Employee or independent contractor? The cost of mislabeling

Employee or independent contractor? The cost of mislabeling 750 750 Gordon Media Company

While most workers find job stability and set employee benefits ideal, a growing number are becoming independent contractors in favor of working nine-to-fives. Greater flexibility, according to studies, does improve happiness and productivity after all.

Companies also benefit from independent contractors, relying on short-term help and outside expertise at a fraction of the cost of hiring an employee. However, there are companies that treat independent contractors as though they are employees, which puts the business in legal jeopardy.

According to the Internal Revenue Service (IRS), independent contractors are considered self-employed workers and provide services without the company having extensive control over the worker’s schedule, where the job is done or how the job is done. The greater the amount of control the company exercises over an independent contractor, the more likely this worker would legally be considered an employee. In such case, the company is responsible for withholding and paying applicable taxes for the worker. Some companies use independent contractors to get around paying employment taxes, with the full burden falling on the worker.

The pros and cons of being an independent contractor

There are important differences between employees and independent contractors. In short, employees typically have predetermined schedules, paydays and at least some benefits. And, in addition to the employer sharing the burden of employees’ Social Security and Medicare taxes, it takes care of employees’ income tax withholdings. Drawbacks to being an employee may include an inflexible schedule, having to commute to an office and supervisors dictating your daily work.

Independent contractors set their own schedules, but with additional flexibility comes more risk and responsibility. Although able to self-govern work, this may coincide with working longer hours to find clients. Many independent contractors also spend a fair amount of time invoicing clients and awaiting payment. Furthermore, those who are self-employed bear the full employment tax burden, the responsibility of withholding income tax and costs of health insurance. These additional responsibilities may be justifiable costs for freedoms like working with multiple clients at once, flexible hours and being able to work remotely.

How companies mislabel employees and independent contractors

Many companies hire independent contractors and impose limits to their independence while avoiding payroll taxes. They dictate independent contractors’ schedules, supervise their work and require them to work inside the company’s office – basically treating the worker as an employee. This practice is not legal, according to the IRS. A worker is either an employee or an independent contractor and should be treated accordingly. The IRS is clear: “You are not an independent contractor if you perform services that can be controlled by an employer (what will be done and how it will be done).”

One common practice is a company, rather than hiring a worker, using independent contractor agreements over a “probationary period.” Again, the greater the extent of the company’s control, the more likely the worker would be considered a common-law employee. A company cannot treat a worker like an employee while also avoiding payroll taxes, even if it’s only temporary. It does not work both ways.

Ride-share companies Uber and Lyft offer great examples of how independent contracting works. While these companies set guidelines and safety standards for drivers, and also disburse their customers’ payments, drivers are on their own schedules and do not report to anyone. Drivers determine when and where they will provide their services. And since drivers are not employees, taxes are not withheld and drivers are responsible for paying all applicable taxes on their income.

Criteria for determining a worker’s appropriate classification

Hiring an independent contractor should be beneficial and fair to all parties, and this is accomplished when laws are followed. “Although a contract may state that the worker is an employee or an independent contractor,” says the IRS, “this is not sufficient to determine the worker’s status.” Fortunately, the government provides the following rules to assess the company’s extent of control and determine the appropriate worker classification:

  1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
  2. Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
  3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?

The IRS recommends employers consider all factors to determine the correct classification. They also provide a service to determine a worker’s status if it remains unclear.

The cost of mislabeling a worker

If it is determined that an employee is misclassified as an independent contractor, a company can face a number of penalties by both the U.S. Department of Labor and the IRS, including being required to pay fines, back-taxes and interest on wages. Also, misclassified workers may be able to claim employee benefits retroactively. (Some businesses qualify for relief from federal employment tax with reasonable basis defined under the IRS’ Section 530.) Many class action lawsuits have materialized due to the mislabeling of independent contractors, resulting in multimillion-dollar settlements from companies like DoorDash and FedEx.

Remedies for workers who are mislabeled

If you signed an independent contractor agreement but are being treated like an employee, there are solutions. First, you might speak with the company and explain what you’ve learned about worker classifications. Hopefully, the company will take action to investigate and, depending on their findings, agree to reclassify you and pay applicable taxes. Second, you can get the IRS involved.

Misclassified workers can file Form 8919, Uncollected Social Security and Medicare Tax on Wages, to report the share of uncollected Social Security and Medicare taxes the company should have payed. Note that the IRS may contact the business to investigate before arriving at their determination, which can cause tension between you and the company. A third option is to file a complaint with the Dept. of Labor.

To be clear: correctly classifying workers is the employer’s legal responsibility. In many cases, mislabeling is an honest mistake. In order to remedy mislabeling a worker before legal issues arise, employers may participate in the Voluntary Classification Settlement Program, allowing reclassification of workers as employees for future tax periods, “with partial relief from federal employment taxes for eligible taxpayers that agree to prospectively treat their workers (or a class or group of workers) as employees.”

Independent contractors are vital to businesses across many industries. With more workers becoming contractors, it is imperative to understand classification.

For employers, mislabeling a worker can be costly legal mistake, whether committed knowingly or unknowingly.

As an independent contractor, the worker must fight to protect his or her independence, and thus the ability to thrive as self-employed. Many businesses seek to protect their own interests first, so know your rights and be your own advocate. For more information on the rights of independent contractors and employees, visit irs.gov.

The information presented in this article is for general guidance on matters of interest. The application and impact of laws can vary widely based on the specific facts involved. This article is not to be considered legal advice and should not be used as a substitute for consultation with an attorney.