The Risks of Misclassifying an Employee as a Contractor

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Client: “John, could you prepare an independent contractor agreement for me?”

John: “Sure.  Who’s it for?”

C: “Her name is Ruby N. Rails.”

J: “What’s she going to be doing?”

C: “She’ll be doing web development, reporting to our Chief Architect.”

J: “How closely will she be supervised?”

C: “Very closely.  Our Architect has very firm ideas as to what needs to be done, and needs to have her on-site pretty much every day.”

J: “How many hours per week will you use her?”

C: “This is full-time.”

J: “How long will you be using her?”

C: “Oh, indefinitely.  For the foreseeable future.”

J: “You know, Ruby really sounds a lot more like an employee than a contractor.  There are some real risks in your not hiring her as an employee.”

C: “Really?  What are they?”

J: “If things didn’t work out, and you had to let her go, she might apply for unemployment insurance, which could trigger a California EDD audit, which could trigger an IRS audit.  If they find that any of your contractors are really employees, you could be hit with back taxes, back wages, overtime pay, and penalties.  This could be a really significant amount of money.  Furthermore, if she were to be hurt on the job, she wouldn’t be covered by your worker’s compensation policy, so she could go after your company for her medical expenses.”

C: “Do you really think I’d get an IRS audit?”

J: “I can’t say.  But the Obama administration is stepping up enforcement.  Check out this New York Times article (http://www NULL.nytimes NULL.html?scp=1&sq=INDEPENDENT%20CONTRACTORS&st=cse).”

C: “So what should I do?”

J: “If you really want the relationship to be as you described it, I’d recommend you hire her as an employee.  Otherwise, you could hire her on a project basis, with specific deliverables, a finite timeframe, and milestone-based payments.  Or restructure the relationship in other ways that make her look more like a contractor than an employee.  Here, take a look at the IRS ‘independent contractor test’ (http://www NULL.twc NULL.state NULL.tx NULL.html) and the California Employment Development Department ‘test for employment.’ (http://www NULL.taxes NULL.bus NULL.shtml#California) These tests set forth criteria the IRS and the EDD use in determining whether an individual is an employee or a contractor.  And, if you do retain her as a contractor, be sure to file a form DE 542 with the EDD within 20 days of retaining her, provide her with a Form 1099 by the end of January each year, and file the 1099 with the IRS by the end of February each year.”

C: “OK.  Thanks!”

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