Downsizing from Employees to Independent Contractors?

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.

See also in Blue Avocado:

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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?

It's legal. The place where the work occurs is only one of the issues considered in a review of the status of a person, but it's an important one. The company or organization can ask you or require you to do this, but it puts them in danger of losing the audit if it comes to that.

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"

I've taken over as Treasurer for a non profit youth sports club. We pay a stipend to coaches at the end of the season. The previous treasurer treated the coaches like employees, paying payroll taxes and filing a 941. I have reviewed several checklists and have concluded the coaches are not employees but seasonal contractors. They have other jobs, as well as control their work with the exception of game schedules. Going forward, I will issue a 1099. My question is what to do about the previous 941 filing, other taxes? Do I have to notifiy the IRS or state that we are changing the status of the coaches to contractors?

You do not have to notify the IRS about a change. It sounds as if your club is very well organized!

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

Dear Carrie,

you can write to the IRS, from their online site and explain the situation. The government is now offering top rewards to anyone who helps them recover taxes. Which means your switch from employee to Independent contractor was to avaid taxes. You can simple turn in your ex employer and reap rewards from the US government.

Good luck.

Since you voluntarily resigned your job, it will not be easy to apply for unemployment if you decide to do so. What is clear is that you have been treated badly. I am not a lawyer but I would suggest writing a letter to your boss that recaps what happened so that you have documentation in the future.

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

If I was hired by a non profit as an independent contractor but now realize that they are clearly treating me as an employee, do I have any liability? Can I be fined for filing a 1099 and not meeting the requirements?

The liability is on the employer, not you.

I live in Arkansas and have worked for my current employer for five years as an employee. State income taxes, federal taxes, Social Security, and other withholdings were withheld every week without fail. Today at lunch I was handed cash instead of my normal paycheck. I talked to the owner and he said he had to take me off the payroll at the accountants office, would no longer be paying taxes, liability insurance or workers comp for me. He now wants me to work as a contractor and give me a 1099 at the end of the year. Is this legal, and if I refuse to do this would I be eligible for unemployment benefits. It seems to me by doing this he is attempting to re-classify me but actually has fired me.

I am not an attorney but I believe that you have lost your job and should be eligible for unemployment.

I agree. I have a friend who worked as a car salesman and they changed from being salary plus commission to commission only. As a result he quit and collected unemployment. When his unemployment ran out he went back to work for them!

I'm currently a full time job employee I'm considering to resign and to become an independent consultant and to provide consultant services to the current employer.
The company is in CA should the company face any low problems hiring me as a contractor? do they can face any payroll tax audit?

So many wonderful and useful comments! How about the reverse situation? Does anyone know what steps should be taken within a nonprofit that would like to switch an independent contractor to employee status? Thank you.

I have the same question, our organization hired temporary contractors for our busy season namely the summer but now I think they should be classified as employees. Does anyone know how we can make this change?
Thank you.

The good news is that there isn't anything extra to do to switch a person from contractor to employee. Just have them complete the same paperwork you would use with any new employee. Just remember not to have the period in which a person is an employee overlap with the period during which you were paying them as a contractor. That's it! For once, not complicated! Jan

In my case, I am working as an interpreter for a nonprofit Asylum and Refugee Family Services Organization that is government supported. I began to work as an employee and half a year later was gathered at a meeting with six other interpreters to change our status to ICs.

Our contracts with this Agency, agreed upon in the State of Florida, are very specific and these are a few main examples:

Prohibition against Subcontracting (unless having a written approval);
Prohibition Against Assignment and Delegation;
Indemnification of Insurance (lowering pay rate if not insured with an outside agency including Liability and Workers Comp.).

After letting go of the thought of adding or amending to contract, I kept feeling like, although I may enjoy learning to handle my own self-agency, there may be unclear manners in the contract and Agency for which I work.

The Agency representative asked the former employees if they wanted to make the shift, however, the choices were narrow and leaving no space to choose otherwise. We are working just the same as before but with a lower pay rate because of their standards on becoming ICs. The difference in pay rate was of -1USD without bought insurance or regular rate as when employees if insured. We utilize the same products, like for example, the same "provider sheets" for their clients but now with hour input. As for freedom in schedule it is the same as when employees in terms of accepting or declining jobs. Moreover, interpreter's clients are workers from the same company who write the hours of arrival and departure unlike as employees we would write the hours of departure from what we logically thought was beginning and end of work. Very importantly on freedom, when clients make a request for an interpreter they are not allowed to call us directly and we shall go through an "interpreter specialist" to communicate, hence treating as employees. They do not consider negotiations such as a "rush fee" when it is a last minute appointment, nor a "large group interpretation" fee. In other words, the pay rate is the same at any effort level and the quality of my work I will not put at stake for resigning an available job or resigning.

Moreover, I feel incapable or amending or adding to the contract since on the terms it limits to communication with authorized officials, names not mentioned. Also in the contract it does not mention the Employee’s right to amend to the contract, while it does mention the Agency's holding of right to amended to the contract. Also, when looking for answers to my "fishy" feel of this, they had mentioned that years before they were contracting interpreters and recently decided to change to employees and now back to ICs. I decided to trust the agency, but I do not hold an insurance of any kind, nor an accountant that I could afford to do this year's half 1099 half W2 Income and Self Employed Taxes. The Agency mentions often the goodness of being Independent, flexible, and counting ones own deductibles, but I want more fairness to the overall economy, not just for myself. For a year they have been the only Agency I worked with because of my novice on the subject of going solo.

In all of this I just want a more knowledgeable thought on how is that they choose this change, question that the specialist cannot answer. Also, I would like to know how to file a crossbreed tax for an employee/IC year.

Thanks,
Florida Independent Contractor

In my opinion you should consult the IRS in this matter. There is very little benefit of the 1099 deductions if your expenses are minimal. It seems that your employer is cheating the system and just trying to skimp out on paying 1/2 of your taxes and not have to provide benefits.

I am in the same position, I think you should ask your boss to pay your taxes or you report the case to the IRS, concluding in an audit which can have tremendous penalties or even jail time.

can we pay and hire just anyone to hlep with our work at Not for profit organization? Should we follow rule and regulation? This is just for temporary work to help with an event.

I have worked as a bookkeeper, in my home, for the same company for 10 years. They are now trying to save some money and have asked me in July to declare myself an IC. Everything remains the same; I never received healthcare benefits through them because I am covered under my husband's insurance. I am puzzled by two things...first, is my ex-employer going to get in trouble. Second, am I now actually making less money since I have to pay full social security benefits...a difference of about 8%?

I have worked with my company for 6+ years in California, my husband is being relocated to Texas. My boss says he will keep me on, but believes the easiest way is to declare me as an IC. I will be working at home and in charge of my own schedule, and if I want (which I wouldn't) I could take additional contract jobs. How do I ensure that I still get things like sick days, paid vacation, and how much more tax should I expect to pay? I believe he would give me a raise to meet me half way if I knew how much. He is more than fair and I would like to continue my work from home is Texas. How do I make sure I am not giving myself the short end of the stick? Thanks- Sasha

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