Out of the desperation that companies are feeling to find inexpensive alternatives, a deluded solution has arisen: using independent contractors/consultants to do employee work.
The general idea is that an independent contractor is an industrial godsend; you do not have to provide them the same benefits or share ownership that an employee requires, nor are you [presumably] responsible for their fiscal success. You can hire them, fire them, and get what you want all in a day’s work. Many early stage companies indulge in this practice, unaware of the fact that the IRS and state enforcement agencies are growing more forceful in their inquiries and punishments for worker misclassifications. Approximately 70% of tax audits find misclassified workers, and the employer pays for it. If you think this is a minor charge, think again. The government is hungry for money and doesn't mind taking yours.
The truth is, while blurring the line between independent contractor and employee seems prudent - almost brilliant - your company may pay a bigger price than was agreed in the initial terms and conditions.
Lessons & Legalities
Under the law, an employer is required to withhold income taxes, including social security, Medicare and state disability from an employee's pay. Employers are then required to submit the withheld taxes, plus matching social security and Medicare along with unemployment taxes, to the appropriate governmental entity. Additionally, employees who work more than (usually) 30 hours per week as defined per group benefit plans are entitled to receive group health and other benefits.
Independent contractors are required to pay their own income taxes via quarterly estimates, including both employee and employer portion of social security and Medicare taxes. No one pays either state disability or unemployment taxes as contractors are not eligible to receive these government benefits. Further, their health and other plans are their own responsibility.
If an independent contractor is deemed an employee under the law, the company could be required to pay taxes for the period of time in which the contractor worked for them, plus penalties. Often, the audit and subsequent determination of an employee relationship occurs several years after the "offense" by which time the bill can be quite significant and costly. And in this economy, no one has the time and money to pay for a mistake that could have been easily avoided.
Early stage companies are often caught making this error due to pure ignorance rather than any conscious intent to avoid the law. They believe it is more expeditious to bring people in on a contract basis until they know they have funding, or until they bring in payroll resources, or just because it seems easier to write a check and not worry about payroll processing, payroll tax returns, etc. Big mistake-what little money you have trying to get your company off the ground will be sucked up in a penalty-laden tornado that will leave you destroyed.
The Employment Development Department (EDD) is the California authority responsible for auditing and assessing the employment/independent contractor relationship. Sometimes a company is audited because an independent contractor unwittingly files an unemployment claim; other times companies are audited as part of a regular rotation. In any case, the company needs to make sure employees are paid as they should be and anyone called an independent contractor truly qualifies as one.
A Look At The Numbers
Misclassification is a gamble and you up the ante with every misclassified employee. If the company is audited, and it likely will be, and the determination made that a contractor earning $120k per year has been misclassified, the assessment penalty can amount to $45,000 per year, and since tax assessments go back three years, that could total $135,000 related to one person. For two founders and five engineers, those assessments could reach approximately $1 million.
It doesn't end there. Statistics show that a company saves approximately $24,000 in fringe benefits by classifying a single $120k employee as an independent contractor. That initial $24,000 you were supposed to pay for health benefits can easily become a civil law suit with its related astronomical legal fees. And the retroactive charges for overtime, benefits and stock options will dry up what you haven't spent paying for your "brilliant" idea. Even the most savvy CEO knows that investors will not line up to provide funding for a company facing unnecessary lawsuits.
Employees vs. Consultants
There are a few defining factors that delineate between an independent contractor/consultant and an employee. First and foremost, the very purpose of an independent contractor is usually to complete a one-time project. There is no ongoing relationship; it is an agreed-upon interaction between a company and a consultant. Secondly, the company that has contracted to the individual does not have the right to control day-to-day work, which includes means and methods of accomplishing the task initially hired for. The last two facets are mostly in relation to the independent contractor's procedures themselves. The contractor should have other clients and not depend solely on one client. Lastly, the contractor has a chance to gain profit or bears the risk to harbor loss from the decisions he or she makes about how to perform and complete their work.
An employee, however, is subject to the direction and discretion of an authority figure on a day-to-day basis. The job they are performing is on an ongoing basis, which may or may not be a series of tasks or projects for the employer. Lastly, an employee is paid on a consistent basis and compensated for expenses, and risks no financial loss.
In this day of outsourcing essential functions, it is critically important that companies understand the risks inherent in hiring independent contractors, especially those who are not associated with or employed by an outsource firm. Companies should go through the factors described above for every independent contractor or consultant they use every time they bring in a new one.
Is the agreed-upon work of a project nature?
Will the company supervise and control the consultant’s day-to-day work?
Can the consultant certify that they have more than one client for whom they perform similar work?
Does the contractor face some risk of loss if the work is not completed or unacceptable to the company?
If the answer is no to any of the above, then serious consideration should be given to treating the worker as a temporary employee.
The offer letter should clearly document the employment relationship, temporary employee, as well as the expected duration of the relationship.
Plan to withhold appropriate taxes and pay the employer taxes. Negotiating a lower compensation rate by approximately 10% can mitigate employer tax costs.
Plan to provide group benefits if this employee will work more than 1000 hours per year (approximately 6 months full time or 12 months part-time).
Alternatively, clients should consider hiring a worker employed by a consulting firm who will certify the employment relationship with that firm and release the client of all employment-related claims by its consultant.
According to the EDD, 2010 is going to be the year of the misclassification audits-and you won't get away with it.