2 employee base. W2 employees have their taxes withheld at each paycheck and their employer pays most, if not all, payroll taxes on their behalf. The IRS and multiple state taxing agencies are now challenging the validity of the “independent contractor” status, ensuring that employers are not using a worker’s preference to work independently as a way to avoid otherwise mandated tax calculations, payments, and reports. When employers organize work in ways that blur the distinctions between their W2 and 1099 workers, they are often doing so without being fully aware of the risks of creating a basis for a misclassification audit, which can be costly for both employers and 1099s.

We have prepared the following Q and A to outline the issues employers are likely to face when defending the classification status of their 1099 workers. Make no mistake, if you are a large or significant user of the 1099 worker model, there is likely a state or federal taxing agency who either has you and/or one of your 1099 workers on their radar as we speak.

Why independent/1099 workers?

The independent/1099 worker provides employers with all the traditional benefits of flexibility. They are paid only for hours actually worked or in some cases results produced. Savvy independent contractors price their services at a level to appropriately cover the costs of taxes and benefits, so the per-hour rate is often considerably higher than applied to their W2 employee counterparts.  Employers are willing to pay the higher rates preferring a process where there is little to no paperwork for them, no hidden costs, and no complicated benefit packages to administrate.

Convenience aside, the most frequently stated reason why companies hire independent contractors is that it has become a workforce made up of highly talented and sought after technical and managerial professionals—many calling themselves consultants. Most 1099 workers have not only fully mastered their craft, but because of their exposure to a wide range of project and organizational challenges, have created profiles with the skills, expertise, and talents that are highly valuable to most employers.

Why do workers choose to work as “independent contractors”?  

The popularity of independent contractor status within the employee community is also growing exponentially. At some points in their career, workers like the exposure they get to a wide range of technical or professional challenges, plus the flexibility that comes from being able to work when they want to.

For many professionals, the higher per-hour pay they can earn as a “consultant,” in addition to the deductions they can take on their individual tax return for certain business expenses not normally deductible to a W2 employee, creates a level of financial security they would not be able to obtain working as a W2 employee.

What is the difference between an independent contractor and a regular W2 employee?

Theoretically, the two types of workers should be noticeably different in terms of when and how work is performed, how it is financially transacted (by invoice or paycheck), and the length and scope of the working relationship between worker and employer/client. In the real world, however, the differences between the two types of workers are not always that easy to discern and often comes down to a determination of whether or not the independent worker has legally created their independent contractor status (business license, tax id numbers, professional liability insurances, etc.). Given this breakdown between theoretical intent and pragmatic execution, the intended distinction between the truly independent and the truly W2 worker populations has been blurred, creating real consequences for worker misclassifications at an alarming rate.

If I classify a worker as an “independent contractor” do I avoid having to pay all payroll taxes?

Not really.  A nuance and little known aspect of Washington State law is that employers who use Independent Contractors to perform personal work are required to pay the Workers Compensation insurance and the state’s SUTA tax on hours and dollars paid to these 1099 workers. Only if a 1099 contractor is a fully licensed and incorporated business entity (an LLC for example), paying the required business revenue taxes, can these costs be avoided.

Bottom line, classifying an individual worker as a 1099 in the State of Washington does not automatically bypass the employer’s responsibility to report hours of work for workers compensation insurance or earnings that are used to calculate and pay Washington State’s SUTA tax. There is more involved before those taxes can be fully avoided.

Why do we need to classify workers correctly?     

The issue at stake revolves around an employer’s obligation to calculate and pay taxes for W2 employees that they do not have for independent contractors. For their 1099 workforce, employers pay an invoice and there is no withholding for federal or state income taxes, calculation and payment of social security, Medicare or unemployment taxes. If a worker is originally classified as a 1099, but under audit turns out to be an employee, the employer is often subject to back taxes, fines, and penalties.

The liabilities associated with a misclassification audit are both unforeseen and expensive.  Since September 2011, the IRS has collected 9.5 million dollars in back taxes, penalties, and fines from employers who have misclassified more than 11,400 workers.

How do you “test” if a worker is a W2 or an independent contractor?     

One of the common misperceptions with 1099 workers comes from employers who believe that if their “contractor” is legal, (i.e. they have the proper business licenses, UBI (tax ID) numbers, insurances, etc.) and a contract between themselves and their contractor that labels them “independent”, they meet all aspects of the 1099 test. Most taxing agencies, on the other hand, operate from the belief that the “legality” of the claim of independent contractor status lies with the nature of the work to be performed and the degree of control the employer has over how and when it is performed—not the legitimacy of the contractor’s right to work as an independent contractor.   

There are a number of tests that are administered by different state and federal taxing agencies to determine if a worker is really an independent contractor or a W2 employee. Unfortunately, not all of these tests are fully compatible, nor is case law clear on how any test can be applied, making the whole landscape of proper classification a slippery slope.

In the end, most of the classification tests come down to:

  • The degree of control the company has over the worker’s behavior. The more control an employer has over where, when, and how work is performed, the less likely the worker can be considered “independent.” Employers who place their independent contractors on work teams with required hours of work, mandatory attendance at meetings, and required collaborations around work products, often do so at the risk of having that independent contractor be re- classified as a W2 employee.
  • The degree of control over a worker’s financial opportunity. The more control an employer has over a worker’s source of income, the less likely that worker will be found to be “independent.” An agreement to pay a fixed cost per week, for example, can be just as suspect as an agreement to pay an hourly rate if the agreement includes a provision to work 40 hours/week—both tie a worker to a single source of income for extended periods. Other considerations related to “financial control” include payments or reimbursements for business expenses, equipment or tools. The more these sources of income are directed and controlled by the company/client, the less independent a worker will appear.
  • The type of relationship (exclusivity or duration) that is formed between worker and company. Case law around the permanency of a relationship suggests that work assignments intended to last six months or longer make the independent status more suspect than shorter term work arrangements. A related factor is whether or not the worker is free to pursue other business opportunities during the term of their agreement. Companies who regularly entertain independent contractors who work a regular 40 hour work week, and for years at a time, are clearly stretching the definitions of “independent.”

What if I misclassify?      

The first thing for you to know is that you’re not alone. The IRS estimates that businesses misclassify workers as 1099’s anywhere from 10-60% of the time. The bad news is that if a misclassification is uncovered under audit, the outcome can be serious—back taxes, fines, and penalties in addition to costly law suits stemming from unprotected workplace accidents or injuries.

Why is the misclassification issue such a hot topic right now?     

With state and federal government budgets fighting the pinch of reduced revenues, they have become increasingly aggressive about collecting monies they believe are owed to their agencies. When we first started writing about the misclassification issue two years ago, we were only concerned about federal agency (D of L, or IRS) audits. Today multiple state agencies have gotten involved because depending on how a worker is classified, this could impact who pays the workers compensation insurance, state unemployment and revenue taxes in the city of Seattle. For example, access to mandated Seattle Sick and Safe benefits is targeted to put increasing pressure on employers to clarify who is entitled to this benefit and who is not, and to defend that claim in a lower court test.

The federal government has set goals for the number of employers they will audit, and have set aside significant budget dollars to resource these audits. Most alarming is that federal, state, and local governments have formal agreements to work together when cases of misclassification are uncovered—multiplying the financial ramifications that employers are likely to face under audit.

What are some “red flags” that might trigger a misclassification audit—what should we avoid?  

Here are some simple rules of thumb:

  • Overlapping a W2 and 1099 status for the same employee in the same report year can be an audit trigger. Avoid firing a W2 worker and bringing them back a week later as a 1099.
  • There is a form, IRS SS-8’s, which can be used to request government determination of a classification status. Keep the number of these forms you file or your 1099’s file on your behalf to a minimum.
  • 70% of misclassification audits get triggered by independent contractors filing for benefits routinely available to W2 workers, (i.e. workplace injury claims, unemployment claims). Make sure your workplace policies and practices avoid references to these benefits.    

What happens if an independent contractor files for unemployment or is involved in a workplace accident?

One of the most common ways regulatory agencies become aware of misclassifications has come out of the increased number of unemployment and worker’s compensation claims that are being filed by workers formerly considered independent.  Unemployment officials have not only been granting 1099 workers benefits—implying they’re an  employee, not independent status—but have alerted other agencies as to the possible misclassification of other “similarly situated” workers, turning a claim for unemployment into a much larger misclassification audit.

Another serious source of liability can occur if a workplace accident occurs involving a 1099 worker who is not covered under the employer’s Workers Compensation policies. Lacking coverage, the employer is not protected from the limited liability provisions of workers compensation laws, and can find themselves sued for double, if not triple personal injury damages.

What can companies do to protect themselves from misclassification issues?

The best answer is the simplest—make sure your independent contractors are really independent contractors, working in ways that would normally apply to someone or a company who works independently—free of your control.

If that level of independence isn’t possible, as it often isn’t, your choices are 1) to end your relationship with the 1099, or 2) convert the 1099 to your W2 workforce. A third option, new to the misclassification issue, is to insert an Employer of Record Service provider who can turn your 1099 workforce into a low cost W2 workforce. This option is discussed below.

If your analysis reveals that there is room for a genuine independent contractor to work in your organization, you need to:

  1. Develop and execute an independent contractor agreement that, among other things, acknowledges the intent of the relationship and waives any rights to company sponsored health or retirement benefits. We recommend including in your agreement a provision that the independent contractor recognizes you as their common law employer with respect to protections under workers compensation laws in the event of workplace accidents. We also recommend you include an indemnification clause that excuses you from any liabilities associated with an independent contractor’s failure to pay their own mandated self-employment or W2 taxes.
  2. Create specific policies and procedures for working with true independent contractors. Train your front line managers on the requirements for “independence” to ensure the lines of differentiation stay clean.
  3. Review benefit plans to ensure a clear definition of plan participants, specifically excluding the employees of third party employers and independent contractors.
  4. Conduct internal audits of your current 1099 workforce, ensuring all contracts are up to date, and that your company is paying the required taxes on those who are providing personal services.

What is an Employer of Record Service?  How can it help with misclassification issues? 

Because the issues surrounding employee classifications are not white/black and courts are inconsistent in their rulings on the cases they have heard, one of the ways to avoid any risk of a misclassification audit is to create policies that prohibit the use of personal service 1099’s in your organization, while offering an alternative method for providing quick and easy access to high impact talent.

Employer of Record Services do that by converting a 1099 workforce into a W2 workforce at a fraction of the costs associated with most employers W2’s. The Employer of Record Service provider simply handles paperwork, ensures worker compliance, arranges for weekly pay, and oversees the filing of all government required paperwork.

As a benefit for the former 1099 worker, the Employer of Record Service provides full administrative and HR support, including a facilitation of their access to the benefit entitlements of W2 workers. The bill rate or “take home pay” either goes up or remains the same, but their financial benefits are substantially increased.

Employer of Record Service providers typically will supply electronic paperwork to onboard or off-board workers quickly, preserving the benefits of immediacy and flexibility, while eliminating the risks of liabilities down the road. The IRS is happy with this solution as are all local taxing agencies. Your company is no longer on the target list for misclassification audits.

The PACE Staffing Network now offers a full range of menu driven Employer of Record Services that can be used to turn a potentially dangerous 1099 workforce into a “legally compliant”  W2 workforce. We handle all aspects of the “change process” by working closely with your team to explain the financial benefits to your 1099s for becoming W2s, oftentimes facilitating their own ability to move between assignments with different companies.

For a discussion about how your company currently uses 1099 contractors and the options you have to mitigate the risk of misclassification, contact our Employer of Record Specialist, Kyle Fitzgerald at kylef@pacestaffing.com.


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