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Employees vs. Contractors: How Incorrect Classification Can Sink Your Business

Employees vs. Contractors: How Incorrect Classification Can Sink Your Business March 19, 2017Business Tips0 Comments

In the summer of 2015 my web-design company was suffering with a problem contractor. I will not going into great details here, but suffice it to say, his performance and general demeanor were killing my business, poking holes in my relationships with clients and also damaging ability to sleep well at night.

I knew that I had to let him go, but he had commented one day that I could never fire him because he knew all our company passwords and he could destroy my business. At the time he claimed he was joking, but I had become increasingly aware that he possessed a very self-destructive and unstable personality. True to his word, when I did stop giving him projects he reported me to the IRS claiming that I treated him like an employee and not a contractor.

At first, I dismissed it as not a big deal. But the more research I did, the more I learned that, not only was it a big deal, but that in the eyes of the IRS he was probably right. And that it could cost my company many thousands of dollars in back taxes for failing to file a W2. What was happening? I was certain that I had classified my workers correctly. They worked from home, set their own hours and used their own programs to perform the work. Could I have been wrong all this time?

My restless sleeping at night only grew worse as I waited months for the IRS to make their decision. I hired an attorney. I did everything I could, but in the end the IRS ruled that the problem contractor who reported me and two other contractors I had hired were actually employees and I needed to re-classify them.

Why this is Actually a Huge Deal

Note: some of the following is an opinion and none of it is written by a tax professional. We advise you to seek the advice of a CPA who can best determine the right course of action for your business if you are considering hiring employees.

As most small-business owners know, hiring employees is far, far more intensive and expensive than working with contractors. It is common practice in my industry to give a worker a project, throw a W9 at them after they earn $600, let them pay the 15% self-employment tax and move on with life.

The problem is that the IRS defines an employee very differently than most small business owners define one. This page, straight from the IRS outlines the “official” difference between the two. If, after looking this over, you still are not sure into which column your workers fall, you can always file an SS-8 and let the IRS decide for you. However, if you do go this terrifying and potentially ill-advised route, be prepared for an answer you may not like. And then be prepared to re-classify all your “contractors”.

If you do decide to blow the whistle on yourself you could also join the Voluntary Classification Settlement Program (VCSP) safe harbor for businesses looking to reclassify without penalties. This might be a good path for you, depending on your situation.

Either way, I have been told that the IRS heavily weighs employees/contractor decisions in favor of the workers being employees, and in my experience that was the case. While the IRS is determining the status of your workers (which took six months for me, and may be even longer for you), you should do some research to determine how much you will owe if the determination does not come back in your favor, which is likely.

Some companies have owed millions in back-taxes. Uber won it’s case in 2016, but I am guessing you don’t have millions of dollars rotting under your bed for legal fees that you can throw down to fight a decision made my the IRS.

Most likely you will owe money. And it could be a lot of money. Generally you’ll need to pay about 7.5% for FICA and possible penalties up to 100% for failing to file a W2 if the IRS feels you knew that your workers were employees but were deliberately reporting a 1099. The math gets a little tricky, but if you paid $50,000 to workers who were ruled to be employees over a few years you could owe as little as a few thousand. That’s the best case scenario.

So yes, this is a pretty big deal. My company survived it. Yours can too, but this little mistake had ended the lives of many businesses.

Can’t I Just Cross My Fingers and Hope for the Best?

I certainly would not. While not everyone runs into a vindictive contractor I have recommended to more than one business owner that they reclassify their workers as employees, even if they are on the fence by definition. You never know when an audit might happen. Reclassification will cost a bit up-front to be sure, but then, why not consider raising your rates? This is what I did.

Per the IRS ruling, I reclassified the one worker who was still with my company in 2017 that they found to be an employee, and now he is sitting pretty, no longer needing to cover the self-employment tax. I raised our rates for all new clients to cover the cost. There are ways to make it work.

I am not here to debate whether or not this is fair or whether or not the IRS takes too much from business owners. In the big picture, does it really matter? So the system is messed up. That is fine. Save your angry energy and build the best business you can imagine, and be proud of your new employees. It’s cool to have employees and will make you sound like a big shot at the next marketing mixer. Much sexier than saying “My contractors are working on my new company website while I am sleeping!”

Yeah, I know it is expensive up front. Don’t be cheap. Your new employees may just save you a lot of money in the end, as it may be the excuse you need to restructure your company for the better! My higher rates did not cost me any clients. In fact, my newer clients seem to view us in a more professional light. We’ve entered the world of the higher-tier media client.

Final Thoughts

If you still are not sure about reclassification here is a good way to tell whether you are really harboring employees and not contractors.

Ask yourself the question, “Does my worker perform work for my company that is, first of all, an important part of company operations and secondly, performs a service that my company sells to it’s clients?”

If yes to this question, the IRS will almost certainly request a W2 in the event of an employment audit. Be prepared, fellow brave soldier of business ownership.