7 Deadly Outcomes of Treating Employees as Sub-Contractors

7 Deadly Outcomes of Treating Employees as Sub-Contractors

We all hope that having employees will help us better succeed in our business. Whether it’s in production, sales or admin, 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.

Because of this, oftentimes a small business owner will be tempted to try and treat their “employees” as “sub-contractors”. This seemingly allows the business owner to ‘1099’ the worker, rather than set up payroll and follow the proper procedures when hiring an employee. But the problem is, the risks can FAR outweigh a little savings in employment taxes.

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. In fact, the State of California has joined forces with the IRS and significantly increased their enforcement of employee mis-classification. These agencies and other jurisdictions consistently warn 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.

Here are 7 outcomes that could be the death of your business if you aren’t careful.

  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 by an “employee”. This is an interesting risk because many don’t expect their own worker to turn them in to the State. But if you have a disgruntled worker after you fire them, this pseudo-employee could feel they deserve unemployment benefits. 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’? As soon as the State Unemployment office hears about your reckless behavior, they’ll be knocking on your door wanting back premiums for SUTA for several prior years. It will certainly add up quick.
  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. ERISA and Retirement Discrimination Claim. Let’s assume you may have been funding your 401k or SEP these past few years while you were issuing 1099s to workers rather than W-2s. Do you think the Department of Labor will find it fair that you weren’t contributing to your employee’s retirement accounts, while dumping money into your accounts? I don’t think so. The penalties and catch up payments you may have to make into your ‘worker’s retirement accounts’ could devastate your business.
  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 lawsuit and neither party won. It was a disaster.
  7. Third party injury claim. 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 you’re 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.

Just because you ‘call’ a worker a sub-contractor, and even sign a ‘sub-contractor’ agreement, doesn’t make it so. Thus, see my other article “The difference between Sub-contractors and Employees”, wherein I break down this seemingly complex analysis.

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.

* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.

Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. 

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