Practice Pointer: Avoid Misclassification of Independent Contractors – Understanding the Risks and Consequences

July 10, 2024

Many organizations opt to hire independent contractors because the worker “prefers to be paid that way,” often without fully understanding the implications of independent contractor status. Along with the savings of not paying benefits or employer-related taxes, it seems like a win/win for both parties. However, hiring someone as an independent contractor is not that simple. It is important for organizations to understand the laws surrounding hiring and classifications. Unintentionally or not, misclassification of independent contractors or employees can have costly legal consequences.

While the distinction is not always clear when a worker should be an employee versus an independent contractor, the responsibility for classifying a worker falls squarely on the employer. There is a common misconception that an organization can simply reclassify a 1099 worker as an employee (or vice-versa) and be safe treating them as such if both parties agree, but that’s not the case. Employers must apply all applicable “tests” and follow the guidance and regulations set forth by the Department of Labor (DOL), relevant State Laws, and the Internal Revenue Service (IRS).

The DOL issued a final rule in January 2024 which clarifies the definition of an independent contractor as it pertains to classification under the federal Fair Labor Standards Act (FLSA). The new rule applies an “economic realities” test where employers must use a “totality-of-the-circumstances analysis.” The test consists of six factors that are considered equally, meaning, none carries greater weight than the other. If the worker is considered economically dependent based on the six factors, they are an employee. Otherwise, they may be an independent contractor. The six factors are:

1. Control Over Work: Does the worker have the autonomy to make their own schedule or set pricing?
2. Opportunity for Profit or Loss: Can the worker negotiate pay or choose which projects to work on?
3. Skill and Initiative: Does the worker have specialized skills and seek their own professional development?
4. Permanence of Relationship: Is the worker exclusively working for the company? Are they project-based?
5. Investment in Equipment: Does the worker invest in their own equipment?
6. Integral Service: Is the work crucial to the company’s business function?

Dangers of Worker Misclassification

Along with conducting the six factor “economic realities” test, we recommend a pre-engagement screening to ensure the correct classification is made. If a worker is misclassified as an independent contractor and is later found to meet the legal definition of an employee, the organization may be required to:

• Reimburse the worker for wages that should have been paid to them under the Fair Labor Standards Act (FLSA) or state overtime and minimum wage requirements. Misclassified workers are entitled to benefits they were denied.
• Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare, unemployment, and state disability/paid family medical leave if applicable. This includes federal employment taxes, income tax, Medicare taxes, social security and Medicare, and social security taxes. Misclassified workers may also face the burden of self employment tax, leading to higher taxes and penalties.
• Pay any misclassified injured employee workers’ compensation benefits. Non-compliance with unemployment insurance laws can result in significant penalties.
• Provide employee benefits for which they would have been eligible, including health insurance, retirement, etc. Misclassification can also deny workers their wage rights, including overtime pay.
• In addition, non-compliance with unemployment insurance laws and denying workers their wage rights, including overtime pay, can result in significant penalties

Overall, worker misclassification poses significant risks, including legal ramifications, financial penalties, and damage to the business’s reputation.

Employer Due Diligence when Classifying Independent Contractors

Employers are responsible for conducting due diligence when determining workers classification as either W-2 employees or independent contractors, ensuring a clear employer-employee relationship. The default recommendation is to presume employment and classify individuals as W-2 employees whenever there’s uncertainty. If the work is temporary or seasonal, employers can classify a worker as a part-time, temporary employee.

When utilizing independent contractors, it’s essential to ensure compliance with IRS guidelines. Employers should have a W-9 form on file for each contractor at the start of the contract to avoid backup withholdings. Contractors should invoice for agreed-upon work and specify payment terms.

Employers can also consider the Voluntary Classification Settlement Program (VCSP), which allows taxpayers to reclassify their workers as employees for future tax periods with partial relief from federal employment taxes.

Additionally, it’s advisable to establish clear contractual agreements with independent contractors, confirming compliance with labor, immigration, and tax laws, as well as possessing liability insurance. Before engaging independent contractors, several key considerations should be addressed up-front:

1. Legal Entity: Verify if the independent contractor operates as a legal entity (LLC, Sub Chapter S Corp, Corporation, etc.), and obtain their federal tax ID if applicable.

2. Liability Coverage: Determine if the contractor maintains professional liability coverage, such as errors and omissions (E&O) insurance.

3. Commercial Auto Coverage: Confirm whether the contractor has commercial auto coverage, which safeguards both the contractor and the hiring entity in the event of accidents during job-related driving.

4. Workers’ Compensation: Assess whether the employer’s current workers’ compensation insurance extends coverage to contractors.

5. Tools and Equipment: Ensure that the independent contractor possesses all necessary tools and equipment, including a computer and email address, to fulfill the contract requirements effectively.

The Wage and Hour Division at the US Department of Labor plays a crucial role in enforcing compliance with wage and hour regulations, highlighting the importance of proper worker classification.

By addressing these pre-engagement considerations and implementing diligent practices, employers can mitigate risks and ensure compliance when engaging with independent contractors.

If you have any questions regarding this Practice Pointer, please email us.