As we have come to know, there are significant incentives for a company to misclassify an employee as an “independent contractor.” Savings include payroll taxes, costly employee benefits, unemployment compensation etc. Another motivating factor is avoidance of having to comply with myriad employer rules. Now, under Obamacare the incentives are even greater. Under the new law, “large employers” – those with at least 50 full-time or full time equivalent employees are subject to the employer mandate which requires the employer to provide minimal essential health care coverage, or face a penalty.
I have heard rumors that some companies simply plan to reclassify existing employees to get below the threshold. This is just not a good idea. In the event of government examination, the employer will have a very difficult task in having to explain how the relationship conveniently changed just before the requirement was enacted.
There also could be innocent misclassifications. As an example, a company has 40 employees and 15 independent contractors in the beginning of 2015. The business owner thinks that he/she is not subject to the mandate. An agency comes in and finds that 10 of the independent contractors are misclassified. Not only is the business liable for back taxes, interest and penalties for the misclassified workers, the business may also be subject to the $2,000 per year per worker “failure to offer” penalty for the 2 year duration of the penalty. That would be $140,000 just for the Obamacare penalties.
For the last few years, both federal and state tax departments have been making a concerted effort to identify these misclassifications and collect their “due.” There is every reason to believe that this effort will continue and perhaps even expand with the new law. In 1984 (the last time a quantifiable study was completed) it was estimated that $1.6 billion was being lost by the federal government to misclassification. The next study, due in 2015 will quantify the current extent of the problem.
There are certain people who are and should be classified as independent contractors. Proper worker classification is based on the actual working relationship, not an agreement. There is a 20 factor test that should be used (found in Rev. Rul. 87-41) that determines whether an individual is an employee under common law rules. The business should prepare and retain documented evidence that was used to first determine the worker status upon hire. This will prove helpful if one is ever called to defend classification.
Misclassification is always a bad idea and every company should avoid making the error at all costs. If you have additional questions about independent contractor issues, please contact:
– Tracy Badgley, CPA, Partner