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The AR Group

The True Cost of Worker Classification

By Victoria Aguilar

Most businesses do not experience growth in a linear fashion. Rather, growth most often occurs in intermittent and unpredictable spurts. This reality generally requires business owners to take something of a leap of faith when making staffing decisions, since the presence of immediate demand carries with it no guarantee of continued growth or continued need for additional staff. Given this reality, businesses must constantly balance the need to staff to meet client or customer demand against the risk of over committing finite resources to meet increased payroll.

In considering their options, business owners often mistakenly assume that the solution to meeting increased demand is to rely on independent contractors as either an interim or even long-term solution, since this approach, they believe, provides time for them to evaluate the consistency of demand and therefore the need for additional staff. Unfortunately, simply hiring someone as an independent contractor does not make them an independent contractor. In the eyes of the law, being an independent contractor requires various elements or standards be met and many of these standards are very distinct from the standards required of an employee.

Proper worker classification requires consideration of a number of factors, including standards devised by various regulatory agencies including the Internal Revenue Service and various divisions of both state and federal Departments of Labor. It is important to remember that unlike employees, independent contractors are responsible for their own taxes, insurance, and retirement savings. There are various reasons for this but chief among them is the fact that an independent contractor is supposed to serve in a project role under a properly drafted agreement. The scope of the work generally should reflect the unique skills and qualifications of the contractor and the contractor is supposed to carry risk in the transaction and have the opportunity for reward. This generally means that the contractor is not an individual but a business, and that the contractor provides a service to many companies, not just one. In short, a contractor is not supposed to look like or be ?temporary staff?. Accordingly, before a business sets out to rely on the assistance of contractors instead of employees, it should carefully consider what?s at stake including the factors below:

Employment taxes

Employers typically incur costs of approximately 10% of a worker?s pay to cover employment taxes, which include the employer?s share of FICA (Social Security and Medicare taxes) and federal and state unemployment taxes. Because most business are also required to carry workers? compensation and unemployment insurance for employees, the actual cost often approximates 13% of a worker?s pay. It is without question that it is more costly for a business to have an employee than an independent contractor.

The IRS uses various factors1 to determine worker classification while the state and federal Departments of Labor use slightly different tests to determine a worker?s status. While there are some differences among the various ?tests?, common factors include assessment of the degrees of 1) behavioral control (i.e., the degree to which the business may tell the worker when, where, and how the work is to be done); 2) financial control (i.e., the degree to which the worker controls when payment is made and/or if expenses incurred by the worker, including tools for the job, are paid by the business), and 3) the nature of relationship created by the parties (i.e., what both envision, whether there is a written agreement, and the permanency of the arrangement).

If the IRS or either a state or federal Department of Labor questions a business? reliance on an independent contractor, the business may face back taxes and serious penalties. However, businesses should be aware that the IRS allows certain employers to voluntarily reclassify workers as employees by using the Voluntary Classification Settlement Program2. If eligible for the program, the cost to reclassify is only 10% of the tax for the most recent year, with no interest or penalty. Safe harbor options (Section 530 relief) may also be available for some employers.

Employee benefits

To the extent that an employer offers a benefit program, such as a qualified retirement plan, it must include employees. In contrast, independent contractors cannot be eligible to participate in employer sponsored benefit programs. Since employee benefit programs can add an additional 10% to an employer?s payroll, many business conclude that hiring independent contractors is less expensive and thus an attractive option to consider.

Government mandates

Employers are required to comply with various state and federal workplace laws that are intended to provide employees with fundamental protections. Some of these laws apply to employers on the basis of the number of employees employed (the number of employees as indicated in parentheses), including:

  • Age Discrimination in Employment Act bars workplace discrimination of those age 40 and older (20 or more employees)
  • Americans with Disabilities Act barring discrimination on the basis of a physical, mental, or emotional disability and requiring reasonable accommodations for the disability on the job (15 or more employees)
  • Civil Rights Acts bars discrimination in the workplace on the basis of a variety of factors (e.g., race, gender) (15 or more employees).
  • Equal Pay Act mandates equal pay for men and women performing substantially the same work (2 or more employees)
  • Fair Labor Standards Act for minimum wage and overtime rules (2 or more employees)
  • Family and Medical Leave Act for unpaid time off (50 or more employees)

Employers that violate these laws can be subject to government penalties and lawsuits by employees. By contrast, employment laws do not apply to independent contractors.

Conclusion

In determining the cost associated with employment, businesses can easily add 15% to 50% of employee compensation to the budget for taxes, insurance, and benefits (e.g., a $40,000 employee actually costs the business at least $46,000 and, depending upon the benefits package, as much as $60,000). Misclassification of a worker as an independent contractor, can however, cost the business significantly more as a result of the fines and penalties that can be applied by the various agencies that regulate employers in this area. Before hiring additional staff, a business should carefully evaluate its options and make sure that any decision to outsource is based on adequate consideration of the law.

SMART TIP: Work with an employment law attorney so that workers are properly classified in conformance with legal requirements. Additionally, an employment attorney can work with you to make sure that your independent contractor or employment agreements contain the proper language to reflect the relationship contemplated by the parties.