It is common in many industries to use the services of individuals as independent contractors, or “1099 employees,” rather than putting them on payroll as W-2 employees. This is not exactly paying people “under the table,” as their income is reported on 1099 forms at the end of the year, but it is still a risky practice under Massachusetts law, and one which can cost an employer far more than the savings realized by using independent contractors.
The Law About Independent Contractors
The Massachusetts Wage Act defines an “employee” as any individual performing any services, unless the employer can prove all three of the following:
It is important to understand that all three of these tests must be met, and if any one is lacking, the individual will be considered an employee under the law, not an independent contractor.
It is the second prong that has proven most troublesome for employers. Even if a person functions independently, and “freelances” for other companies in addition to providing services for the business, if what that person does is part of the ordinary operations of the business, the employer could be breaking the law by classifying that person as an independent contractor.
For example, if I hire someone to paint my office, or plow the parking lot, those activities are not part of the usual course of my business as a law firm. If, however, I hire someone for 10 hours a week to do legal research, even on a temporary basis, that person is performing a core function of my business, and likely should be paid as a W-2 employee, no matter how few hours he or she works, or how temporary the assignment.
Ancillary support services (IT consultants, payroll or accounting services) are generally permissible to engage on a contracted services basis, assuming the other tests are met (actual independence and provision of similar services to others), and assuming those are not your core business activities. Gray areas abound. If you operate a restaurant, it is likely that you can hire a webmaster as an independent contractor, but if you operate an online store, an argument could be made that the website is part of your usual course of business, and therefore should be managed and staffed by employees under the law.
But My Accountant Said it was Okay!
We hear this all the time. Your CPA or accountant may have told you that, under the circumstances, it was permissible to classify certain workers as independent contractors. Your accountant is not necessarily wrong- he or she is just applying a different set of rules for a different purpose.
Specifically, your accountant’s job is to make sure you are following applicable tax rules. If you are paying someone as a 1099, you are not paying the employer’s share of employment taxes, and essentially shifting that burden to your worker, who will be responsible for self-employment taxes on that income. Should the IRS decide that the individual really was an employee, it may re-assess responsibility for those taxes to the employer.
To that end, the IRS has a series of factors it considers, referred to as the “20 Factor Test.”
Unlike the Massachusetts Independent Contractor Law, there is no one deciding factor, and the IRS can place different weight on different factors according to the circumstances.
Also unlike the Massachusetts Independent Contractor Law, the 20 Factor Test recognizes things like flexibility of schedule, part time or full time status, location of employee’s work, provision of tools and materials, and contractual terms between the parties as relevant factor. None of these matter under the Massachusetts Independent Contractor Law, if the employer cannot demonstrate all three elements cited above.
Why Is It Important to Get This Right?
It is truly surprising how many businesses in Massachusetts get this wrong, so you should not assume a practice of using independent contractors instead of employees is lawful, even if it is common in your industry. Further, it is important to understand the potential consequences under Massachusetts law of incorrectly classifying workers, even if your classification passes muster under the federal tax rules.
First, a violation of the Independent Contractor Law is a violation of the Wage Act, which means that if an employee wins a lawsuit and proves damages, those damages are automatically tripled and the employer is required to pay not only its own legal costs, but the employee’s as well.
Second, the measure of damages may be greater than you think. These can include the value of benefits that W-2 employees receive, the amount of self-employment tax liability the employee has incurred by being classified as a contractor, the lost opportunity to collect unemployment benefits if terminated, and any overtime pay that person would have been entitled to as a W-2 employee.
By way of example, imagine an independent contractor earning $50,000 per year in a company where W-2 employees receive two weeks of vacation per year, paid federal holidays, and an employer contribution to health insurance of $500 per month. In this scenario, the contractor is terminated and unable to find another job for three months. The damages that individual might claim are:
Even assuming this person never worked overtime (which could add substantially to the damages), there could already be a claim for almost $15,000 in single damages, which if proven would then be tripled by the court.
Then Why Do So Many Businesses Get This Wrong?
One reason is the confusion described above between the federal tax rules and the Massachusetts wage and hour rules. Many businesses rely on their accountants in the first instance to “vet” these decisions. This is entirely appropriate as it relates to taxes, but the employment law analysis is a different animal.
Another reason is that violation of the Independent Contractor law is so common that people assume it is acceptable because so many others are doing it.
Finally, in our experience many business owners are simply not doing the math correctly, and assume that putting employees into W-2 status is more expensive and burdensome than it really is. Yes, you do have to assume the employer’s share of payroll taxes (7%), pay into unemployment, and take out workers compensation insurance. At the present time, you are not obligated to provide health benefits unless you have 50 or more employees, which exempts all or most of the businesses we encounter.
Whatever the costs, it is important to compare them to the costs of answering a misclassified employee’s civil lawsuit, including the costs of your own legal representation.
Have more questions? Contact our team at slnlaw LLC for more information on independent contractor classifications in Massachusetts and what it means for your business.