Beware of the Temptation of Independent Contractors (Part 1 of 2)

Many employers and “employees” perceive that there are financial benefits for both, by performing work and paying/receiving compensation as an “independent contractor” as opposed to an employee. For employers, these perceived benefits include lowering or eliminating workers’ compensation insurance premiums, avoiding the employer’s contribution to Social Security taxes, avoiding the expense of medical insurance required by the Affordable Care Act, eliminating “employee benefits” such as paid sick leave, and avoiding the cost of unemployment insurance.

For employees, the perceived benefits primarily consist of receiving a check or cash for the “gross” amount earned without deductions for withholding and, in many cases, without a 1099 at the end of the year. These “independent contractors” or, as they are sometimes referred, “1099 employees,” hope to reduce or avoid paying taxes on the income they receive.

The perceived fiscal advantages of using “independent contractors” often lure employers into misclassifying individuals as independent contractors when legally they are in fact employees. The policy of the state and federal government is that unless there is strong proof that a person is in fact an independent contractor, they will be treated as an employee. For example, the Labor Code has at least two provisions that create a presumption that a person rendering service for another is an employee, unless they can prove that the “employee” is in fact an independent contractor. (Labor Code §§ 2750.5 and 3357.)

Misconceptions regarding working as an independent contractor can result in costly consequences to both employers and workers if misclassification occurs and comes to the attention of a governmental entity or the “independent contractor” belatedly decides that they were an employee all along.

The Risks for Employers

The misclassification of an employee as an independent contractor is prohibited by law and can result in a multitude of negative consequences for an employer. The following is a list of some of the major potential consequences for employers who intentionally or innocently misclassify employees:

  • Claims for unpaid wages for failure to pay minimum wage and/or overtime, plus attorney fees and possible fines and penalties.
  • Claims for failure to provide rest and meal periods, plus attorney fees and possible penalties.

  • IRS and/or Franchise Tax Board claims for failure to withhold and pay both the employee and employer’s share of all payroll taxes that should have been withheld and/or paid, plus interest and penalties of up to 100% of the amount not withheld and paid. The failure to withhold can also result in civil and criminal liability. (See, e.g., IRS Code § 6672)
  • Unemployment claims that are not covered by unemployment insurance can result in criminal prosecution for a misdemeanor, a minimum fine of $10,000 and reimbursement to the state for the cost of the investigation. (Labor Code § 3700.5)
  • Failure to obtain and/or maintain workers’ compensation insurance is a criminal offense and it can also result in a “stop order” prohibiting the operation of your business until coverage is obtained. In addition, fines of up to $10,000 can be imposed and a penalty for the greater of twice what the employer would have paid for workers’ compensation insurance during the period the employer was uninsured or $1,500 per employee. (Labor Code § 3722(b))
  • If an injured employee who is not covered by workers’ compensation insurance files a workers’ compensation claim, the employer can be ordered to pay a penalty of up to $10,000 per employee on the payroll at the time of the injury up to a maximum of $100,000 when the matter is resolved. (Labor Code § 3722(d))
  • Civil lawsuit by “independent contractor” for on-the-job injuries that would have been covered by workers’ compensation if the injured “independent contractor” had been properly classified as an employee.

In California the willful misclassification of an employee as an independent contractor can result in the assessment of Civil Penalties of between $5,000 and $25,000 per violation.

The Risks to “Employees”

Some individuals prefer to be paid “under the table” or as an independent contractor because they perceive that their “take home” pay is much greater. Some individuals simply do not report income received “under the table” in order to keep more of the money they have earned for themselves. In doing so these individuals risk fines, penalties and criminal liability.

Other workers who report the income and claim to be self employed can end up paying both portions of the Social Security and Medicare tax when it is time to pay their taxes. This is commonly referred to as the “self-employment tax.” In 2014, the Social Security portion of this tax was 12.4% and for Medicare it was 2.9%, for a total of 15.3%. (Click here for more details.)

In addition, workers who knowingly or ignorantly allow themselves to be misclassified, place themselves at risk of not receiving the benefit of many workplace laws that have been adopted to protect them. These protections include the following:

  • Workers’ compensation coverage for workplace injuries
  • State disability insurance coverage
  • Social Security benefits
  • Overtime pay
  • Meal and rest periods
  • Unemployment insurance

Conclusion

Many employers and employees are ignorant of the risks associated with misclassification of workers as independent contractors. This ignorance exposes both employers and workers to potentially significant financial consequences that can be devastating to both individuals and businesses.

In Part 2 of this article, I will discuss how to determine if a worker is an employee or independent contractor.

By Dan Rowley