We have recently noticed that organizations, in general, are paying more and more workers “off the payroll” as “1099 employees”—-which is an oxymoron since a worker is generally either an employee or an independent contractor, not both.
The purpose of this PayDay is to educate employers about the huge financial risks if they are misclassifying employees as “1099 contractors”, and to provide educational resources so employers can “make the right call” as to the correct legal status of their workers. Various government agencies are increasingly active in looking for worker misclassification by employers, and they are also sharing their findings with one another. The financial stakes are high in making sure you correctly support your position, since reclassification of a large number of your workers from contractors to employees could literally be a bankrupting experience!
ALL EMPLOYERS SHOULD EDUCATE THEMSELVES ON WHO IS AN EMPLOYER VS 1099 WORKER
AccuPay wrote PayDay emails back in 2014 about “worker classification”—frankly, the essential rules/laws have not changed except the magnitude of surveillance has increased. We suggest that any organization which pays workers “off the payroll” read our previous PayDays here on how to determine if a worker is an employee or contractor and here if you wish to strengthen your case that you have 1099 workers. We view these 2 previous PayDays as primers for worker classification which all employers should read if they pay people “off the payroll” as 1099 workers.
The IRS also has some excellent materials on their websites about worker classification determinations. IRS financial consequences for reclassification of a 1099 worker to employee status includes back taxes which should have been withheld from employees, substantial penalties/fines and increasingly the employer becoming subject to all the very harsh consequences of Affordable Care Act penalties by becoming a “large employer” once the contractors are reclassified to employee status (ACA fines/penalties are a newer and significant financial risk for those employers who are avoiding ACA large employer status by paying workers as 1099 contractors).
The DOL is also highly interested in worker classification since they administer overtime/minimum wage matters for the protection of employees. Check out the DOL Fact Sheet 13 which will detail factors involved with worker classification from the perspective of the DOL. You may notice that the DOL’s interpretation of “who is an employee” is actually broader than the IRS “common law” tests for worker classification. DOL financial risks include back wage payments for overtime/minimum wage violations, substantial penalties, back claims for employee benefits, etc.
HOW DOES THE GOVERNMENT FIND OUT ABOUT OUR WORKER CLASSIFICATION AS 1099/CONTRACTOR STATUS?
The most common way in which various government agencies are alerted to review/audit your pay policies is that a worker “turns you in” to the IRS or DOL. While the worker is being paid as a 1099/contractor, all is well since they have no tax withholdings from their pay. When they file their annual income tax returns, they find out they owe substantial tax since their 1099 is subject to “self-employment tax”, which is at the tax rate of 15.3% of their 1099 amount (before any tax deductions for business expenses in earning the 1099 income).
So a worker with a $40,000 1099-MISC (soon to become 1099-NEC’s to more clearly identify 1099’s for “non-employee compensation”) income learns that they owe $6,000 in federal tax on their 1040—they do not understand “why” they owe the tax and learn it is because they were treated as “self-employed” by their “employer”. They learn more and finally notify the IRS that their employer incorrectly paid them as a 1099 contractor instead of an employee.
The IRS will review the pay practices of the employer while reviewing this “complaint” and what starts out as a single, angry worker leads to a full-scale audit of many workers as to how they are paid. As to the DOL, a worker is aware of benefits being paid to other workers (perhaps the administrative staff) and calls the state or local DOL—it is easy to find both numbers to call and determine a “worker’s rights”——Another way is for a former worker to apply for unemployment benefits and be told they do not qualify since they were not an “employee”—again, this inquiry starts the path of an inquiry of the employer’s overall pay practices.
The IRS and DOL also do conduct random audits, as do the state unemployment tax agencies (who are precisely auditing employers for workers paid “off the payroll”). The state unemployment tax audits are actually rather common, and in some cases can lead to referrals to the IRS and/or DOL for a broader audit of organizations who are paying several workers as independent contractors.
Audits by the IRS and DOL generally will comprise a 3 year period, which can result in immense back wage claims, back taxes, possible ACA penalties and substantial penalties (the penalties are much greater for intentional disregard of laws)
CERTAIN INDUSTRIES MAY BE TARGETED FOR AUDITS BY IRS/DOL
Employers involved in industries which normally have a high turnover of lower wage jobs are often targeted for worker classification audits by either the IRS or the DOL. Those have included construction, home health care, food/beverage establishments, transportation/trucking and employers who employ many part-time workers. NOTE—-working part-time has no bearing on whether a worker is correctly classified as an employee or a 1099/contractor—-a part-time receptionist is every bit as much an employee as a full-time receptionist. Educate yourself by reading the resources listed above as to how the IRS and/or DOL determines “who is an employee”——part-time work is not a factor in this determination.
KEY TAKE-AWAYS ABOUT WORKER CLASSIFICATION
The costs of having many in your workforce reclassified from 1099/contractor status to that of employees can be staggering—-and actually bankrupting. Educate yourself so that you know how to determine if you are correctly misclassifying your workers—-read our May 2014 PayDay along with our above links to IRS and DOL online information about worker classification.
If you feel that you have strong legal grounds for classifying certain workers as 1099/contractors, be very careful in drafting your written contractor agreements so they include many characteristics of “independent contractors”—-hiring a lawyer who specializes in employment law is worth the money if you have several 1099/contractors—worker classification should not be left to online “contractor agreement templates”—hire an attorney to help you get this right before the IRS or DOL knocks on your door.
The fact that the IRS has prepared a brand new 1099-NEC form for use starting Jan of 2021 is indicative of their interest in potential major abuses in worker classification. The new 1099-NEC (for non-employee compensation) is a replacement for including non-employee compensation in a “box” on the current 1099-MISC form—–so those 1099 contractors will now require a totally separate reporting form for payments made to them as workers by their “employers”—-this should help the IRS identify organizations which have a large number of 1099-NEC forms vis a vis their number of employee W-2 forms.
If you reach the point where the various IRS/DOL factors for worker classification become a “50-50” conclusion as to status, you may consider putting the person on the payroll and reducing their total compensation by 10-15%, since they will save 10-15% in matching payroll taxes, unemployment benefits eligibility, workers compensation protections, etc—-you will need to educate the worker as to the value of benefits as an “employee” and you can then sleep better knowing you have classified the worker as an employee, which is what the IRS/DOL would be so inclined to conclude in an audit.
The preparation of a brand new form for 1099 reporting only for non-employee compensation (Form 1099-NEC) tells me that the government is increasingly interested in potential abuses and revenue from misclassified workers——Learn more by reading our resources listed in this PayDay and seek professional advice from an attorney who is an expert in labor law—-if you can not get an attorney to write you an opinion that your workers are indeed “1099/contractors”, you need to give serious consideration to putting them on the payroll!