We all hope that having employees will help us better succeed in our business. Whether it’s in production, sales or admin, if done right, the proper team of employees can make all the difference in the world.

However, many small business owners are often wary of the costs and extra paperwork to bring on an ‘employee’ in the business and try to cut corners. Terms such as SUTA, FUTA, FICA and Workers Compensation will often times scare the employer into making a decision that devastates their business.

They try and treat their “employees” as “sub-contractors” and 1099 them rather than set up payroll and follow the proper procedures when hiring an employee.

I will simply refer to this incorrectly classified worker in your business as a  pseudo-employee (someone that is really not a sub, but an employee that should be on a W-2.)

The reality is that this can be a very dangerous practice and the IRS continues to crack down on small business owners treating employees like sub-contractors. The IRS consistently warns taxpayers that if they are caught paying ‘employees’ as ‘sub-contractors’, they will pay stiff penalties on top of the taxes and interest owing for payroll withholdings that should have taken place.

But believe it or not, the IRS, may be the least of your worries. Below are 7 deadly results that could occur by trying to call an ‘employee’ a sub-contractor when it’s truly not the case.

  1. Workers Compensation Claim…or the lack thereof. What happens if your pseudo-employee gets hurt on the job picking up a delivery or even slipping and falling at your workplace? Can they make a Workers Comp claim that comes to your rescue to pay the medical bills? No. Because you don’t have Workers Comp! You treated them as a sub-contractor and so now you face personal liability and the piercing of the corporate veil because you were negligent in your management of the business and employment practices. This could actually be far more devastating than an audit because claims for medical costs or pain and suffering could easily exceed a tax or penalty.
  2. Unemployment Claim. Let’s assume you ‘fire’ this pseudo-employee and they feel they deserve unemployment. How do you think this is going to fly when they start calling the State Unemployment office and you aren’t paying unemployment insurance? In fact, your company name is nowhere to be found. Can you say ‘audit’?
  3. Workforce Services and Over-time claim. Ironically, it’s not the unemployment claim I see more of…it’s the worker putting in over 40 hours a week and required to do so. But oh yeah, I forgot, you require them to work all of these extra hours, but they’re not employees and then claim you stiffed them for overtime. This happens A LOT and frankly there isn’t much you can do about it. Attorneys love to get a hold of one of these disenfranchised employees/subs because they get attorney’s fees, on top of the fact you could pay up to 3x the cost of the unpaid overtime. If you really are going to play this game, don’t overwork your pseudo-employee- not good!
  4. State Employment Claim. As soon as the State Unemployment office hears about your reckless behavior, who do think they’re going to call? Let me tell you…it’s not the Ghost Busters! It’s your friendly State payroll tax auditor that is going to start sniffing around and trying to figure out how many people you are paying ‘under the table’ and as 1099 subs…oh yeah…all those other pseudo-employees are going to come out of the woodwork and wonder why they weren’t getting benefits or a paycheck with withholdings.
  5. Federal Tax Audit. Now that the State is involved, the party just gets bigger and bigger and new guests arrive. The IRS now wants back FICA and FUTA for all of those withholdings you never made. This is when the penalties, taxes and interest really start adding up and the fun begins.
  6. Partnership claim. Just when you thought your pseudo-employee wasn’t smart or creative, they pull a fast one. They claim they are really a ‘partner’ and not even a sub-contractor. They will hang their hat on any sort of verbal promises you may have made and then it’s off to the races in court with the ‘he said-she said’ battle. I once had a client that owned a massage therapy school and his ‘manager’ who was paid as a sub-contractor and received a ‘bonus’ from the profits, decided to turn that relationship into a claim for partnership. The business shut-down due to the law suit and neither party won. It was a disaster.
  7. 3rd party injury. Just when you thought it couldn’t get any worse, consider the following nightmare scenario: You ask your pseudo-employee to run to 711 to get drinks for everyone at the office or worksite and while they are driving down the road with Big Gulps in the front seat they decide to text their best friend and get into a car accident and seriously injure or kill someone. Guess what the worker is going to say he was doing? That’s right…running an errand for his boss that is paying him under the table. Who do you think the ambulance chasing attorney is going to go after? The broke worker driving a 1987 Mazda or the business owner who sent him on the errand? Now your praying your insurance is going to cover the claims and they don’t exceed policy limits. It’s worse than your pseudo-employee getting hurt.

So if I haven’t motivated you by now to carefully consider your situation if you are pushing the envelope, I don’t know what will. Let’s hit the definitions of these important classifications and see if we can help you through the process. Here are a few basics.

So of course, the golden question is: What is the difference between an employee and a sub-contractor? The answer is complex and there are statutes and cases that would tower over a conference room table, however let me boil it down to this.

The Employee Definition: The IRS and State Workers Compensation Agencies essentially define an employer/employee relationship as one in which the employer controls the workspace, the hours worked, the equipment to be used and directs the daily and weekly activities of the worker.

A Sub-contractor by contrast is one that typically carries their own tools, supplies, bills for their time and/or services, controls their hours worked and serve multiple customers or clients and aren’t supervised or directed by one employer in particular.

The best test to determine if an employee is an employee is that of the old adage, “if it looks like a rose, smells like a rose, feels like a rose, then it’s a rose”. Just because you call or label a worker a ‘sub-contractor’, doesn’t mean they will be treated like one in the eyes of the IRS or in the case of an injury by the Workers Compensation Fund.

Bottom line, PLEASE be careful and make sure you discuss this issue with your CPA and attorney when hiring a worker that may be falling within this grey area. This is not a situation you can ignore or take lightly.

Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”  and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.