It may seem like we’ve been talking about worker misclassification a lot these days. (Need a refresher? Check out the posts, “This Common Mistake Can Cost Small Businesses Thousands” and “$2 Million Fine for Misclassifying Employees.”) And it seems all the talk is warranted because things are about to get real for small-business owners.
Accounting Today reports that the U.S. Department of Labor is cracking down on worker classification by funneling funds to states to help with enforcement – $10,225,183 to 19 states, to be exact. The DOL hopes that the extra cushion allows states to beef up worker misclassification detection programs and protect unemployment insurance programs. In practice, this means states can fine-tune their ability to audit employers.
This is a big issue for small-business owners because they often rely on freelancers and independent contractors when they first start out. When you hire freelancers, you get the help you need without the worry of offering benefits or paying half of their employment taxes. But if your freelance worker is legally considered an employee, you can be in a world of financial trouble. You could be liable for…
- Back payroll taxes.
- Workers’ Comp benefits.
- Healthcare benefits (depending on how many employees you have).
- Other penalties.
Let’s take a look at how you can avoid these fines and why the employment contract you use with freelancers matters less than you might think as far as regulators are concerned.
Distinguishing Employees from Independent Contractors
There’s no hard-and-fast distinction between an employee and a 1099 worker. Rather, the IRS gauges a worker’s classification based on…
- The amount of control the worker has over how they complete their work.
- How the employer compensates the worker.
- A worker’s ability to work for other businesses or clients.
- How essential the worker’s job is to the survival of the business.
You could run into trouble if your freelancer…
- Stays with your business for the long term.
- Only has time to work for you.
- Is required to keep a certain schedule.
- Uses your equipment.
- Is responsible for the bulk of your business’s work.
- Doesn’t submit invoices in order to receive payment.
All of these factors could indicate an employee-employer relationship to the IRS. The main consideration is that the freelancer must be able to operate as their own entity without constant oversight from their client. A client can establish deadlines and project parameters, sure, but they can’t decide the manner in which the contractor completes their work.
The Triple Whammy Punch of Worker Misclassification
When an employee is wrongfully classified as an independent contractor, it’s not just the IRS’s wrath you’ll face. The IRS, DOL, and Workers’ Compensation Board can all dispute the status of a worker and levy fines.
As you may already know, employers are required in almost all states to insure their employees with Workers’ Compensation Insurance. But let’s say you accidentally misclassify workers as independent contractors, so you don’t have Workers’ Comp coverage. If your business is audited and your workers are reclassified as employees, your state can file a lawsuit against your business so you’ll pay the fines for being uninsured. You can read about those steep fines here: “State Sues Small Business over Workers' Compensation Insurance Violation.”
Carrying Workers' Comp is far more affordable than these fines. Learn more about Workers' Comp costs in our Workers' Comp Insurance Cost Analysis.
But I Have a Contract!
As a responsible small-business owner, you probably use employment contracts to avoid these kinds of legal snafus. But even a lawyer-penned contract can’t override the reality of your working relationship, as far as state regulators are concerned.
This isn’t to say you shouldn’t use contracts – you most definitely should. They can back up your claims that your contractor isn’t an employee. But you’ll also need to give your contractor enough freedom to earn a living from other clients and to do their work on their own terms as long as they meet your deadlines and project requirements.
For more information on how to properly classify workers, see the IRS’s helpful guide.