Last month, a US District Court halted the Biden Administration’s effort to reverse a Trump-era rule that made it simpler for employers to classify workers as independent contractors. The reasons were due to a procedural error, but the decision was a victory for small businesses across the country that otherwise would have had to classify more independent contractors as employees. But the battle for workers’ classification is far from over.
According to some reports, the National Labor Relations Board recently indicated “an opening” to review worker classification rules and the Department of Labor is also “evaluating all legal options.”
“The district court’s decision is both surprising and disappointing,” labor attorney Seema Nanda said in a statement. “When employers misclassify workers as independent contractors, workers lose key rights and protections, undermining labor standards across the board and making it harder for law-abiding employers to compete on a level playing field.”
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The implications for small businesses are significant. Hiring an independent contractor instead of an employee means that business owners do not have to incur payroll taxes, pay fringe employee benefits, or be subject to certain employer-employee responsibilities, particularly for safety and health. Therefore, as the administration takes a closer look at these rules, it is important for small businesses that use independent contractors to be aware of their risks.
“Small business owners really need to be careful because from a worker classification perspective, there are multifaceted opportunities that need to be challenged,” said Patrick McCormick, a tax attorney and director of the Offit Kurman law firm in Philadelphia. “There are multiple federal agencies, including the IRS and the Department of Labor, that can go after you for misclassifications, which can have huge consequences on wage garnishments, social security, workers’ compensation insurance, and unemployment payments.” .
Nikki Johnson-Huston, a former Philadelphia city tax attorney who now helps businesses and individuals with local, state and federal tax problems, also points out that it’s not just the federal government that could cause a problem if there’s noncompliance. Both state and municipal authorities will also be interested.
“With the advent of better technology and better systems, tax authorities share that information with each other,” he says. If it is reassessed, Johnson-Huston warns, and the city and state find out, there could be heavy fines and penalties.
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“I have seen some businesses close because of this,” he said. “Depending on how long the situation lasted, there could be tens of thousands, if not hundreds of thousands, of fines per employee. Once a tax entity finds out, they are likely to share that information.”
So how can you ensure that you correctly classify your employees and independent contractors? The IRS posts rules on its website, and the Department of Labor also offers guidelines. Both sets of rules focus primarily on an important aspect of the employer-employee relationship: control.
“What you’re really looking at from the IRS perspective is the independence of workers,” McCormick said. “And the ability they have to exercise independent control over their activities and over the final product.”
This means that to be properly classified as an independent contractor, workers must have full control over the work they are doing, the hours worked, where the work is done, the tools they use, and the people they are allowed to employ. Although only one social security number is required to report a contractor’s payments on the federal 1099 form each year, the contractor should preferably provide an employer identification number (EIN) and should have multiple clients in addition to their business. The relationship must be arm’s length and in no way should the contractor be included in his payroll calculations or offered any employees. In effect, they should have their own independent businesses that bill your company for their work.
“One of the things that everyone needs to understand is that the government, whether it’s the Department of Labor or the IRS, assumes that everyone is an employee until the company proves otherwise,” Johnson-Huston said.
To document this, all parties must sign a current independent contractor agreement and update it periodically. The agreement must specifically stipulate the responsibilities of both the worker and the employer. Good examples can be found at LegalZoom and Rocket Lawyer. File 1099 forms annually with the IRS, state, and city. It’s also a good idea to get help from a tax attorney or certified public accountant.
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Be careful: even when a contractor provides all the required information, you must be careful.
Johnson-Huston said she has seen cases where an employer is audited even when the contractor committed fraud. “A lot of times when an individual problem is found, authorities can start thinking, ‘hey, this could be a bigger problem,’ and they can start getting more records for that business.” Even if you are fully compliant, the cost of an audit could run into the tens of thousands of dollars.
Given the cost savings and lower regulatory requirements, it’s tempting for small businesses to avoid hiring employees and use independent contractors instead. There is nothing wrong with this. I do it all the time. But in today’s pro-worker environment, both in Washington and locally, it’s important that we make sure we follow the rules, even if they change.
“I look forward to a continuation of the increased enforcement of existing rules,” McCormick said. “It’s a hot topic and small business owners need to be very cautious in this area because of the huge exposure they can get from making the wrong decisions.”
