One of the most egregious misclassifications too frequent in our industry is the 1099 "employee." The fact that many refer to their independent contractors as 1099 employees is a true tell that these employers are getting it wrong. A person is either an independent contractor or an employee. These two classifications aren't intended to be blended.
Here are the three common law rule categories an employer should review closely:
- Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job? Do they have freedom in determining how their tasks are performed? Do they wear a company uniform? Are they free to explore other contracts/jobs? Is the person given training?
Financial. Are the business aspects of the worker's job controlled by the payer? Are they providing their own supplies? Paying for their own liability insurance? Are business expenses being reimbursed?
Type of relationship. Are there written contracts or employee-type benefits? Will the relationship continue and is the work performed a key aspect of the business? Is the relationship going to be short-lived or a one-time project? Is the position one that the business requires permanently? Is the business proving health insurance, a retirement plan or paid time-off (PTO)?
Assumptions to avoid:
1. The worker wanted, or asked, to be treated as an independent contractor.
2. The worker signed a contract.
3. The worker does assignments sporadically, inconsistently, or is on call.
4. The worker is paid commission only.
5. The worker does assignments for more than one company.
The IRS wants its money.
Generally, an employer must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. The IRS frowns heavily upon 1099’ing someone to get around these taxes. Well, they do more than frown. They fine. Heavily. This is serious stuff. Along with penalties, an employer would be held liable for all the employment taxes of the misclassified employee. Suits have totaled in the hundreds of thousands to millions for businesses in violation (Orange County Register, FedEx, etc.). Penalties can go back as far as three years. Here’s a breakdown of what a misclassification may cost you:
· 1.5% of the employee’s wages.
· 20% of the employee’s share of the FICA taxes + entire amount owed by the employer.
· No rights to recover from the employee what is due to the IRS.
· Failure to file Form 1099 doubles the percentages: 3% for federal income tax and 40% of the employee’s portion of the FICA + employer’s share.
· The full amount of income tax that should have been withheld.
· The full amount of both the employer and employee shares for FICA.
· Interest and penalties.
· Criminal and civil penalties may be issue
In addition to civil penalties, the IRS may levy criminal penalties of $1,000 and/or one year in prison for failure to properly classify and withhold wages. If the IRS obtains a felony conviction against a person or company for “attempting to evade or defeat tax,” the fines are up to $100,000 ($500,000 in the case of a corporation), or imprisonment not more than five years, or both, together with the costs of prosecution.
The penalties may extend beyond the ownership, as a responsible person (including corporate officers and employees or members or employees of a partnership) with authority over the financial affairs of the business who willfully fails to collect and pay taxes may be held personally liable for the total amount of the uncollected tax up to 100% under the provisions of the Internal Revenue Code, as well as subjected to criminal prosecution.
Ultimately, one in three companies fail a worker classification audit and 46 percent of independent contractors reviewed by the IRS are found to be misclassified. The government is starting to pay much closer attention to instances of misclassification and audits are becoming more frequent.
Meanwhile, class action lawsuits by groups of independent contractors requesting employee status are becoming increasingly common; reports suggest that this is one of the hottest areas in employment litigation. Contractors claiming that they were effectively employees may successfully sue a company for employee benefits.
Why do employers misclassify workers?
In most circumstances, the reasoning comes down to money. By classifying an employee as an independent contractor, an employer avoids paying: the employer’s share of the social security and Medicare taxes (hence the penalties document above); overtime pay; employee benefits such as sick leave, vacation and medical; unemployment tax compensation and workers’ compensation insurance.
So how does an employer know which way to classify?
The IRS says, "Businesses must weigh all factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no "magic" or set number of factors that "makes" the worker an employee or an independent contract, and no one factor stands alone in making this determinations. Also, factors which are relevant in one situation may not be relevant in another."
Clear as mud, right?
After going through a full review of what the person does and how they do it, an employer still may be left scratching his head. Here's a simple way to approach the issue: if it walks like a duck and quacks like a duck, it's a duck. Or in this instance, if the position requires the person to be directed as to how, when, where and with what to do the job, he’s an employee. Fill out that W4 and file those taxes!
If after thorough review, an employer still is unable to make a classification decision, he can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, with the IRS. While waiting for a determination from the IRS, the employer should treat the worker as an employee, withholding all necessary taxes.
Seek out advice from your accountant or attorney to help you properly classify your staff. Understanding the difference between independent contractors and employees and classifying accordingly will keep your business compliant and protected.
Melissa Knowles serves as the Vice President for Gym HQ, A ClubReady Company. With over a decade of industry experience, her knowledge spans strategic operations, development of staff training materials and programs, cost-savings analysis, reporting development and implementation, fitness department overhaul, client retention systems and corporate management. She’s especially well-versed in all operational and HR focused areas, and she holds HR certification through SHRM. Melissa is a graduate of the University of West Florida and holds an MS in Exercise Science and a BS in Sports Medicine.