Nothing defines the modern workforce quite like the gig economy. As of 2018, about 36% of the American workforce works in contract jobs, with that number projected to exceed 50% by 2027. The gig economy is making it easier than ever for people to earn some extra income through a side hustle.
On the other side, it also allows employers to stay leaner and more flexible, especially during growth stages. Rather than hiring someone for a full-time position with full-time benefits like health insurance and paid time off, many businesses find it’s more cost-effective and efficient to bring on specialized talent to handle specific projects.
Building a contractor workforce isn’t without its issues, however. There are risks involved when designating workers as independent contractors. Employee misclassification can put organizations at risk of incurring financial penalties, excessively complicated taxes, and more issues that can affect your bottom line. Here, we’ll take a closer look at some of the risks of misclassification and what you can do to avoid them.
What’s the Difference Between Full-Time and Contract Employees?
The key difference between full-time and contract employees is the tax form used for each. Companies provide a Form 1099-MISC to independent contractors and Form W2 on behalf of full-time employees.
Independent contractors on 1099s generally provide specific services, laid out by a written contract. Companies hire independent contractors on a per project basis or for a defined period of time, as outlined by the contract. Contractors handle their own tax burden, the tools they use to complete a project, and define how and where they work.
Full-time W2 employees are what we tend to think of as typical, salaried employees. W2 workers participate in your company’s employee benefit programs like health insurance and retirement plans, and work according to the business’s needs and schedule. They’re guaranteed minimum wage by law and are subject to employer payroll taxes. Employers also provide all the necessary tools and supplies for W2 employees and must reimburse them for business-related expenses incurred during their employment.
Each type of employee comes with pros and cons, and it’s up to you to decide what works best for your business. Now that you know the types of employees, let’s look at how you can avoid some common pitfalls of misclassification.
Wage Law Violations
Under the federal Fair Labor Standards Act (FLSA), employers are held liable for failure to pay overtime and minimum wage. FLSA violations may result in back wages being levied against employers as well as criminal action being sought against company executives. The Department of Labor takes wage violations extremely seriously, making the potential liability exposure for companies that misclassify employees enormous.
The statute of limitations on wage claims is two years for non-willful violations and three years of willful violations, which is important to keep in mind if you’ve worked with contractors before fully understanding employee misclassification. (Before you read this article!)
Companies should always be up to speed on any state and federal minimum wage or overtime requirements—but when managing a payroll of full-time and contract employees, it can get a little dicey. Of course, if you’re paying below minimum wage to full-time employees, that’s a flagrant, easily avoidable violation.
However, it’s more common for companies to mistakenly label full-time employees as independent contractors than it is the other way around. It’s enticing to want to save money by hiring administrative assistants as contract workers, but if you’re asking them to work extensive hours or perform any work that falls outside the purview of your written agreement, you may be at risk of a lawsuit.
To avoid exposing yourself to wage law violations, familiarize yourself with federal and state wage requirements, and be thorough and specific with the agreements you share with contractors.
I-9 Tax Violations
Say you’ve got a large team of remote content creators, and one in-house editor assigning projects and ensuring their quality. Proper classification would most likely have each remote content creator as a 1099, and the editor as a W2 employee, thus saving you the tax burden on each creator.
However, it’s crucial that employers also comply with federal I-9 requirements. Employers must keep completed I-9 forms for each of its employees, including common law employees. If you have that in-house editor as a 1099 employee, but have set their work hours and include them in your business hierarchy, there’s a good chance they’ve been misclassified. If that’s the case, you may owe hefty back taxes, fines, and interest on that employee’s wages.
When investigating I-9 violations, the Department of Labor especially targets construction, home healthcare, warehousing, and food processing where labor is generally not closely controlled or monitored—so if you’re in one of these industries, take note.
To figure out what kind of employment status individuals qualify for, take a look at the IRS’ rules, and ensure you have proper documentation for each of your employees.
Not all misclassification fallout comes from government investigation. In 2017, the ADP Workforce Vitality Index reported a Job Turnover Ratio of 26.5% across all industries, an expensive problem that no business wants to deal with.
On the one hand, employing many independent contractors allows you to get high-quality talent for your projects at a relatively low cost. You may have a great customer service team—however, without W2 benefits like health insurance, workplace protections, and overtime pay, you may find it more difficult to retain your top agents.
If you’re asking independent talent to work the kind of hours that full-time employees are, you should be prepared to pay a premium on a per-project or hourly basis to ensure the job is rewarding. Otherwise, you risk losing talent and incurring the costly challenge of searching for new contractors, training them, and spending time trying to get them up to the same level of the departed person. That’s time lost and time is money.
The bottom line on misclassification
Failing to keep accurate records and uphold employment standards in your organization can lead to both legal and personnel trouble. As such, it’s important to take the time to ensure your employees are properly classified, especially if you’re taking advantage of the gig economy.
If you’re ever in doubt, you may want to enlist the help of a small business accountant or lawyer. Getting expert insight into how a hire, or many hires, will affect your bottom line is always the right move. Accounting software is an excellent resource, but remember: You don’t have to go it alone the whole time.
ABOUT THE GUEST AUTHOR
Eric Goldschein is an editor and writer at Fundera, a marketplace for small business financial solutions such as business loans. He writes extensively on financing, marketing, entrepreneurship, and small business trends.