Classifying Workers

An accountant's suggestion to turn a few employees into "subcontractors" comes in for criticism ó along with some information about the rules for that sort of thing. September 30, 2010

My accountant says we are getting killed with employee costs and taxes. He suggested that we do the independent contractor thing, but I don't think so. He also suggested that we cut their wages and compensate the difference by giving them gas cards, grocery store gift cards, etc. Any thoughts on this?

Forum Responses
(Business and Management Forum)
From contributor K:
If you pay them as subs then they will need to have a contractorís license and you will have to tell the IRS that they work in the field only, at least that's the way it works in California.

From contributor M:
The first part (the independent contractors) sounds a lot like something an accountant would say. Unless your staff is willing to quit and forgo whatever benefits you provide, and merely take the equivalent of their current net pay as 1099 payments, or you planned on cleaning house anyway and your area has a lot of matched skill workers out there looking to sign on as 1099 ICs for whatever money you want to pay, I don't see how it is very practical advice.

Frankly I am a bit surprised at his second suggestion. I don't see how that plan to provide alternate forms of compensation can work at all on a sustainable basis. Your employees would still be liable for the same amount of taxable income (whether it is provided as a salary or cash equivalents), according to the IRS. Of course, you can reduce your payroll tax liability by whatever amount you drop their wages. Unless you had some big (continually replenishing) slush fund somewhere from which to purchase your cash equivalents, and didn't need to account for the expenses in any way on your books, a very cursory review by state or federal auditors would reveal what is going on very quickly. I'm not a tax attorney so I won't pretend to know specifically what they call such evasive tactics, but I suspect that they aren't smiling when they talk about them - aside from the fact that most employees would be very concerned about relying on a completely undocumented source of income for any length of time, especially since it would replace their current, bona fide wages.

Now I'm not saying that there are not legitimate forms of providing alternative compensation like profit sharing plans, equity stakes, and matching employer contributions to a 401K plan (which are often non-trivial to self administer and can be costly to farm out), but gas and grocery cards arenít the same thing!

From the original questioner:

Actually we have a few guys that do have gas cards. The gas gets written off to the business. I don't see a problem with this. I do see a potential problem with grocery store gift cards and that type of thing. This is why I posted the question in the first place, for the collective wisdom of the forum to possibly offer other alternatives. I would like to reduce my employee costs, tax deductions, workers comp, unemployment contributions, etc.

From contributor S:
The government tells you what you have to pay as far as benefits go, so the only way to reduce them is to get rid of staff or reduce their wages. In Canada if a person works for you and you alone , then he is an employee and cannot be considered a contractor .

From contributor F:
I think your accountant isn't do you any favors, if you give them gift cards its compensation, if you have benefits you can go to a cafeteria plan which moves all the benefit cost to pre tax dollars, that lowers FICA and workers comp expense. If you go true independent contractor you can't really tell them when to come and go. Itís very tricky and hard to do correctly you would be better off getting help from labor ready. What is the issue, you have to sell at prices that are too low to cover costs or your employees are all driving Mercedes? If you need to cut wages then you need to see how many leave.

From contributor C:
What about the idea of hiring your employees through a temp agency? You could still use the same guys you have now, except that they would be working for the agency, you legally pay the agency, and the agency legally pays them. The temp agency may also be able to offer benefits that you, as a small shop, cannot. That might include vacations, health insurance, etc.. This may also be a plus for unemployment benefits. You probably would not be worried about rising rates if you had to lay someone off. Is anyone out there doing this successfully already? I've heard about it but have no first-hand knowledge of it. I also question your accountant's advice.

From contributor G:
There must be more to your story than employee costs being too high. Maybe your selling price, shop or office efficiencies are too low. Employees should make you money, not cost you money.

From contributor S:
I would say you have to talk to a few different accountants or tax experts and see what is legal and what isn't. I am from Canada and there are hundreds of companies that subcontract to only one company in a fiscal year. Certain definitions apply to what an employee is.

From contributor M:
You do not want to turn employees into subcontractors. IRS won't go for it, and the employees will see this as a ploy for you to get the same results by lessening their benefits. I believe you would be better off reducing the number of employees you have and using other companies to do some of your work. I say this because it sounds like your employees are not earning their keep, because we are having this discussion. I can buy some of my components already cut and drilled ready for install, for less than I can buy the raw product. Plus I would have to pay labor, insurance, etc. Also with the employees you keep (if you still meet the minimum requirement) look at using a legitimate payroll service. When I had more employees I did this for a couple of years. For the fee I paid, it was worth it.

I also got a better rate on workers comp because of their buying power. I also received employee manuals and their legal expertise. If an employee thought I wronged him or threatened suit, I could tap into their lawyers for free advice. Payroll was simpler to do, but one warning. If you have cash flow problems, there is no wiggle room. When they delivered my checks, I had to give their currier payment. No payment, no payroll. Caution here also, some of my employees felt alienated by my using a payroll service, but they were not the better employees. I'm not encouraging you to layoff anyone,
but if it is coming anyway, you are better off to deal with it before it gets out of hand.

From the original questioner:
His advice about the independent contractor seems way off and I lost some confidence in him at that point. I came up with the grocery store gift card idea just to get an example of an idea out there. We are taxed, and insured to death, and if I can reduce that, then I will look at it. Some responses make me wonder if not all have been through this difficult time, you seem anxious to pay whatever. It is hard to be profitable right now even though things have improved some.

From contributor K:
I think the first thing you need to do is to identify what "getting killed" on taxes actually equates to in real dollars. All your other options will still cost you money (and more management of the execution and implementation), but the bigger factor is what employees think of your solution, and no matter how you tell them that they are still getting the same amount, it's just that you will be paying less in taxes, while their actual paycheck from week to week goes down, will not go over well at all no matter how you sugar coat it. In the end, you are the only benefiting from this scenario, and it will come off as you making decisions about how to spend their money all for the purpose of benefiting you. Right or wrong, that will most likely be how it is viewed.

The better solution is to identify how much you are "getting killed" by and find ways to offset it through internal cost reductions, process-improvement, increased sales, increased prices or a combination of the above. In the macro-sense, your business is like a three-legged stool. One leg is you, one leg is your customer and one leg is your employees. Your support braces between legs are your costs, your processes, and marketing. The seat is sales, which bring them all together. Without it, none of the rest has any purpose. Identify which part of your stool needs attention.

From contributor A:
Misclassifying a worker as an independent contractor, rather than an employee, is becoming a heated topic among authorities, and misclassification suits are drawing increased attention. A new emphasis on state investigations and correcting misclassification of workers is drawing concern for labor and employment lawyers. A prime example is FedEx Ground, which has faced a wave of litigation by current and former driver-contractors challenging FedEx's classification of the drivers as independent contractors.

Classifying a worker as an independent contractor has a definite appeal for the contracting party (employer) and the service provider (independent contractor), particularly in difficult economic times. Plaintiffs' lawyers and management attorneys have reported a surge in misclassification lawsuits. Benefits to the employer include decreased payroll tax obligations, freedom from minimum wage and overtime requirements, no medical insurance or retirement benefits costs, and other administrative savings. Advantages for the independent contractor include flexibility, more money up front and tax benefits unavailable to employees, including deducting legitimate business expenses.

Classifying a worker as an independent contractor removes almost all employment rights created by federal and state law to which employees are entitled. Thus, behind the financial benefits of an independent contractor arrangement lies a minefield of possible liability for the employer. For example, the company that engages a worker as an independent contractor who is later determined to be an employee can be liable for unpaid taxes. Further, as an employee, the worker would be covered by wage and hour laws and could make a claim for unpaid overtime.

There is no single federal agency or statute that prohibits or regulates employer misclassification. The Internal Revenue Service has final authority for deciding whether a worker is an independent contractor for federal tax purposes, while other federal and state agencies, including the Equal Employment Opportunity Commission and the National Labor Relations Board, have final authority for purposes of the statutes within their jurisdictions.

More significant than federal and state activity is the presence of the plaintiff's bar and a disgruntled independent contractor. Litigation, and ultimately liability, can stem from an injured independent contractor who fails to appreciate that there is no entitlement to workers' compensation until after the relationship sours.

Similarly, discontinuing the relationship can give rise to disputes regarding alleged employment discrimination, unemployment compensation, and minimum wage and overtime obligations. A complaint by a disgruntled independent contractor opens the relationship to judicial examination. Employers can minimize liability by engaging legal counsel to assist in assessing the relationship.

Entering into an independent contractor agreement, wherein the independent contractor acknowledges the rights and obligations of the relationship, also provides some protection. Companies should refrain from relying upon industry practice to avoid liability for worker misclassification.

An independent contractor relationship can provide a seemingly win-win financial exchange for both parties. However, ultimately the risk of liability for misclassification lies with the employer. With misclassification suits on the rise, and drawing more attention from authorities, it behooves companies to carefully and thoroughly assess the situation, thus avoiding costly misclassification investigations and lawsuits.