Misclassifying Employees as Independent Contractors ... One of
the Most Expensive Mistakes of Them A
The time comes for every successful home-based business owner
when one person can no longer do it all. In the early days of
your fledgling business you accepted that not only were you CEO,
CFO, COO, secretary, treasurer and marketing director, you also
had to be laborer, receptionist, janitor, chief cook and
bottlewasher. That is simply what you have to do when starting
out. In fact, I'll bet you worked harder in your "little home
business" than you ever did in your former life as corporate
whatever, right? But now the time has come. You have
successfully taken your business past the initial, maddeningly
slow, frustrating start-up phase to the point where you're
seeing some growth ... so much growth in fact that you're
finding it near impossible to keep all the balls in the air.
The time has come to hire some help. OK, but what kind of help
do you need? If it's a secretary/receptionist, that's easy. You
go out and hire yourself a competent employee. But what if it's
someone to carry out specific projects such as designing a
website for a good customer you just can't service within the
timeframe the customer needs? What if it's someone to create a
marketing program to launch your business to the masses? What if
it's a bookkeeper to handle your accounts payable, receivable
and everything else in between? The difference between these
types of activities and our secretary/receptionist example is
that the former are all specific projects whereas the latter is
not.
When considering whom to hire for your project work, you have a
choice ... hire a full-time or part-time employee or hire an
independent contractor. By the time you include all the add-on
costs of hiring an employee (in addition to wages or salary you
need to add on federal and state payroll taxes, social security
tax, federal unemployment insurance tax, state unemployment
insurance, workers' comp premiums and employee benefits, not to
mention shelling out for office space and equipment), hiring an
employee becomes a relatively expensive option compared to
hiring an independent contractor to do the same work. The add-on
costs of hiring an employee usually add about 30-40% to the
bill. In other words, if you pay your employee $10 an hour,
you'll really be paying $13 - $14 an hour once you include all
the add-on expenses.
In contrast, although you usually pay an independent contractor
more than an employee, that cost will still be less than an
employee with the add-on expenses. You may pay an independent
contractor $12 an hour without any additional charges. Sound
good? Well, read on. It's not as easy as it looks.
WHAT IS AN INDEPENDENT CONTRACTOR?
So, what is the difference between an employee and an
independent contractor anyway? Quite simply, an independent
contractor is someone who contracts with someone else to provide
specified services for a set price on terms and conditions
outlined in the contract.
For example, let's say you hire a gardener to mow your lawn and
get rid of weeds once a week. Your contract (whether written or
not) is that Joe Gardener will arrive at your house on Friday
morning, mow your lawn, get rid of weeds and generally tend to
your garden. In exchange, you agree to pay Joe $40 for this
service each week. Joe supplies his own lawnmower, hedge
clippers and weeding tools. Joe decides what time he arrives and
how long the job takes (within reasonable parameters). You do
not supervise Joe in his tasks or dictate to him how they are to
be done. Joe is an independent businessperson and you treat him
accordingly. The final product is either to your satisfaction or
it isn't. When he's finished, you pay him if you're satisfied
with the end result and you don't pay him if you're not.
Contrast this with an employer/employee situation. Let's say you
own the business Joe's Gardening Service. You employ three
employee gardeners to perform services for your business. As the
gardeners' employer, you pay them a fixed wage and you withhold
taxes, unemployment insurance and various other benefits from
their wages to remit to the appropriate government agencies. In
addition, you provide your employees with the tools and
equipment they need to perform their work. You tell them what to
do and supervise them while they're doing it. At the end of the
job they get paid by you whether your customer is satisfied with
the job or not. In other words, although your customer may not
pay you (the independent contractor) because she is dissatisfied
with the work performed by your employees, you must still pay
your employees because they are not independent contractors -
they are your employees and are entitled to be paid a fixed
wage. If you are dissatisfied with their work, you can fire them
but you can't decide whether to pay or withhold their wages
based on the end result of the particular project.
ADVANTAGES OF INDEPENDENT CONTRACTORS
=> Cost
As mentioned above, the main advantage of independent
contractors versus employees is cost. You can get the same or
better service from independent contractors for a lower hourly
rate than you can from employees because you don't have to incur
all the add-on expenses that go along with hiring employees.
=> Equipment and Materials
In addition, you don't have to provide office space or materials
and equipment to independent contractors. As independent
contractors (who may also go by the terms "freelancers",
"consultants", "self-employed", "business owners" etc.) are
self-employed business people, they have their own "tools of the
trade". If they're website designers, they have their own office
space, computer and printing equipment. If they're gardeners,
they have their own lawn mower, whipper-snipper, wheelbarrow and
pruning shears.
=> Legal Liability
At law, an employer is vicariously liable for the torts of his
or her employees. This means that if you hire an employee
gardener who accidentally runs over your customer's pet cat in
the driveway of her home when the customer had made it clear
that your employees are always to park in the street, in
addition to suing your employee for negligence, she can also sue
you, the employer, as you are vicariously responsible for the
acts of your employees. (And, by the way, this applies whenever
your employee is acting within the scope of employment, whether
under your express instruction or not. If your employee has a
car accident when traveling between jobs and his negligence at
least partially caused the accident, you're responsible to the
same extent as the employee.)
This is generally not the case with an independent contractor
unless the independent contractor has been engaged to perform an
inherently dangerous activity (such as blasting) or you have
attempted to delegate to your independent contractor a
non-delegable duty (such as keeping a rental property you own in
good repair for the benefit of the tenant).
In addition to minimizing legal liability for torts, hiring
independent contractors also minimizes your liability for other
types of lawsuits such as wrongful termination or job
discrimination.
DISADVANTAGES OF INDEPENDENT CONTRACTORS
There are two main disadvantages to hiring independent
contractors versus employees.
=> Misclassification
Far and away the most serious disadvantage is if you misclassify
employees as independent contractors. Merely labeling a worker
as an independent contractor is not enough. They must actually
be an independent contractor.
If you do misclassify an employee as an independent contractor,
you must pay the IRS all back-taxes owed, plus interest, plus
penalty (12% - 35% of the total tax bill).
Also, you expose yourself to an increased risk of state audits
when your terminated independent contractor files for
unemployment benefits. Never mind that you and your independent
contractor intended that there be no employer/employee
relationship, many's the disgruntled independent contractor who
unilaterally decides to recategorize the relationship as one of
employer/employee when the spectre of unemployment benefits
raises its pretty head. In such situations, you'd better be able
to protect yourself by proving that the arrangement was for an
independent contractor and not an employee.
=> Legal Liability
Unlike an employee who is limited to workers' compensation
benefits, an independent contractor can sue you for negligence
if they're injured on the job. That's what liability insurance
is for though.