Business owners may not understand when to classify an individual as an employee versus an independent contractor. Proper classification of a worker as an independent contractor may save a company money and benefits, such as group health insurance. However misclassification can result in significant liability.
Employers are often tempted to classify workers as Independent Contractors because they don’t have to pay the employer share of taxes or provide benefits to those workers. The Affordable Care Act’s (ACA) upcoming employer mandate makes this type of arrangement even more tempting. Under the employer mandate, which will go into effect in 2015, employers with 50 or more full-time or full-time equivalent employees will have to provide healthcare insurance to at least 95% of their full-time workforce or face fines. Even if they provide coverage, they could be fined if that coverage does not meet the ACA’s standards.
Who is counted as an “employee”
Under the common-law standard, an individual is an employee if a legal employer and employee relationship exists. Generally, that relationship exists when the company “has the right to control and direct the individual” regarding “the details and means by which” the individual’s work is performed for the company. There are several factors that are considered under the common-law standard, including the right to discharge, the furnishing of workspace or tools, the source of the individual’s employment wages, etc. The determination depends on the particular facts and circumstances of the relationship.
Ultimately, the determination of whether an individual is an employee or independent contractor is based on a holistic analysis of the relationship between the business professional and the company. It should be noted that just because a company classifies and pays a business professional as an independent contractor, it does not always mean that the business professional is truly an independent contractor under the law. Courts typically focus on the substance of the relationship over its form.
The rules tell us little more than that an employer’s ACA obligations extend to every person who is its “common law employee.” For health care reform, “employee” is defined using the common-law standard found in 26 CFR § 31-3401(C)-1(b). The IRS uses a 20-factor “right to control” test to determine whether a common law employment relationship exists. No one factor determines the result, but if an employer can tell a worker what to do, when to do it and how to do it, then, generally speaking, the worker is that employer’s common law employee.
What is an independent contractor?
An independent contractor, also known as a 1099 contractor, refers to a worker who contracts their services out to a business or businesses. An independent contractor is considered to be self-employed, not an employee of the business or businesses with which they work. “1099” refers to the IRS form that an independent contractor must receive to state their income from any given business in a given tax year.
Why Does It Matter?
Misclassification of an individual as an independent contractor may have a number of costly legal consequences.
If your independent contractor is discovered to meet the legal definition of an employee, you may be required to:
- Reimburse them for wages you should’ve paid them under the Fair Labor Standards Act, including overtime and minimum wage
- Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment.
- Pay any misclassified injured employees workers’ compensation benefits
- Provide employee benefits, including health insurance, retirement, etc.
- Pay ACA penalties if the misclassification results in increasing the number of employees to 50 or more.
Penalty and Claim Examples
The California Legislature enacted Senate Bill 459, which imposes hefty fines for each “willful misclassification” of a worker. The penalties are not less than $5,000, nor more than $15,000 for each violation of the statute. Employers may also face penalties ranging from $10,000 to $25,000 for each violation if the employer engaged in a “pattern or practice” of such misclassification.
In May 2014, Lowe’s agreed to pay $6.5 million to settle a class action lawsuit that accused the company of misclassifying over 4,000 installers, and hundreds of businesses, as independent contractors.
Defining Employee for Health Care Reform
If an IRS audit reveals that an employer misclassified workers and reclassifying those workers as W-2 employees puts the employer over the 50-employee threshold, they could be subject to the fine for failing to offer healthcare coverage. That fine is $2,000 per full-time employee if even one employee obtains insurance through The Marketplace with government subsidies. If they do offer coverage, but that coverage doesn’t meet the ACA’s standards for minimum coverage and affordability, the employer could pay $3,000 for each employee who goes to The Marketplace for coverage and obtains a government subsidy.
The info graphic, embedded below, created by payroll software company ZenPayroll, provides a flowchart to walk you through determining whether you need to be classifying a worker as an employee or a contractor.
Assumptions to Avoid in Classifying Workers
A hiring firm should not assume it is safe to classify a worker as an independent contractor simply because:
- The worker wanted, or asked, to be treated as an independent contractor
- The worker signed a contract
- The worker does assignments sporadically, inconsistently, or is on call.
- The worker is paid commission only
- The worker does assignments for more than one company.
IRS Form SS-8 can be used to request a determination of the status of a particular individual. The IRS will use the information provided on the form, as well as any other information that can be obtained from the parties involved to determine whether an individual is covered under the payroll tax laws. The IRS determination does not necessarily indicate worker classification under other employment-related laws.
It is important for businesses to understand difference between and employee vs. independent contractor, especially in today’s ACA climate. Correctly classifying workers before they perform services can save a business confusion, difficulties, and possible fines down the road.
At Cleary, we know how important a comprehensive benefits package can be to your continued success. Give us a call today at 617-723-0700 and we will work with you to create a plan that meets your business objectives, takes into account state and federal laws, and capitalizes on incentives and innovative solutions now being offered.