Lesson #291: Properly Classify 1099 Contractors vs. W-2 Employees to Avoid Legal Troubles

Back in Lesson #30, we talked about when it is appropriate to hire employees vs. contractors.  But, often times, small businesses try to permanently take the contractor path instead of hiring employees, to try to permanently avoid paying employee benefits and payroll taxes.  That can get you into a lot of trouble.  This post will help you know when staff members will legally be classified as employees vs. contractors in the eyes of the IRS, to help you avoid costly penalities down the road.  To help me with this post, I solicited the input of Maria O. Hart, a member of the employment litigation, trials, and appeals practice group at Parsons Behle & Latimer.

For most small businesses, labor is the biggest line item on their P&L statement — and it can be a vicious circle of needing employees but not being able to afford them. These businesses need employees to scale (and, in some cases, survive), but the true cost of an employee can push even the lowest paid workers off the budget. When that happens, business owners turn to 1099 contractors to fill in the blanks. But expecting these contractors (workers who aren’t entitled to the same benefits as full-time employees) to act as employees, and be treated as such, could result in a major Fair Labor Standards Act (FLSA) violation or, at the very least, some substantial tax fraud accusations.

So, how can you comply with federal labor laws? It starts with knowing the difference between 1099 contractors and W-2 employees. It’s not black and white, but there are a few ways to determine a worker’s correct classification, as you can read at this link at the IRS website and the summary chart below from Law Gives:

 Ask yourself, do they work on site? Do you control their schedule? Do they use the company’s tools and equipment to get their job done? Do you discourage or prohibit them from taking on more jobs or other jobs in your niche or industry? Do they work more than 30 hours per week? If you answered yes to one or more of the above questions, you might need to consider that contractor a full-blown employee.

Misclassifying an employee as a 1099 contractor could land you in some hot water with the U.S. Department of Labor, or you may find yourself defending against an FLSA lawsuit from an unhappy employee or contractor — after all, misclassification lawsuits are on the rise. That’s because the line between employee and contractor is blurrier than ever. More and more workers are able to work remotely using their own devices and equipment. It’s a technological loophole the FLSA’s creators couldn’t have imagined when they drafted the statute in 1938 — and more business owners are falling prey to this deadly sin.

Avoid a potentially catastrophic lawsuit by classifying your workers correctly from the start and reclassifying them as needed. Know what your workers are doing and how they’re doing they’re assigned duties. Circle back frequently and perform annual audits to ensure everyone is classified as they should be. When in doubt, put yourself in their shoes. Would you feel taken advantage of if you were in their situation? And, of course, always check with your attorney or employment counsel.  Because if you don't, the price could be steep, including penalty payments plus unpaid past taxes all coming due obligations of the business and its owners (even if they think they are protected from limited liability company structures).

Thanks again, Maria, for your help with this post.  If you have any further questions on this topic, feel free to reach out to Maria at  208-562-4893 or mhart@ parsonsbehle .com.

For future posts, please follow me on Twitter at: @georgedeeb.