Independent Contractors vs. Employees: There's a Difference

It is important to be productive and earn money in our society; any successful person knows that and, in addition, should understand their obligation to obey the law. This is the story of a gifted young man in too much of a hurry “to make it” and not interested in following sound advice when it comes to independent contractors vs. employees.

For a trainee in the general contracting trades, having the benefit of a wise and experienced employer is not always a given, but Mike, 25, was fortunate, as he was taken under the wing of Eric, 55, who holds several California licenses.

“Just give me your word that you will show up on time and pay attention,” Eric said he told Mike, “and you will be the beneficiary of my adult working life as a general contractor and electrician. When you leave me, you will be able to go out on your own and establish your own successful business.”

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

They shook hands, and for the next two years, Mike “proved to be my best trainee and then full-time employee ever,” Eric told me. “He was covered by insurance, and proper deductions from his pay were always made.” Mike, for his part, always spoke highly of Eric. And then it was time for him to leave the nest, go out on his own and establish his own company, which he called Mike’s General Contracting and Electrical.

During those years, I came to know Batman and Robin, as I called them, well, and they were the most reliable jack-of-all-trades people, doing myriad small jobs for our office and home.

Independent Contractors vs. Full-Time Employees

Mike’s business flourished, and one day, he dropped by our office to chat. “I am so busy and have enough work to hire most of my family members,” he said, volunteering, “I’ve made them all independent contractors to avoid all the messy paperwork otherwise required.”

“Messy paperwork?” I replied. “Wait a minute, Mike. Do they report to your office every day at a fixed time and then are sent out on jobs?”

“Of course!” he said.

“Do you provide them with tools or whatever is needed to do the jobs they are assigned?

“Yes.”

“Have you got workers’ compensation insurance for them?”

“I have insurance only for myself.”

“What about other required deductions from their paychecks? That’s what is required of an employer,” I replied.

“Look, Mr. Beaver, why can’t I just call them independent contractors? That’s what they want so more money is in their paychecks. They even signed an agreement stating they are independent contractors and are responsible for their own taxes. What’s wrong with that?”

Lawyers want to have good thoughts about their friends and clients, but right then, I was so disappointed. Clearly, Mike knew what he should have been doing — Eric had both explained it to him and demonstrated by example. Also, this father of a 3-year-old had a lot to lose.

Employment Lawyer Says Mike Could Get into Big Trouble

I ran this situation by a friend of this column, Southern California labor lawyer Jay L. Rosenlieb, and asked, “Just how much trouble is Mike facing?”

“Dennis, to be blunt, Mike faces the potential loss of his business and huge penalties from state and federal taxing agencies. Merely saying, ‘You are an independent contractor,’ does not make you one. 

“The IRS has a ‘right-to-control’ test that is used to determine whether an individual is an employee or an independent contractor — and most states follow this test. But there are other tests used by numbers of state and federal agencies to determine if someone truly is an independent contractor.”

California, for example, is even more restrictive, with its use of the ABC test, which determines who is an employee.

“Here, Mike is clearly treating his family members as employees,” Jay went on. “When you are told to report to work daily and sent out on jobs by the employer, furnished with what is needed to do the job, you are an employee. When a company contracts with an independent contractor. They inform the person what the scope of work is, but the company doesn’t have any control over how the contractor achieves the desired result. The contractor may use their own materials and have expenses that aren’t reimbursed.”

Mike is like so many employers who knowingly misclassify employees as independent contractors to avoid:

• The employer's share of Social Security and Medicare taxes.
• Employee benefits, such as overtime pay and holiday and sick pay.
• Unemployment insurance tax.
• Workers' compensation insurance.

How Could Mike Be Caught? What Could It Cost Him?

Jay made it clear that he has seen countless cases where the employees — people just like Mike’s family members — are “happy to be classified as independent contractors because it does, at first, mean more money in their paycheck, as all those ‘nasty deductions’ aren’t taken out. But if they’re found out, the government would expect to be paid what the employee should have paid through proper payroll deductions in the first place.”

And, just as I told Mike during our office chat, Jay noted, “The employer’s world turns upside down when a worker who has been misclassified as an independent contractor files for unemployment benefits and is disqualified because no record of payment (of a state’s unemployment taxes) can be found. Or, a worker is injured on the job and tries to file a workers’ compensation claim. Generally, then, a state like California will pay for medical care, and then come after the employer for reimbursement!”

Jay underscored, “What Mike is risking can easily run into the thousands to hundreds of thousands of dollars, including the very real possibility of being criminally prosecuted.”

A Ruined Livelihood in Exchange for a Few Extra Bucks

I phoned Eric to urge him to try to talk some sense into Mike before things could go south.

“Dennis, I have had this conversation with him several times. I am saddened and so worried, because sooner or later, someone is going to get hurt on the job, and then all that Mike holds dear, including respect from the community, will come crashing down. And all for a few dollars more!”

The moral to this story is that anyone going into business needs to consult an accountant and a business lawyer and follow their advice on how to classify employees and pay the proper taxes and fees. What it will cost is money well spent.

Dennis Beaver practices law in Bakersfield, Calif., and welcomes comments and questions from readers, which may be faxed to (661) 323-7993, or e-mailed to Lagombeaver1@gmail.com. And be sure to visit dennisbeaver.com.