Pitfalls of Misclassifying “Contract Labor”

If you are a business owner or manager, you may have had this great idea at one time: “I can save my company lots of money if I hire ‘contract labor’ instead of employees to do this job.”

The hope of every business person is that hiring a contract laborer will allow the company to avoid the headaches that accompany being an employer.

Employer anticipate a savings by not paying the employer’s portion of federal payroll taxes, worker’s compensation premiums, retirement and health benefits, as well the cost savings of avoiding state and federal unemployment taxes. Also, refusing to put another employee on the payroll is believed to help prevent the liability for discrimination and overtime wages.

Unfortunately, if you decide to take a bite of this poisonous fruit that the serpent is offering and hire a contract laborer, you could face regrets and costs much greater than anything you incur by accepting the responsibilities of being an employer.

You can’t just choose to classify a worker as a contract laborer when he is performing work for you. Chances are very high that all of the people who perform work for your business are actually your employees, whether you call them that or not and even if they agree to the arrangement. The IRS and the Department of Labor will see this as the tax dodge that it really is.

There is someone called an “independent contractor”, but he performs work for your company as well as others. You exercise no control over where, when and how the specific job for which you hired him gets done. This could be your lawyer, your accountant, your plumber, or other workers who are usually self-employed or employed by another company and are not economically dependent on you.

But if you dictate the manner and means by which work is done for you, provide training, supervise the worker, set the hours, provide the tools and equipment or make a profit off of the labors of the worker, he is an employee and cannot be classified as contract labor.

If you misclassify an employee as an independent contractor, there are already significant penalties, and those may soon increase.

A bill was filed in both houses of the United States Congress on April 22, 2010, aimed at insuring that workers are classified as employees, making them eligible for the legal protections and tax benefits provided to employees by law.

If passed, the Employee Misclassification Act will require employers to keep records of every worker classified as an independent contractor along with the analysis of the reasons that the worker was classified that way.

If you are wrong in that analysis, the Act will also increase the penalties for employers who misclassify their workers, including double damages for any violation.

Even if this new legislation doesn’t pass, regulators in President Obama’s executive branch are already on the lookout for companies who misclassify workers as contractors rather than employees.

The United States Department of Labor has increased its resources, investigators and emphasis on enforcement against employers who misclassify workers as contractors. The DOL estimated in 2000 that 30% of companies are guilty of this error.

The DOL’s 2011 proposed budget adds $25 million and 100 investigators just to focus on the “Misclassification Initiative”.

In addition, the IRS announced in February that it will audit 6000 businesses at random over the next three years to determine if any of them have misclassified employees as contractors. So you could get investigated by two federal agencies who have the power to impose significant penalties on your company.

Industries that often have problems with misclassifying their employees include the home health industry, construction, trucking, shipping and delivery, security, spas, technology and media companies. Even a group of strippers sued their club owner in 2009 for making them “pay for the pole” and earn only tips, when the women claimed they were regular employees who were due hourly wages and overtime.

So as a responsible business owner or manager, what can you do to avoid being one of those companies that faces federal enforcement of the regulations prohibiting you from classifying an employee as an independent contractor?

  • Assume that everyone who works for you is an employee. Don’t classify someone as contract labor unless you have a legal opinion specifically addressing whether that person really is an independent contractor.
  • If any worker actually is an independent contractor, you need a written agreement spelling out the terms of service with that worker.
  • Keep careful records of your classification of all workers and how you compensated them for each day’s work.
  • Annually review the duties of anyone who works for you and make sure that your initial classification of that worker, whether employee or contractor, still applies.

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