In 2020, the United States experienced a record-breaking number of unemployment claims. If you had to make the difficult decision to furlough or let employees go due to the coronavirus, you were not alone.
As we continue to struggle with the economic realities of a global pandemic, many clients are asking about alternative hiring arrangements, including rehiring furloughed or terminated employees as independent contractors. Rather than lose key employees, many employers believe they can rehire workers as independent contractors in order to retain talent while reducing payroll and benefit costs. Such a strategy, however, comes with significant risk. Misclassifying an employee as an independent contractor can result in significant costs to an employer, including back-owed taxes and penalties. Below are just a few of the various potential outcomes for both the service provider (i.e., the worker) and service recipient (i.e., the employer) in the event of worker misclassification.
In the employee benefit context:
- If the employer sponsors a pension plan, there will not be a bona fide severance from employment if a participant is rehired directly after he or she is terminated. If the worker is receiving pension plan payments and is rehired as a contractor but then is reclassified as an employee, the pension plan would have to suspend distributions, potentially retroactive to the date of rehire (therefore requiring repayment of any pension plan payments improperly received by the worker during a period of employment). Moreover, the worker could also earn additional accruals during the rehire period and may be entitled to a new benefit election upon subsequent termination.
- If the service provider had received a distribution from a qualified defined contribution retirement plan at the time of the prior termination of employment but did not have a bona fide severance from employment, arguably the distribution should never have been made. The employer may need to correct the erroneous distribution under the applicable IRS correction program to avoid significant penalties and possible plan disqualification. Moreover, the service provider may be eligible for plan participation upon the worker’s rehire, and the employer might be on the hook for employer contributions and deferrals that would have been made during the worker’s rehire period.
- If the service provider is determined to have been misclassified as an independent contractor rather than an employee, the service recipient may be subject to employer shared responsibility penalties if the worker is considered a full-time employee for purposes of the Affordable Care Act.
In the federal and state tax context:
- The service recipient will have liability for failure to withhold and remit federal income tax from employee wages, failure to pay the employer’s share of FICA (Social Security and Medicare) taxes, and failure to withhold and remit the employee’s share of FICA (Social Security and Medicare) taxes.
- Other possible adverse results may include penalties from unpaid taxes plus statutory interest; $250 per W-2 not filed; numerous other possible penalties relating to failure to file and pay tax (depending on circumstances).
- The service recipient will have liability for failure to withhold and remit state income tax from employee wages, along with possible adverse results and penalties similar to the federal penalties detailed above.
- Expenses that the misclassified service provider treated as fully deductible “trade or business expenses” on Schedule C will become “unreimbursed employee business expenses” on Schedule A (subject to phaseouts and the 2% floor for miscellaneous itemized deductions).
In the employment law context:
- The service provider may be entitled to overtime pay because he or she was not paid on a salary basis and/or does not qualify for other exemptions under the FLSA.
- Possible adverse results or penalties include back wages, liquidated damages and fines.
Employers must weigh all the benefits and risks when considering whether to rehire an employee as an independent contractor following either a furlough or termination. While there is no one “magic factor” that is determinative, a service recipient should become familiar with the tests and factors that government agencies and courts apply to worker classification disputes to prevent reclassification problems.