The federal government is scrutinizing worker classification rules and small businesses should be worried
Hiring an independent contractor instead of an employee has some benefits for business owners but also some risks.
Last month, a U.S. District Court stopped the Biden administration’s effort to roll back a Trump-era rule that made it simpler for employers to classify workers as independent contractors. The reasons were due to a procedural mistake, but the decision was a victory for small businesses across the country that otherwise would have had to classify more independent contractors as employees.
Yet the worker classification battle is far from over.
According to some reports, the National Labor Relations Board recently indicated “an openness” to revisit worker classification rules, and the Department of Labor is also “evaluating all legal options.”
“The district court decision is both surprising and disappointing,” Solicitor of Labor Seema Nanda said in a statement. “When employers misclassify workers as independent contractors, workers lose key rights and protections, hurting labor standards across the board and making it harder for law-abiding employers to compete on an even playing field.”
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The implications for small businesses are significant. Hiring an independent contractor instead of an employee means that business owners don’t have to incur payroll taxes, pay additional employee benefits, or be subject to certain employer-employee responsibilities, particularly for safety and health. So, as the administration takes a harder look at these rules, it’s important for small businesses using independent contractors to know their risks.
“Small-business owners really need to be careful because, from a worker classification perspective, there are multifaceted opportunities to be challenged,” said Patrick McCormick, a tax lawyer and principal at law firm Offit Kurman in Philadelphia. “There are multiple federal agencies, including the IRS and Department of Labor, that can come after you for improper classifications, which can have enormous consequences on wage withholdings, Social Security, workers’ compensation insurance, and unemployment payments.”
Nikki Johnson-Huston, a former tax solicitor for the City of Philadelphia who now helps businesses and individuals with local, state, and federal tax issues, also notes that it’s not just the federal government that could cause a problem if there’s non-compliance. Both state and city authorities may also be involved.
“With the advent of better technology and better systems, taxing authorities share that information with each other,” she says. If reassessed, Johnson-Huston warns, and the city and state finds out, there could be hefty fines and penalties.
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“I’ve seen some companies put out of business because of this,” she said. “Depending on how long the situation occurred, there could be tens of thousands, if not hundreds of thousands, of fines per employee. Once one tax entity finds out, it’s likely that they’re going to share that information.”
So how can you make sure that you’re classifying your employees and independent contractors correctly? The IRS posts rules on its website the Department of Labor also offers guidelines. Both sets of rules mainly focus around one important aspect of the employer-worker relationship: control.
“What you’re really looking at from an IRS perspective is the independence of the workers,” said McCormick. “And the ability they have to exert independent control over their activities and over the end product.”
This means that, to be properly classified as an independent contractor, the workers must have complete control over the work they’re performing, the hours worked, where the work is performed, the tools they use, and the people they may employ. Although only a Social Security number is required to report a contractor’s payments on the federal 1099 form each year, the contractor should preferably provide an employer identification number (EIN) and should have multiple customers in addition to your company.
The relationship should be arms-length, and in no way should the contractor be included in your payroll calculations or be offered any employee benefits. In effect, they should be running their own independent businesses that is invoicing your firm for their work.
“One of the things that everyone needs to understand is the government, whether it be the Department of Labor or the IRS, presumes that everyone is an employee until the company shows them otherwise,” Johnson-Huston said.
To document this, an up-to-date independent contractor agreement should be signed by all parties and updated regularly. The agreement should specifically stipulate both the worker’s and employer’s responsibilities. Good examples can be found on LegalZoom and Rocket Lawyer. File 1099 forms annually with the IRS, state, and city. Getting help from a tax lawyer or certified public accountant is also a good idea.
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Be warned: Even when a contractor provides all the required information, you still have to be careful.
Johnson-Huston said she has seen cases in which an employer is audited even when fraud was committed by the contractor. “A lot of times when an individual problem is found, the authorities may start thinking, ‘Hey, this might be a larger issue’ and they can start pulling more records for that business.” Even if you’re completely in compliance, the cost of an audit could run into the tens of thousands of dollars.
Given the cost savings and lower regulatory requirements, it’s tempting for small businesses to avoid hiring employees and instead use independent contractors. There’s nothing wrong with this. I do it all the time. But in the current pro-worker environment, both in Washington and locally, it’s important for us to make sure we’re in compliance with the rules, even as they change.
“I expect a continuation of the heightened enforcement of existing rules,” McCormick said. “It’s a hot-button issue, and small-business owners should be extra cautious in this area because of the enormity of the exposures that they can have for making the wrong decisions.”
Gene Marks is a certified public accountant and the owner of the Marks Group, a technology and financial management consulting firm in Bala Cynwyd.