Paying taxes isn’t much fun.

So it should come as no real surprise that smaller companies, including small hooch companies, regularly try to minimize their tax burdens. In fact, to do otherwise would be imprudent. But occasionally, attempts to lessen a business’ tax burden become problematic.

One particularly tempting tax-minimization strategy (read: scheme) for many businesses – large or small – involves the mischaracterization of individuals as independent contractors when they are more properly characterized as employees.

By calling someone an independent contractor rather than an employee, the business can avoid paying the employer’s share of Social Security and Medicare taxes, unemployment tax and workers’ compensation insurance. In addition, the employer avoids any obligation to comply with overtime payment rules, and generally avoids any need to provide employee benefits. So a business that can call an individual an independent contractor rather than an employee stands to save quite a bit of cash.

But just as overindulging in the evening can lead to a headache in the morning [trust me – stop after the 5th Mai Tai, no matter how good they are or how beautiful the sunset in Waikiki], drinking too deeply from the benefits of independent contractor classification can lead to misery down the road. If the business has incorrectly classified an employee as an independent contractor there may be significant penalties. Even if the mistake was unintentional, a business getting caught by the Internal Revenue Service (or the business’ state or U.S. Department of Labor) can expect to incur penalties of at least:

  • 1.5% of the wages paid to the employee;
  • 40% of the social security and Medicare (FICA) taxes that were not withheld from the employee’s wages; and
  • a penalty of 0.5% of the unpaid tax liability for each month – up to 25% of the total tax liability.

As if this weren’t enough, the business getting caught misclassifying employees will also be required to pay 100% of the FICA taxes that the employer should have paid (i.e., the employer matching portion), and can expect to pay interest on the FICA amounts from the date they should have been remitted to the government to the date they are actually paid.

This is what the employer will owe if it did not mean to misclassify the employees. If the business intended to misclassify employees (i.e., if the misclassification was fraudulent or was intentional misconduct), additional fines and penalties (including potential criminal penalties) can and will be imposed.

The government takes this very seriously. In fact, the U.S. Department of Labor – Wage and Hour Division has an ongoing “Misclassification Initiative” in partnership with 31 states. The purpose of the initiative is to ferret out misclassifications and collect these penalties, and it appears to be having some success. In 2015, the initiative resulted in the collection and payment of more than $74 million of back wages (i.e., excluding fines and penalties) for more than 102,000 workers.

With that as background, a refresher course in how to determine the appropriate classification is probably in order. Luckily, there are many resources available for businesses that want to get this right. A good place to start is with the IRS discussion on the topic. As noted on the linked page, the basic issues are whether the business has the ability to control the activities of the person providing the services and, conversely, the degree of independence enjoyed by the person providing the services. Factors to consider in this analysis include:

  • Does the company have the right to control (or actually control) what the worker does – and how the worker performs the job?
  • Are the financial and business aspects of the worker’s job controlled by the company? For example, are the worker’s expenses in performing the job to be reimbursed by the company? Does the worker bear the burden of paying for her own tools or materials to do the job?
  • Has the company committed to providing any employee-type benefits such as insurance or vacation pay?
  • Will the relationship between the company and the worker continue indefinitely, or is the relationship intended to end upon the completion of a certain task or by a certain date?

These factors aren’t exhaustive, but they give the company/employer a very good starting point to make a determination. And in recognition of the fact that the DOL is on a mission to catch as many cases of misclassification as it possibly can – the prudent company will probably want to err on the employee-classification side of the ledger in any close case.

But in this situation – as with any in which legal risks are measured – the thoughtful company will want to balance the legal risk of the close case (and the potential for audit or concern) against the business risk arising from the increased costs associated with retaining employees as opposed to independent contractors. If the increased costs of employees over independent contractors will have the effect of putting the business into the red – or worse yet closing its doors – the company may well be willing to take the potential legal risk over the definite business risk in that close case. This is particularly true if the business – like most small hooch companies – has a relatively small number of workers. The DOL and most states are allocating their audit resources primarily toward situations where their initiative can have the greatest effect – businesses with large numbers of employees – so smaller companies are a bit insulated against this risk. But be warned, having a small number of employees won’t help your business if one disgruntled would-be employee takes it upon himself to be a whistleblower.

By writing this, I don’t mean to suggest that the employee/independent contractor classification is unimportant – or that businesses need not follow the applicable rules. But I do mean to suggest that in this situation (like many situations involving compliance with regulatory requirements) the legal risks associated with noncompliance in the close case must be considered in the context of the business risks and costs of compliance. While paying taxes isn’t fun, and paying tax penalties is even less so – neither is going out of business.