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The Cost of Misclassifying Employees as Independent Contractors

The Cost of Misclassifying Employees as Independent Contractors

The rise of the “gig economy” has led to a dramatic increase in the number of businesses using independent contractors (IC) instead of traditional W2 employees. At the same time, there’s been a sharp rise in the number of companies being penalized and/or sued for misclassifying workers as ICs.

Indeed, within the past 10 years, there’s been heightened scrutiny from regulatory agencies at all levels and numerous lawsuits filed over the issue. These lawsuits have forced companies like FedEx, Uber, and Citigroup to pay out hundreds of millions of dollars to those they’ve misclassified.

State-level studies show that between 10 and 20 percent of employers misclassify at least one employee as an IC, and you can be penalized regardless of whether or not you did it intentionally. Given this, you should carefully scrutinize all of your workers and have the proper contracts in place to shield your business. Fortunately, with legal guidance from me, you can easily avoid these risks and stay totally compliant.

However, since you can save an estimated 20 to 40 percent on labor costs by not contributing to a worker’s Social Security, Medicare, and other benefits, you may be tempted to take your chances and pass off some of your employees as ICs. But in doing so, you’re risking serious consequences, which have the potential to destroy your business.

Getting busted
It’s easy for the IRS to be alerted to a potential misclassification. A worker can file an SS-8 form, alleging you’re in violation of the law, or he or she might simply receive a 1099 and W-2 in the same year. Beyond that, you can also get caught if a worker tries to claim unemployment or disability, as this results in an audit of your business.

Plus, because there’s no single test to determine a worker’s classification, it can be easy to misclassify a worker by mistake. And regardless of whether or not the misclassification was intentional, if the allegation proves valid, you’re potentially on the hook for paying back taxes, benefits, and numerous fines.

Fines, Back Payments, and Penalties
If you misclassify an employee, you face fines from the U.S. Department of Labor, IRS, and state agencies that can total millions of dollars. Moreover, you can be held responsible for paying back-taxes and interest on employee wages, along with FICA taxes that weren’t originally withheld. Failure to make these payments can result in additional fines.

You can also be held liable for failing to pay overtime and minimum wage under the Federal Fair Labor Standards Act as well as under state laws. Such claims can go back as far as three years if it’s found you knowingly made the misclassification.

If the IRS believes your misclassification was intentional, there’s also the possibility of criminal and civil penalties. Additional penalties and fines can be assessed depending on the severity of your misclassification.

Back benefits and a tarnished reputation
Outside of the fines paid to state and federal agencies, if an employee is misclassified, they’re eligible to claim employee benefits he or she missed out on. These can include healthcare coverage, stock options, 401(k) matches, PTO, and even unpaid break time.

Don’t Take The Chance
’With such severe consequences, it’s simply not worth taking the chance of misclassifying your workers. To this end, you should consult with me to make sure you have all of your bases covered.

Whether you need help reviewing your IC classification practices or would like assistance with creating sound employment contracts, I can be of service to you. Contact my office at (858) 432-3923 to get started.

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I’m Starting a New Business – Should I Use an LLC (Taxed as a Partnership) or an S Corporation?

I’m Starting a New Business – Should I Use an LLC (Taxed as a Partnership) or an S Corporation?

Entrepreneurship has been called the new American dream.  Being self-employed starts with an idea that develops into a business plan, but not without careful financial and legal considerations. Among the decisions that new business owners grapple with is whether to form a limited liability company taxed as a partnership (LLC) or a corporation making an S election (S corp).* There are similarities and differences between LLCs and S corps that business owners should understand before choosing between the two.

Similarities

  • Both entities are created by filing the necessary paperwork with the state. Unlike a sole proprietorship or a general partnership, LLCs and corporations are not recognized under state law until the filing has been made. In addition to state filings required to form the corporation, a special filing on Form 2553 is required for the state-law corporation to elect S status for federal tax purposes.
  • Both entities provide owners with limited liability, meaning the owner’s personal assets are protected from any business creditors’ claims.
  • Assuming an LLC does not make an election to be taxed as a corporation, both LLCs and S corps are pass-through tax entities, allowing business profits and losses to flow through and be reported on the owners’ personal tax returns.

Differences

  • Unlike LLCs, which can have an unlimited number and type of owners, S corps are subject to strict ownership rules. S corps can have no more than 100 shareholders, may not have non-U.S. citizens as shareholders, and cannot be owned by corporations, LLCs, partnerships, or many types of trusts.
  • As opposed to LLCs, which have flexibility in structuring the economic arrangement among its owners, S corps cannot issue classes of stock with different economic rights. However, an S corp can issue voting and non-voting classes of stock.
  • S corps are subject to mandatory requirements as to how the entity is managed. For example, S corps are often required to adopt bylaws, issue stock, hold regular meetings, and maintain meeting minutes within its corporate records. LLCs, on the other hand, are not subject to these types of requirements.
  • Owners of S corps, unlike LLCs, may be able to reduce or eliminate the need to pay self-employment tax. An S corp owner can be treated as an employee and paid a reasonable salary. Employment taxes are withheld from the reasonable salary, while corporate earnings in excess of that salary may be distributed to the owners as unearned income, free of self-employment tax.
  • S corp owners must share profits equally based on their percentage of ownership, while LLC owners have wide latitude to split profits and losses in any manner that is agreed upon.
  • LLCs are generally cheaper to form and operate.
  • S corps generally provide enhanced asset protection, as the structure creates more separation between the owners and the company.

*For the sake of simplicity, this brief overview is based on the assumption that (i) any reference to “LLC” is to an LLC taxed as a partnership, and (ii) any reference to “S corp” is to a corporation taxed as an S corporation. These entities are easily confused, in part because an LLC can make an S election. In that case, you have a state law LLC taxed as an S corporation under federal law. Why would anyone choose to do that? In many cases, it is the business owner’s desire to avoid strict state law corporate compliance coupled with the desire for favorable S corp taxation.

Each business has its own set of circumstance to consider and it is important to obtain competent legal advice when staring your own business.  I am here to discuss how to properly structure, form, and protect your business. Please give me a call at (858) 432-3923 to schedule a consultation.

 

 

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