By: Helios on March 25th, 2014

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Independent Contractor vs. Employee: the Cost of Misclassifying

Total Rewards | Risk Management | Benefits | Employee Relations

When used properly, ICs (Independent Contractors) can be an excellent way to augment business services and operations.  Classification continues to be hot button issue with the IRS. Misclassifying a position as an IC (also referred to as a 1099) when the position should be classified as an employee can create significant liability for a business, small or large.  One of the more well known cases in recent memory involved a suit that Microsoft settled with a group of Independent Contractors for nearly $100M.  At issue in the Microsoft suit was participation in various benefit programs, including employee stock options.  But even small companies may find themselves targets of litigation.  To help you understand exactly what is at stake, here are some areas of risk to keep in mind:

Wage and Hour Violations – Independent Contractors are not subject to the Fair Labor Standards Act.  If you classify a position as a 1099 when the work performed meets the definition of employee, you could be liable for up to three years of overtime payments and possibly liquidated damages, also known as double damages.

Unemployment Insurance – ICs are commonly used by companies as a way to staff for work they anticipate will be short term in nature.  But as you’ll see in other Helios articles on this topic, the duration of the work alone is not a determining factor in correct classification.  If used to complete a short-term project, a true Independent Contractor would not be eligible to collect unemployment benefits at the conclusion of the project since they don’t contribute to the system from their earnings nor does the employer contribute on their behalf.  However, ICs do sometimes file for unemployment, arguing that they should actually have been employees and are therefore eligible for the benefit.  As you can imagine, even one such occurrence can attract the interest of government auditors.

Workers’ Compensation - Like unemployment, Independent Contractors are not covered under a company’s workers’ compensation insurance. If it’s determined that the IC was actually performing the work of an employee at the time of injury, your company would be liable to pay for their workers’ compensation insurance and you may also arouse the suspicion of your workers’ compensation carrier or the government agency administering workers’ comp.  Even if your Independent Contractor is classified correctly, an on-the-job injury can create a legal headache for your company because the IC may opt to sue.  Remember that workers’ compensation is an exclusive legal remedy meaning that an employee who is hurt while working can only file a workers’ comp claim; they do not have the right to sue for damages.  By contrast, an IC may pursue legal recourse, ultimately costing you a lot more money.  Your best strategy is to require Independent Contractors to be licensed and to make sure that protective language is included in any business agreement that you sign with an IC.

Benefits – Another reason why companies may elect to classify a position as an Independent Contractor is to avoid awarding benefits that would otherwise be given to them as an employee.  The Microsoft case (Vizcaino vs Microsoft Corporation) is probably the best known example of this legal hazard but there have been many others. The judge in the Microsoft case determined that misclassifying was a company-wide practice, giving way to a very costly class-action law suit.  One defining characteristic of Independent Contractors is that they perform work outside the company’s normal scope of services or operations.  If your business has 30 W-2 employees and 25 Independent Contractors, you should look closely to determine if nearly half of your total workforce is truly performing work that’s outside your company’s scope.  Using Microsoft as a reference, the more you make mistakes with classification, the more risky and more potentially expensive the situation becomes.

Businesses most frequently misclassify ICs for two reasons: expedience and a perceived cost savings.  Someone is needed immediately to perform work of a short or unknown duration and Independent Contractors are viewed as a way to achieve workforce flexibility.  But as I’ve discussed, the legal risks are significant.  If your objective is to avoid adding a position to your payroll, one common alternative to the IC arrangement is to hire employees though a staffing agency or a Professional Employer Organization (PEO).  I’ve worked with many hiring managers who balk at these options because it seems more costly on the surface.  If you can engage someone’s services at $12/hr. they ask, why pay a PEO bill rate of $16/hr.?  In reality, what you’re paying for is a fair and legal way to achieve the flexibility your business needs.   As I’ve shown, misclassifying ICs can potentially be far more expensive than paying an inflated bill rate.

It’s critical that businesses understand the difference between Independent Contractors and employees. Equally important to understand is that it can vary by situation so a thorough analysis is necessary.  Just because someone represents themselves as an Independent Contractor and perhaps performs true IC work for another company, doesn’t mean that you can hire them as an IC.  You need to evaluate the work you’re asking them to perform and determine if it meets the definition of employment or if it can truly be done by an Independent Contractor.  Talk to the Helios HR experts if you have questions about classifying employees or finding workforce solutions for your business.  Helios has published several blog posts in the past to help you understand how the IRS distinguishes between ICs and employees and how companies can use ICs effectively: