Classifying Workers as Contractors vs. W-2 Employees

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An employer that pays a regular employee as a contractor may be subject to employment law fines and penalties in addition to tax liability for failure to withhold.
 

Whether an employer classifies a worker as a contractor or a W-2 employee raises important wage and tax withholding issues.  Nonexempt W-2 employees are entitled to overtime and both exempt and nonexempt employees are entitled to minimum wage, meal and rest periods, and reimbursement of ordinary business expenses.  Employers have to pay half of W-2 employees' social security and medicare taxes (the "payroll tax"), while contractors pay 100% of these taxes.

Employers often improperly classify employees as independent contractors to avoid paying payroll taxes, the minimum wage or overtime, and to avoid other wage and hour rules, meal and rest break requirements, and business expense reimbursements.  Additionally, employers can evade workers’ compensation insurance by classifying workers as independent contractors.

Misclassifying an employee as an independent contractor to save a few dollars is a pretty stupid thing to do.  It means that if the worker suffers an on-the-job injury, he can sue the employer and isn't subject to the damages limitations of the worker compensation laws - the worker can get damages for pain and suffering, which may be remarkably high.  And worker compensation insurance is cheap compared to liability for on-the-job injuries.

Most California workers compensation policies require you to present a valid certificate of workers compensation coverage for each contract worker. That is to say, most workers compensation insurance contracts in California require to the employer prove that any 1099 contractors had their own valid workers compensation policies in effect at the time that you employed them.  After all, if they have their own contracting business, we can expect that they will have insurance.

Additionally, the State of California seriously dislikes willful misclassification.  The civil money penalty for a single misclassification is between $5,000 and $15,000, but not less than $5,000.  The employer's share of taxes and insurance for an employee making $31,200 a year is less than $3,000 a year and that includes the peace of mind that comes with knowing you haven't cut corners.

California law even imposes an embarrassing requirement that an employer found to have willfully misclassified a worker must place a prominent notice on the company's website for one year informing visitors of the ignominious offense.

Who Figures Out Whether a Worker Is an Employee or a Contractor?

The state agencies most involved with the determination of independent contractor status are the Employment Development Department (EDD), which is concerned with employment-related taxes, and its Division of Labor Standards Enforcement (DLSE), which is concerned with whether wage, hour and workers’ compensation insurance laws apply.  Other agencies like the Franchise Tax Board (FTB), Division of Workers’ Compensation (DWC), and the Contractors State Licensing Board (CSLB) also regulate independent contractors.  Since different laws may be involved in a particular situation such as a termination of employment, it is possible that the same individual may be considered an employee for purposes of one law and an independent contractor under another law.  Because the potential liabilities and penalties are significant if an employer treats a worker as an independent contractor who is later found to be an employee, employers should have an attorney carefully review each working relationship before classifying a worker as an independent contractor.

How the Employment Relationship Affects H-1B Petitions

A company must prove it is an "employer" to secure an H-1B petition for an employee.  As in the employment law context, the employer's designation of a worker as contractor, or employee is less important than the facts of the relationship which are defined by control.  US Citizenship and Immigration Services issued a memo on January 8, 2010 noting that it would not approve H-1B petitions unless filed by the "employer" as defined by case law addressing the employee-independent contractor question.  Determining Employer-Employee Relationship for Adjudication of H-1B Petitions, Including Third-Party Site Placements, Donald Neufeld, Jan 08, 2010, HQ 70/6.2.8 AD 10-24.

The Neufeld memo notes that INA 101(a)(15)(H)(i)(b) and 8 CFR 214.2(h)(2)(i)(A) both mention "employer" or "United States employer" that has an "employer-employee relationship" as the petitioner.  This memo has caused headaches for staffing and placement firms that do indeed pay payroll taxes, withhold income taxes, pay workers' compensation insurance and otherwise serve as employers except in some cases with regard to their control over the employee's work.  The Neufeld memo looks to two important US Supreme Court Cases that define the factors to consider in deciding whether a common law employer-employee relationship exist.  Those two cases are:

The United States Supreme Court noted in Darden:

We consider the hiring party's right to control the manner and means by which the product is accomplished.  Among the other factors relevant to this inquiry are the skill required; the source of the instrumentalities and tools; the location of the work; the duration of the relationship between the parties; whether the hiring party has the right to assign additional projects to the hired party, the extent of the hired party's discretion over when and how long to work; the method of payment; the hired party's role in hiring and paying assistants; whether the work is part of the regular business of the hiring party; whether the hiring party is in business; the provision of employee benefits; and the tax treatment of the hired party.  Darden at 323-24.

The January 8, 2010 Neufeld memo more or less inquires as the same factors in Darden.  USCIS now requires that the H-1B petitioner establish that it has the right to control over when, where and how the beneficiary performs the job and will consider the following factors (with no one factor being decisive) to determine employer control:

  1. Does the petitioner supervise the beneficiary and is such supervision off-site or on-site?
  2. If the supervision is off-site, how does the petitioner maintain such supervision, i.e. weekly calls, reporting back to main office routinely, or site visits by the petitioner?
  3. Does the petitioner have the right to control the work of the beneficiary on a day-to-day basis if such control is required?
  4. Does the petitioner provide the tools or instrumentalities needed for the beneficiary to perform the duties of the employment?
  5. Does the petitioner hire, pay, and have the ability to fire the beneficiary?
  6. Does the petitioner evaluate the work-product of the beneficiary, i.e. progress/performance reviews?
  7. Does the petitioner claim the beneficiary for tax purposes?
  8. Does the petitioner provide the beneficiary any type of employee benefits?
  9. Does the beneficiary use proprietary information of the petitioner in order to perform the duties of employment?
  10. Does the beneficiary produce an end-product that is directly linked to the petitioner's line of business?
  11. Does the petitioner have the ability to control the manner and means in which the work product of the beneficiary is accomplished?

The Neufeld memo then uses examples to classify employment into four types of acceptable employment:

  • Traditional employment
  • Temporary, or occasional off-site employment
  • Long term, or permanent off-site employment
  • Long term placement at a third-party work site

And three types of unacceptable employment:

  • Self employed
  • Independent contractors
  • Third party placement "job shop"
  • Agents as petitioners

How to Comply with the Neufeld H-1B Memo

The Neufeld memo requires a petitioning employer to supply the following documents to satisfy the employer-employee relationship:

  1. A complete itinerary of services or engagements that specifies the dates of each service, or engagement, the names and addresses of the actual employers and the names and addresses of the establishment, venue, or location where the services will be performed for the period of time requested;
  2. A copy of the signed employment agreement between the petitioner and the beneficiary detailing the terms and conditions of employment;
  3. A copy of an employment offer letter that clearly describes the nature of the employer-employee relationship and the services to be performed by the beneficiary;
  4. A copy of relevant portions of valid contracts between the petitioner and a client that establishes that while the petitioner's employees are placed at the third-party worksite, the petitioner will continue to have the right to control its employees;
  5. Copies of signed agreements, statements of work, work orders, service agreements, and letters between the petitioner and the authorized officials of the ultimate end-client companies where the owrk will actually be performed by the beneficiary, which provide information such as a detailed description of the job duties, the qualifications required to perform the job duties, wages paid, hours worked, benefits, a brief description of who will supervise the beneficiary and their duties, and any other related evidence;
  6. A copy of a position description or any other documentation that describes the skills required to perform the job offered, the source of the instrumentalities and tools needed to perform the job, the product to be developed or the service to be provided, the location where the beneficiary will perform the duties, the duration of the relationship between the petitioner and beneficiary, whether the petitioner has the right to assign additional duties, the extent of petitioner's discretion over when and how long the beneficiary will work, the method of payment, the petitioner's role in paying and hiring assistants to be used by the beneficiary, whether the work to be performed is part of the regular business of the petitioner, the provision of employee benefits, and the tax treatment of the beneficiary in relation to the petitioner;
  7. A description of the performance review process, and/or
  8. A copy of petitioner's organizational chart demonstrating the beneficiary's supervisory chain.

Know the Law Regarding Employees Versus Contractors

Just because someone else is paying a worker's payroll taxes and workers' compensation insurance doesn't mean that you aren't their employer.  Many employers learn through experience that using a staffing or placement service can result in later reassessments of the employer-employee relationship.  A reassessment may reclassify staffed workers as your employees.  An after-the-fact legal determination that a worker is an employee may result in signficant financial liabliity.

If you would like more information about whether a worker should be classified as an employee, or a contractor, please contact us.

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Call us at 408.797.0000

Call us for a consultation at 408.797.0000. We offer expert services and proven experience with complex issues that others can overlook.

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