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Downsizing from Employees to Independent Contractors?
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Q: Our nonprofit group home has to downsize and as part of our reorganization we are considering changing some of our employees into independent contractors as a cost-saving measure. If we did that, we wouldn't have to pay for benefits and we'd have more flexibility - we could match our personnel to our workload. What is the potential downside to making that change?
A: It is possible to transition an employee to a contactor if the worker truly meets the legal tests for independent contractor status. What you need to watch out for is the possibility of a payroll tax audit or the potential for various benefit-related claims. Your group home can incur significant liability if a worker is inappropriately designated an independent contractor - and it is typically the employer's burden to prove that the worker is properly classified if there is a challenge.
Different laws establish different tests and factors for defining whether a person is an independent contractor or an employee, but the main concern is who has the right to control or direct what and how work is to be done. If your nonprofit can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then your worker might be appropriately established as an independent contractor.
If the work is a core service of the nonprofit, it is less likely that the worker would have sufficient control over the work product to establish independent contractor status.
Let's look at two examples.
Example 1 
We Are Family Group Home has decided to lay off its bookkeeper Kim since it now uses a payroll service and it doesn't have enough work to employ a bookkeeper full time. Kim has mentioned her interest in setting up her own bookkeeping business and continuing to do the books for We Are Family. Kim sets herself up as a separate business and buys all necessary equipment, does the books for other businesses, has her own insurance, and does the monthly accounts receivable and payable using her own software but gets the monthly reports back to We Are Family as requested. This transition to independent contractor would likely withstand any legal scrutiny.
Example 2
We Are Family Group Home has recently lost a number of residents so it decides to lay off two case managers, Rosa and James. When the number of residents increases again ABC decides to contract with Rosa to just handle one or two clients until there are enough residents to warrant the hiring of an additional case manager. Rosa performs the same work as she used to perform: meeting with the residents in the group home, attending team assessment meetings with other staff, and bringing any problems to the treatment team manager. She uses We Are Family forms to write her reports; however, she writes her reports at home using her home computer and no longer has a desk at We Are Family. She does not perform case work for any other nonprofit and does not have her own insurance. Rosa is performing We Are Family's core business under its direction and control and is not likely to satisfy any of the tests of independent contractor.
Paying a worker under a 1099 and a W-2 in the same tax year is a common trigger for a payroll tax audit. Other potential liabilities for worker misclassification include claims for unpaid overtime, employee benefits, workers' compensation coverage, and unemployment compensation, not to mention all the penalties that can be assessed.
While successfully establishing an independent contractor relationship with former employees is possible, it is critical that such workers are given the right to control the manner and methods in how the work is to be performed. If the nature of the work prevents delegating the control over the work to a third party due to the required supervision and oversight, then nonprofits should stick to hiring employees, and consider hiring temporaries or part-timers if there is a reduced work load.
Have you successfully worked with an independent contractor who was once an employee? What was the upside of that experience? Have you ever gone through a payroll tax audit? What can you share with other Blue Avocado readers?
Comments
As always, an excellent response in Blue Avocado. I have MANY clients who think this is the "easy way out" for their employees, yet, they do NOT understand (a) HOW to make sure the former employee IS an independent contractor, and, (b) getting the employer to ACT as if the former employee is an independent contractor....
Also, as an independent contractor, I am often faced with clients who demand and expect to treat me like an employee. My defense for these many years has been to make performance based, benchmarked contracts. I am finding, however, that many of my clients do NOT want to enter into this sort of agreement because it limits their flexibility....
Thanks
Debbie Cutchin
My experience from my public accounting years is that employment tax related audits are most often triggered by a terminated “independent contractor” applying for unemployment benefits. Many persons classified as independent don’t understand the implications for unemployment benefits eligibility.
In this situation the state unemployment agency has no record of wages paid to the individual and initiates either audit correspondence by mail or a field audit. And it often doesn’t stop with the individual in question. To prevail, the nonprofit should be ready to supply documentation that the individual is truly engaged in an independent business with more than the nonprofit as its sole client. If the auditor can’t independently find the individual’s business activity through commercial sources, you’re probably toast.
Another common scenario is that an individual becomes disgruntled after being hit with both the employer and employee share of Social Security tax (referred to as self-employment tax for independent contractors). More often than not, the individual will not have paid in enough during the year through other withholding sources or quarterly estimated payments and will start making some unwanted inquiries when they see their income tax bill.
A couple of additional risk areas not mentioned by Rita, relevant to worker misclassification, include health insurance continuation under COBRA, coverage under the Americans With Disabilities Act and/or similar state laws, and The Family Medical Leave Act for employers with the minimum number of respective employees triggering coverage under any of these laws. The risk may go well beyond the individual in question if an adverse reclassification of one or more individuals triggers coverage for all employees under any of these laws.
Bear in mind also that the trust fund “100% penalty” for failing to deposit taxes withheld from wages has the potential to come into play here as well. This law applies in the same way to taxes that should have been withheld from workers improperly classified as independent. In cases where the nonprofit becomes insolvent and such taxes cannot be collected from the employer, the person(s) responsible for choosing which bills get paid can be held responsible for payment.
These are not hypothetical situations. Intentional worker misclassification goes on in both the for-profit and nonprofit sectors. Some employers rationalize it based on common industry practice and dismiss audit potential as remote due to limited IRS audit resources. The tax and insurance savings are just too tempting for some. But this is one area where you truly don’t want to get on the radar.
Last, some states have reciprocal agreements with the federal government for the sharing of adverse audit findings, so if you’re audited by either the IRS or your state, don’t necessarily expect it to end there.
Dennis Walsh
These experiences mirror exactly the ones I have had as a CompassPoint consultant working with nonprofits. Great points, Dennis. Jan
I used to work for a nonprofit as an AmeriCorps member. When my term ended, they wanted me to stay on, but refused to hire me as an employee. I did the exact same work (same desk, same computer, same clients) but was classified as an independent contractor. As Dennis says above, I'm a bit disgruntled now that I've got my tax documents in hand. At the time it didn't seem right to me, but I didn't know any better. Is there anything that I can do now, and is it my legal (or moral) responsibility to call attention to this matter?
I would caution anyone considering reclassifying a worker from "employee" to "independent contractor" to consult with someone knowledgeable about the distinction, or plan to spend a fair amount of time studying it yourself, before making the change.
This is not a simple determination, and the risks of being caught out of compliance are substantial. The analysis can also vary from one jurisdiction to another. In California, I'd recommend reviewing the California Department of Labor and Enforcement site: http://www.dir.ca.gov/dlse/FAQ_IndependentContractor.htm
In my "day job" role as General Counsel of a for-profit company, I require that we obtain adequate documentation, in advance, for every worker we intend to compensate as a contractor. That includes things like proof of insurance, list of their other customers, copy of their business license, screen shot of their web site or other marketing materials. Keeping this information on file can help protect your organization in the event of a payroll audit.
Juliette Hirt
Wouldn't you agree that any "independent contractor" who provides services for only one "client" is almost certainly an employee, no matter where the work is performed, especially if the person used to be a full-time employee?
an employee in N.J.
Not necessarily. If the "independent contractor" controls their daily schedule while meeting the deadlines on their single "client" then they could still be considered independent contractors. Also, they would now have the right to take on work from whomever they chose at any time. Many independent contractors work for single clients, depending upon the service being delivered.
I own a marketing consulting business and contract with businesses and non-profits for projects and/or long term marketing direction. Basically, I act as a "marketing director for hire."
It is my observation that many companies and organizations are wasting valuable dollars on full-time employees that are not necessary; either the job is really a part time job or the job could be divided up into several speciality areas with each one done by someone more qualified as a subcontractor. However, I also have observed that there is a certain personality type and sensibility that defines a good subcontractor and this type is very different than the type of person who wants to be an employee.
I suggest that any company or organization analyze each job to determine how it will be best fulfilled (by an employee or a subcontractor, plus all the corresponsing requirements and responsibilities) and then analyze each employee to see if he is a fit for the new job requirement. Often, it's better to cut the dead weight of emplyees who are not really a good fit and then hire someone else who is a better fit for the new role. This sounds cold-hearted but when you cut people who are not a fit you are doing both parties a favor; the employee now has the opportunity to seek a job that is a better fit for him/her (you can even, as a company, help that person get a new job) and you get to create a more efficient company.
As far as the case studies listed above, in the second example, the employee could have been laid off because there was a lack of work. Instead of hiring the person directly as a subcontractor, the company should have considered hiring per diem through a placement agency. The person who was laid off could go work for the placement agency.
I own my own business and do work as an independent marketing contractor and a freelance writer. I have seen many ads that require freelancers to work at the employer's place of business. Given the fact that the employer cannot tell an independent contractor where or how the work must be accomplished, is this legal?
One solution that protects both the employer and the employee is to payroll the employee through a staffing company. The staffing company absorbs all liability, pays the employee, and will likely have benefits for their associates as well. The employer now has contingent staff to use as needed without the potential issues surrounding the independent contractor status.
Dear Readers - Some have asked about the possibility of volunteering for a non-profit that formerly employed them.
While it is certainly possible to volunteer for a former employer non-profit, this is an area where strict compliance with the legal requirements for creating a volunteer relationship is critical to avoid misunderstandings and potential legal liability. It is recommended that the nonprofit require the volunteer/former employee to sign a volunteer agreement which specifies that there is no expectation for any compensation or benefits, and that the relationship is entered into on a stricly volunteer basis. Wage and hour laws prohibit nonprofit employees from volunteering to perform their regular job for their employer when they are currently employed - so a written agreement should also be required when accepting any volunteer hours from a current employee as well.
Regards, Rita
Not that this would be as cost-savings as perhaps an 'independent contractor' status would, but, in many of the cited examples, couldn't the employees be almost as easily re-hired as part-timers on a per-hour basis, rather than salaried?
If the more expensive benefits are only offered to employees working at least 30-35 hours/week, savings would still be substantial and work could still be assigned to former full-timers. Whether the former employee would want to do this is perhaps the question, but it seems to make more sense.
Michelle H.
I have a question from the other end of the coin. The company I work for has run low on work. They called me in, and said they did not want to fire or lay me off but wanted to make me a "1099 employee". They raised my hourly rate by $2 dollars, put my termination date as that day, and sent me back to work. Within an hour I went from an employee to an independent contractor- and my head is spinning. Since I worked the rest of the day as a "1099 employee" have I made myself ineligible for unemployment. My boss will not guarantee that he can keep me working- and I am worried. Being laid-off is frightening to be sure- but I am worried this situation may turn out to be worse than a lay-off. Any thoughts?
Carrie
Can an employee take on an extra task outside of their normal function and be paid as an independent contractor as well? Does the worker have to be labeled as one or the other, or can it be both, depending on the task?
I am working on a graduate project determining a recommendation for
teaching artsists on this issue of IC vs. Employee. Is there any
research that has been done on the issue as it relates to the arts and
education? I have not been able to find anything specifically geared to
the field, and feel it is very different in a way. Interpreting the 20
questions test is complicated yet almost funny in nature. How an artist
comes by a box of crayons for a class is significant. I would be
interested in any analysis of the materials procurement, the control
issue - as they relate to an artist in front of a class!
Thanks-
Jenny Steinman Heyden
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