Free Enterprise - The FindLaw Small Business Law Blog

What Are the Costs of Misclassifying Contractors?

Hiring independent contractors, as opposed to full-time employees, can benefit your small business. You can be more flexible as you expand, bring in specialists for specific projects, and wave goodbye without any harsh feelings or unemployment benefits to worry about.

But contractors can complicate things, legally speaking, and treating contractors like employees can get you into some tax trouble down the line. So, when are independent contractors not really contractors, and what are the costs of misclassifying employees as contractors?

Contractor Factors

The Internal Revenue Service looks at 20 factors when distinguishing between an employee and an independent contractor. Among the factors that indicate an employer-employee relationship are:

  • Instructions: Employees are typically given specific instruction on how to perform work, while independent contractors are not;
  • Training: Employees are usually trained by the employer, whereas independent contractors are not.
  • Integration: Integration of the worker's services into the everyday business operations are an indicator of employee status;
  • Hiring, Supervising, and Paying Assistants: If the worker has the power to hire and supervise assistants, then that suggests the worker is more of an employee; and
  • Continuing Relationship and Set Hours of Work: Employers and employees tend to have a more permanent relationship, and the employer usually controls the work hours for an employee.

Factors that delineate independent contractors include:

  • Significant Investment: The investment an independent contractor has in his own trade, i.e., contractors generally don't require the hiring company's facilities tools or equipment to get the job done;
  • Realization of Profit or Loss: Realizing a profit or suffering a loss as a result of the services performed is usually more indicative of an independent contractor;
  • Working for More Than One Firm at a Time: Independent contractors, unlike employees, usually work for more than one employer at a time; and
  • Making Services Available to the General Public: Independent contractors typically make their services available to the public on a regular basis.

Classification Costs

While it's true that your small business may save some money by hiring independent contractors (by not paying into unemployment insurance, healthcare benefits, or payroll taxes), misclassifying employees as contractors could cost you in the long run.

The IRS has been consistently cracking down on independent contractor use, and the Department of Labor began a Misclassification Initiative in 2011. The DOL can secure unpaid wages for misclassified employees, and the Internal Revenue Code includes some hefty penalties for failing to deduct and withhold taxes of misclassified employees, including double penalties for employers who disregard reporting requirements.

The IRS has also been known to win punitive damages (monetary awards above and beyond compensation that are intended to punish the guilty party) in misclassification cases in the past.

This means that your penny pinching now may mean paying the piper later. So, before you get into trouble with independent contractors, contact an experienced labor law attorney for help.

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