Assembly Bill 5 - Employee or Contractor?

Independent consultants. Contractors. Gig workers. Whatever the term, these people are 15 million strong according to a recent Labor Department survey, and there is a good chance you rely on 1099 workers to keep your company running at peak performance. After all, they can offer specialized skill sets or boost your employee base to get a big project across the finish line. But, it’s critical to properly classify these contractors so that you maintain compliance and avoid a time consuming and potentially costly audit from the IRS.

What is a 1099 Contractor?

In its simplest definition, independent contractors are self-employed workers. According to the IRS, “The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.” https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-defined Businesses that engage contractors use the Form 1099 to report for tax purposes the income a contractor was paid throughout the year. Form 1099 indicates that the contractor is not an employee and, therefore, the employer is not responsible for paying FICA taxes or withholding income tax. Unlike company employees, 1099 workers do not receive benefits and their pay is generally based on a flat fee or hourly billing as opposed to a fixed salary or wage.

Employee or Contractor?

Regulations for determining a worker’s status vary from state to state, and California’s are among the most stringent. On January 1, 2020 the ABC Test and subsequent Statute AB5 went into effect, whereby a worker is considered an employee unless the business demonstrates all of the following:

A. That the worker is free from the control and direction of the hiring entity in performing the work, both in the contract for performance and in fact

B. That the worker performs work that is outside of the usual course of the hiring entity’s business

C. That the worker is customarily engaged in an independently established trade, occupation, or business of the same nature as the work performed for the hiring entity

According to the National Law Review, “It is Prong B of the test that will likely cause the most difficulty for companies that regularly engage independent contractors. Prong B excludes from the assumption of employee status workers who perform duties outside the “usual course of the hiring entity’s business.” While AB 5 does not specifically define the phrase, many businesses use contractors to help them perform their regular business.” https://www.natlawreview.com/article/abc-test-independent-contractors-set-to-take-effect-california-jan-1 AB 5 also expands the test to include violations pertaining to business expense reimbursements, workers’ compensation and unemployment insurance.

The Cost of Noncompliance

Misclassifying contract workers can have serious implications for businesses. An ADP Research Institute study revealed that a third of all mid-sized companies have been fined or penalized for noncompliance. https://www2.staffingindustry.com/Editorial/Daily-News/ADP-One-third-of-midsize-businesses-fined-for-non-compliance-31802 Companies that unintentionally misclassify employees face penalties of 1.5% of the wages, 40% of the FICA taxes (Social Security and Medicare) that were not withheld, and 100% of the FICA taxes the employer should have paid. Interest on these fines is accrued daily and the penalties are even higher in instances where misclassification is deemed intentional. Employees who feel they have been misclassified can file a complaint with the Department of Labor and, if their claims are found to be true, the employer must pay back-benefits, including overtime, 401(k) and health coverage. Add to all this the damage an audit or lawsuit can do to a company’s reputation and the argument for being vigilant about compliance becomes even more compelling.

https://www.workmarket.com/blog/11-consequences-of-misclassifying-your-1099contractors

https://www.mbopartners.com/blog/misclassification-compliance/employee-misclassification-penalties/

Taking the Risk out of the Reward

The gig economy shows no signs of slowing and employers who rely on 1099 contractors cite a number of compelling advantages. Not having to provide benefits or pay employee taxes puts less burden on a company’s bottom line. Using contractors offers workforce flexibility so employers can grow and contract their workforce as needed. A company’s knowledge base can also be expanded with the expertise these individuals bring to the table. Conducting due diligence and ensuring 1099 contractors are properly classified to the letter of the law will help to ensure these real advantages outweigh the risks.

Please note: This blog is intended for informational purposes only and should not be construed as tax or legal advice. For specific guidance, please contact a qualified legal or tax professional.