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Costly Consequences of Misclassifying Independent Contractors

Out of the desperation that companies are feeling to find inexpensive alternatives, a deluded solution has arisen — using independent contractors and 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 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, which has warned employers of the consequences of misclassification, and state enforcement agencies are growing more forceful in their inquiries and punishments for worker misclassifications. If you think this is  minor, think again.  When a tax audits find misclassified workers, the employer pays for it, and dearly.

The truth is, while blurring the line between independent contractor and employee seems prudent, your company may pay a bigger price than was agreed in the initial terms and conditions. However, a seasoned team of outsourced HR consultants can provide you with the right guidance and support for consistent, accurate employee classification. Hire Ravix Group to help you properly classify those doing work for your company in any capacity.

What Are the Lessons and Legalities of Hiring Contractors?

Under the law, an employer has the following responsibilities toward an employee:

  • Withhold income taxes, including social security, Medicare and state disability from an employee’s pay.
  • Submit the withheld taxes, plus matching social security and Medicare along with unemployment taxes, to the appropriate governmental entity.
  • Provide benefits for employees who work more than 30 hours per week as defined per group benefit plans.

In contrast, independent contractors:

  • Pay their own income taxes via quarterly estimates, including both employee and employer portions of social security and Medicare taxes.
  • Do not pay either state disability or unemployment taxes as contractors are not eligible to receive these government benefits.
  • Procure health and other plans for themselves

What if Independent Contractors Are Legally Deemed Employees?

If an independent contractor is deemed an employee under the law, the company could be required to pay taxes plus penalties for the period of time in which the contractor worked for them. Often, the audit and subsequent categorization of an employee relationship occurs several years after the “offense,” by which time the bill can be quite significant and costly.

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, and other costs.

Big mistake! What little money you have to get your company off the ground could 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, you need to make sure employees are classified and paid as they should be and verify that your independent contractor classifies as such under the law.

Partnering with an outsourced financial controller service provider can help you set up policies and procedures to ensure your job requisitions and duty assignments match the legal definition of a contractor or employee. The next time you ask yourself whether you should implement outsourced HR and payroll services in San Francisco, keep the following penalties in mind.

The Real Cost of Outsourcing Misassigned Employee Roles

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 $21, in fringe benefits by classifying a single $50k employee as an independent contractor. That initial $21,000 you were supposed to pay for health benefits can easily become a civil lawsuit 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: The Million Dollar Question

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, as follows:
    • The contractor should have other clients and not depend solely on one client.
    • The contractor has a chance to gain profit or bears the risk to harbor loss from the decisions they make 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, risking no financial loss.

In this day of outsourcing essential functions, companies must understand the risks inherent in hiring independent contractors, especially those who are not associated with or employed by an HR outsourcing 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.

An external startup business accountant can guide this process while working in a truly contractual relationship. We’ll start by asking:

  • 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. In this case, 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. In addition, you’ll need to provide group benefits if this employee will work more than 1,000 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.

Ravix Group offers outsourced HR consulting services to help you handle all the details of reclassifying any contractors performing employee functions. You can avoid penalties from state and federal governments with the expertise of our premier accounting consultants. Contact us online at or give us a call at (408) 216-0656 to today set up an appointment to discuss your needs.