Hiring Independent Contractors is a legitimate business model in all states, and true Independent Contractors should receive 1099s for compensation for their services. However, many employers give 1099 forms to people who are misclassified as Independent Contractors when they should have been paid as employees.
Sometimes the employer’s motive is honest – they believe that the worker is truly an Independent Contractor; but more commonly, they pay with a 1099 to keep the overhead cost down and not give the employee the true protection they need for their work.
The basic definition of the “Employee” and the “Independent Contractor” as given by the Employment Development Department (EDD) of California is as follows:
- Employee: An individual who performs services for you and is subject to your control regarding what will be done and how it will be done.
- Independent Contractor: An individual who performs services for you, but you control only the result of the work.
The employer must understand these definitions in order to remain in compliance and not be issued all the fines and penalties.
The IRS, Department of Labor, and many state agencies are taking aim at businesses using Independent Contractors due to the suffering tax revenues everywhere. Paying Independent Contractors with a 1099 eliminates wage withholding, employment taxes, unemployment taxes, worker’s compensation, and offers no pensions and fringe benefits to the worker. The employer may be benefitting now, but the ramifications can be outstanding.
If found guilty of misclassifying workers, the employer will be faced with costly audits by the IRS, EDD, and Department of Industrial Relations, additional taxes, penalties, and interest, plus revocation of state/local license.
The state of California passed a Labor Law in October 2011 designed to crack down on the misclassification of workers as Independent Contractors and dramatically increased the penalties on employers who have been found to have willfully done so. The SB 459 added the following fines:
- California’s Labor and Workforce Development Agency can fine you for “willfully misclassifying” an employee from $5,000 to $15,000 per violation.
- The penalty goes up to $25,000 per violation if you commit a “pattern and practice” of “willfully misclassifying” workers.
- There’s joint and several liability for consultants (but excluding practicing lawyers) who advise employers on such independent contractor engagements.
- It’s unlawful to charge misclassified independent contractors any fee or take deductions from the compensation paid to them. Companies cannot deduct fees for goods, materials, space rental, services, government licenses, repairs, etc. provided to contractors who are reclassified.
Paying a true employee with a 1099 and misclassifying them as Independent Contractor may lower the overhead costs now, but should the relationship be terminated, or competitors start to ask questions – both may contact the EDD or the IRS, and the truth will be revealed. The employer will be left having to pay an enormous amount of taxes, fines, and penalties.
The cost is not worth the risk. Be informed of the regulations and the law. Be in compliance at all times for your business.
DE 231, Information Sheet – Employment
DE 231EEE, Information Sheet – Exempt Employment
DE 38, Employment Determination Guide
DE 1870, Determination of Employment Work Status
Employment Status Course
Employee or Independent Contractor Tax Seminar