W-2 or 1099? – Are Your Personnel Employees or Contractors?

More than once a business owner calls me 2 weeks after he or she has hired the first “employee” for the business.  Here’s why:

The problem:

The person hired cannot or will not do the job and the owner has terminated the relationship.  The owner, however, entrusted company equipment to the new worker – typically a phone or a computer – and the now-terminated worker will not return it, claiming that he or she is owed some specified sum of money.  “Ah,” but the business owner protests, “I hired him as a part-time sales person as a 1099 to be paid only on closed sales.  How can I get back my equipment?  Can I call the police?”

The solution:

“Tread lightly and agree to pay a small amount or you can kiss your equipment goodbye” is not what the owner wants to hear, but it is, in all likelihood, good advice.

Why is that?

The remarkable growth of the “gig” economy appears to have led many business owners to believe they can simply pay anyone to do anything for their companies on a contract basis.  No need to pay benefits or employment taxes or to keep track of hours: “That’s just too complicated.”  “Employees cost too much.”  “Too many records to keep.”  “It slows things down.”  “I just want to keep things simple.”  I’ve heard all of these and more.

Employment law, however, has a very different answer, which can lead to significant penalties if violated.

Background

Three factors complicate easy resolution in some cases of classifying personnel as employees or contractors.

First, a hodgepodge of agencies and courts deal with various aspects of the classification issue, including the Internal Revenue Service (IRS), the US Department of Labor (DOL), the Equal Employment Opportunity Commission (EEOC), and the Texas Workforce Commission (TWC). Each has a different focus but all of them work on the assumption that a person who works in a business is an employee, leaving the employer to justify treatment of a particular worker as a contractor.

Second, the laws governing today’s employment relationships were crafted over three-quarters of a century ago for a different kind of economy and stage of technological development, and long-standing laws are predictably slow to change.  Standards that made sense then are not easy to apply in an economy that is far more service driven and demands far more emotional input from personnel for a company’s success.

Third, the standards for classification are not hard and fast rules but are instead guidelines to be used to judge particular situations.

The remainder of the article will illustrate

• Various settings in which agencies and courts have input,

• The standards to determine proper classification,

• Why the classification between employees and contractors has become an area of greater focus for agencies and courts – and thus greater risks for businesses that misclassify their workers,

• Why a business trying to build value for the future might want employees who naturally have a vested interest in a business over contractors who have no particular allegiance; and

• Why the resulting risks should motivate a business owner to consult a qualified professional on these issues before – not after – retaining personnel.

Taxation

The employer is obliged to pay a share of FICA, Medicare tax, and other employment taxes based on an employee’s wages.  Although the employee is liable for income tax, as well as a share of FICA and Medicare tax, tax law obligates the employer to make withholdings for those employee obligations and to pay those withholdings to the government along with the employer’s share of employment taxes.  For an independent contractor, a company does not incur any expense beyond the agreed-upon rate and normally is not required to make withholdings.

The cost to the employer of guessing wrong on the employee-contractor classification question can be very high.  If the IRS audits and determines that particular personnel should have been classified as employees rather than contractors, the business will be responsible not only for the amount of all the taxes owed by the employer on the amounts paid to them, but also for all the withholdings that should have been made on the amounts paid to the personnel.  The IRS can impose that penalty regardless of whether the personnel have paid their tax obligations. The penalties and fines for this liability can quickly add up, not to mention the costs of handling the IRS dispute to that point.

Minimum Wage / Overtime / Employment Discrimination

State and federal employment law provides that employers

1. Pay employees at least the minimum wage for hours worked
2. Pay overtime for hours worked in excess of 40 in one week,
3. Pay employees on time, and
4. Refrain from discrimination on the basis of race, color, national origin, sex, age, religion, or disability.

These protections do not apply to independent contractors.  (The second item on this list – overtime for hours worked in excess of 40 per week – does not apply if an employee is “exempt” from these requirements (see generally, Overtime Issues and Salaried Employees – Do You Have a Problem?), and some other minor exceptions exist.)

The law has special rules for salespeople who are compensated primarily on a commission basis, but still requires an employer to assure that the pay structure results in minimum wage payments to the employee, as well as maintenance of proper time records for commissioned personnel.

The DOL typically deals with minimum wage and overtime matters, while the EEOC deals with most discrimination complaints.  As with taxation, the cost of misclassification can be high.

Also, the company may or may not have time records to show the hours actually worked by personnel.  Even if payment is based on an hourly rate instead of a day rate or flat fee, the hours billed by the worker may not reflect all compensable time.  When a significant portion of a company’s personnel has been misclassified, the costs can be ruinous and the owner can lose the business.

Standards for Proper Classification

Making matters worse, no bright-line or safe-harbor rules inform and protect a business’s classification of its personnel.  Although different agencies and courts use different versions of the guidelines, they focus on the economic realities of a particular situation, and the result in a particular situation under any of the tests would be similar, if not identical.  Relevant questions include:

1.    How extensive is the control over the worker’s behavior while he or she is working?  That is, does the business instruct the worker as to how to do the job or as to when and where to do the job?

Independent contractors for example tend to work on their own schedules and often away from the place of business of the company that has retained them. They usually use their own equipment and often pick who will do the actual work.

Providing training to a worker, on the other hand, suggests that he or she is an employee because the company is telling the worker how to do the job.

2.    Can doing the work result in either a profit or a loss to the worker?  Does the worker have a significant investment in his or her business?

For example, if the worker provides no equipment, has no place of business, and all his or her expenses are reimbursed, the compensation paid can only result in a profit, never a loss, and the worker is likely an employee.

3.    How dependent is the worker on the business for his or her well-being?  In other words, does the worker have other clients, come and go when he or she wants, and perform the work as he or she decides?  How long will the work go on?  How permanent is the relationship?
4.    How integral is the work performed to the core of what the business does?  In other words, is the work essential to delivery of the goods or service that the business delivers to its customers? Is the worker’s occupation distinct from the business that has retained the worker?

For example, a groundskeeper for a building occupied by an air-conditioning equipment company can be either an employee or an independent contractor, depending on other circumstances.  However, that same groundskeeper is almost certainly an employee if he or she is working for a landscaping company – unless that groundskeeper has been brought in to work on a one-time, particularly difficult, and special problem.

Courts and agencies consider other circumstances as well, but these examples illustrate just how difficult the classification issue can be.  In a close case, another important factor is how the parties have characterized the relationship in a written contract, but this is never determinative.

Current Trends

Administrative agencies often default to an employee classification, unless the evidence is strong on the factors in favor of a contractor classification.  Although courts are somewhat more neutral, the strong presumption exists that most workers in a business are employees, not contractors.

The motivation is not difficult to figure out.  Once the worker has been paid, the extra taxes or overtime potentially payable to the worker will “help” the receiving party and the business’s ability to adjust the initial amount paid is gone.

Trends are not always easy to see.  For one thing, enforcement is not always the same, and the agencies and courts go through cycles dealing with the independent contractor classification issue.

These cycles, however, are not always in keeping with how an employer might view current political trends.

Also, because classification cases tend to involve the work of a single worker or small group, the outcomes and circumstances of each case are not well publicized and determining a current trend is difficult.

Even celebrated cases like the relationship of Uber to its drivers provide little guidance. Most courts and agencies considering the issue have indicated that the particular driver whose case was being decided was an employee, but no cases have applied such rulings to a class or group of drivers.  So, even a case involving a company with tens, if not hundreds, of thousands of other drivers does not provide a clear answer to the classification issue.

Building a Business with Value

If one conclusion is not already apparent, the services of a professional who is familiar with classification issues is vital in doing it correctly.  Lawyers who are familiar with employment law are one such resource.

The function of a good business lawyer is to help an owner build a business that has value when it is time to exit, minimize risk, and protect what the owner has built.

Although the safest practice is to retain all personnel in all functions as employees, that is not always practical.  A business owner should keep in mind, though, that most bookkeepers can run payroll and account for withholdings and other providers can handle other administrative burdens.  Also, the total pay package does not have to differ substantially between employee and contractor status because the worker is responsible for all the same taxes anyway if he or she works as an independent contractor and wages are typically less than contractor charges for this very reason.

The real reason to engage employees rather than contractors, however, goes beyond minimizing risk.  Today’s service-based economy often demands workers who deliver not only the service or product, but also delivers a pleasing experience for the customer. This requires emotional involvement in the worker’s part – a constantly positive attitude.

Finding and developing that level of commitment will usually require an employee who feels that the employer will compensate fairly and will appreciate the work done.  Typically, emotional involvement or labor for your business is not the focus of an independent contractor.

Conclusion

In summary, deciding whether a particular worker is an employee or can work as an independent contractor depends upon guidelines, not clear-cut rules, and the consequence for getting it wrong can be costly in terms of penalties and fines, as well missed opportunities to build a business with lasting value.

A business owner is best served by consulting with qualified professionals on this issue and put written contracts in place for independent contractors, especially if he or she wants to classify all personnel as independent contractors.  That may work for a while but, circling back to the scenario at the beginning of the article, a business owner does not want to have the company held hostage by a disgruntled worker.