What Employers Need to Know

In today’s fast paced working environment, it has become necessary for businesses to look beyond their current staff for either specialized or temporary workers. The use of independent contractors has become alluring to companies because independent contractors present the option to businesses to receive the same comparable work product as their current staff without incurring the initially high employee training costs while at the same time benefiting from lower personnel costs. As financially sound as an independent contractor may seem, a company must be careful not to misclassify the service provider as an independent contractor.

Advantages In Using Independent Contractors

When a business retains an independent contractor, the financial advantages include the cost savings from mandated contributions because the client does not pay any employer contributions for state unemployment tax, Social Security or Federal unemployment tax. Additionally, the client can enjoy cost savings from discretionary fringe benefits as the client does
not need to provide or pay for any traditional employee benefits to the independent contractor. By utilizing the services of an independent contractor, the client may be able to avoid labor, wage and hour laws and enjoy a reduced risk of employment related claims such as discrimination, wrongful termination, unemployment, etc. Additional advantages to retaining an independent contractor are that the client has greater flexibility to enter new lines of business, the ability to retain highly specialized personnel on a contract basis and savings on administrative costs.

Disadvantages In Using Independent Contractors

While the financial benefits and decreased risks for liability may seem ideal for retaining an independent contractor, there are factors which may put the client at a disadvantage when retaining a contractor. These factors include the inability of the client to control how the contractor performs the service. The client cannot terminate without cause because the relationship between the client and the contractor is contractual as opposed to at will. Therefore, if the client terminates the relationship, they may be held liable for breach of contract.
To avoid breach of contract, the client will need to be responsible for overseeing the legality of the working relationship. This is to certify the defensibility of the classification of the client/
contractor relationship by monitoring the amount of time and the number of projects the contractor performs. There is also the loss of continuity and ongoing relationship as the client may or may not have a continuous relationship with the contractor. If there is a misclassification of the client/contractor relationship, the client will have to bear all risks involved when cited for same by a government agency.

The Client/Contractor Tests

Different government agencies apply different definitions of “employer” and “employee” versus “client” and “contractor”. There is a great deal of overlay between these government tests,
and employers must be aware of each test’s requirements. The status of the client/contractor relationships are tested under California and federal law. These tests, such as the “Economic Realities” test, are applied by courts and administrative agencies when deliberating independent contractor status. Each test takes into consideration the entire circumstance of the relationship as well as examining the degree to which the alleged employer has the right to control the “means and manner” in which the work is to be performed by the alleged employee. Specifically, the economic realities test determines whether the service rendered by the contractor requires a special skill and whether the company had a right to direct the details of the work performed by the contractor which results in the work product that is achieved.

Potential Penalties for Misclassification

There are numerous potential financial risks for misclassification of an employee as an independent contractor. The employer may be responsible for the withholding of Federal and State Income Tax, state disability, workers compensation and unemployment insurance. The employer could also be subject to various State and Federal sanctions and penalties. There will also be penalties for wages, overtime and payment of employee benefits. The IRS and the EDD are two of the agencies most
likely to audit a relationship that is claimed as client and independent contractor.

Avoiding Misclassification and Liability

Companies should constantly assess their current practices when it comes to retaining independent contractors regarding withholding and payroll tax purposes. A company should also be aware every time they file a 1099-MISC form as a record of payment to an independent contractor that they are providing notice of the client/contractor relationship to the IRS. Indeed, there is the possibility that a disgruntled “contractor” may later allege the working relationship was an employer/employee situation, therefore attempting to hold the employer liable
for withholding obligations and payroll taxes. Accordingly, businesses should be cautious to document contracts with written agreements which clearly delineate the rights and responsibilities of the parties and keep detailed records of the number of projects worked on by the contractor to avoid any future liability. Avoiding legal claims and penalties keeps the
money in your pocket where it belongs.

This article appeared in the May 15, 2006, issue of the San Diego Business Journal.