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Independent Contractors – Are You Doing it Right?

Posted on July 27th, 2016 Read time: 5 minutes

By Trevor Foster, Vice President of Finance

When you need to hire quickly for jobs that are non-traditional, specialized or temporary, it may seem like paying someone as an independent contractor is the easiest choice. You negotiate a rate, describe what things you need done and then issue payments directly to the contractor – no taxes to pay, insurance to offer, or worker’s compensation and unemployment insurance to consider. What’s not to like? Well, as it turns out, quite a lot of things can go wrong in this type of work arrangement. Read on for the biggest problems associated with using independent contractors and what to do instead.

Is it legal?

Let me first say that I am not offering legal advice with this article – this is a truly complicated issue that takes a significant amount of analysis to properly deal with. But, in general, this is like everything else – it depends. There are several ways to determine if someone performing work for you is qualified as an employee (who gets a W2 and comes with the responsibilities of you being his or her employer) or is considered an independent contractor. In the US, this is determined at both the federal and state levels and contains plenty of gray area. In my opinion, the most important factors to consider are control, comparability and compensation.

Do you control what the person does, when they do it, and/or how they do it? If so, you are exhibiting the signs of being the employer which makes it very likely you won’t be able to pay him or her as an independent contractor. But wait, don’t you usually have some level of control over someone performing any kind of work for you? Of course – but the way you exert control is important. For instance, you can control the results of the work (what is the product of the person’s efforts) but you should be careful in controlling the specific actions of the person.

Next is comparability – does the work of this person resemble the work of employees on your staff? If the person you wish to pay as an independent contractor performs work that compares closely to other people who are your employees, you are most likely going to be out of compliance unless you hire that person as an employee.

Lastly, I consider compensation to be important. Not the amount of pay but rather the way that pay is determined. It is safest to pay an independent contractor for the deliverables they produce instead of the hours they work. This is in line with the control of that person – you control the results, so pay on the results. If you pay for the hours worked you are in effect paying for actions of the worker (having performed some work for some period of time, regardless of what is produced during that time). There are notable exceptions, like when an hour worked is the actual result you’re paying for, as is the case for lawyers or doctors.

There are several more factors to consider and, as previously mentioned, it varies state by state. The result is that it can be very difficult to determine if you can pay someone as an independent contractor or if you need to hire them as an employee, where you will be forced to make judgement calls because the rules are not black and white – they are many, many shades of gray.

Ok, it’s hard to know for sure that it’s legal, but what happens if it’s not?

Here’s where a seemingly innocent mistake can have brutal consequences. What that means for you is a combination of taxes, sick pay, Affordable Care Act fines, penalties, as well as lost time spent dealing with this mistake. And with the US government making worker misclassification (the catchy way to say paying employees as independent contractors) a priority, your chances of enduring an audit and the resulting financial and productivity consequences are higher than they’ve ever been. FedEx and Lyft recently settled lawsuits for not getting this right – agreeing to pay $240M and $12.25M respectively. So, basically, if you get it wrong it may cost enough to do serious damage to your company.

What else can go wrong?

Beyond misclassification, two other things to worry about with independent contractors look quite different – the Affordable Care Act (ACA) and poor performance. As we just discussed, if you incorrectly pay workers as independent contractors you may have to pay for lost overtime wages, employment taxes, and penalties on top of both, but what may be even more devastating is the ACA penalty that you may trigger.

Lockton Companies’ Health Insurance Advisory Practice describes the Tier 1 Obligation of ACA as having to provide Minimum Essential Coverage to 95% of full time employees and dependent children – a long way of saying you must offer health insurance of some basic kind to all full time employees. You do not have to offer this coverage to independent contractors and this doesn’t apply if you have under a certain threshold of employees. So, if you have a few independent contractors reclassified as employees that make up more than 5% of your workforce, you may trigger this penalty. How bad is that? Well it’s more than $2,000 per year for every full time employee you have, regardless of whether or not you offered them coverage. For example, if you have 6 independent contractors and 95 full time employees that work all of 2016 and the government determines those contractors are really employees, you may end up with more than $200,000 in penalties. This is true even if your 95 employees enjoyed a generous benefits package paid for entirely by you. There are even more penalties that come from the ACA based on offering affordable health insurance coverage that may also be triggered on those contractors, adding to an already crushing tax bill.

So that’s an example of hard costs that can come from misclassifying workers and independent contractors instead of employees. What about the issue of control? If you are using independent contractors correctly you are required to give up a certain amount of control in how they work – this can create other issues for you like underperformance or public relations issues. If you are unable to cross a certain line with controlling work, you may be unable to tweak a poor performer to do a better job – you probably can’t provide training and coaching or dictate the schedule or method in which work is done. This means you often have to terminate the relationship with a worker or hire them as an employee to avoid misclassification problems – which, of course, removes the benefits of using independent contractors in the first place.

Additionally, you could have independent contractors damaging your brand in the marketplace. Anytime a Lyft or Uber driver commits a crime or even behaves rudely to a customer using the ride-sharing service, the world considers that person very much a part of those organizations. You don’t have the same rights to control behavior as you would if you were the employer in the same situation.

What is the best way around these issues?

While using independent contractors can be a great strategy in some cases, it often brings on more problems than its worth. You may be accumulating a financial time-bomb in taxes and penalties without realizing it or you may be unable to control the way your customers and the community interact with your business. So how do you enjoy the ease of hiring independent contractors without all of the risk and loss of control? Use an employer of record service that also offers Independent Contractor Compliance services.

If you partner with one of the many staffing or payrolling companies out there, you can entirely outsource this pain. The worker can be evaluated to determine if they can be paid as an independent contractor or if they should be hired as an employee, but either way you are avoiding the risk and administrative burden of bringing them on board. Most staffing or employer of record companies have added Independent Contractor Compliance services and can help facilitate this highly regulated area for you – allowing you to hire quickly and efficiently. Simply put, when hiring specialized or temporary help in a hurry, use professional employment solutions tailor made for solving this problem so you can focus on running your business. Why make this harder than it has to be?

The above article is for informational purposes only and is not legal advice.  You should consult with your legal counsel to see if any of the information provided here applies to your organization.

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