Brandon Business Owner faces a challenging situation. His part-time employee, Emily Employee, has approached him asking for a raise. Brandon doesn’t have extra funds to increase Emily’s salary. So they come up with what seems like a win-win solution: change Emily’s status from part-time employee to independent contractor. That way, the money Brandon saves on taxes and benefits can go directly to Emily, effectively giving her a ‘raise’. Emily is ecstatic about the idea. But could this quick fix be a costly mistake?

Let’s examine the overlooked details that could put both of them in hot water.

The Fine Line: Employee vs. Independent Contractor

The Internal Revenue Service (IRS) has strict guidelines that differentiate an employee from an independent contractor. Violating these guidelines can trigger an audit, hefty fines, and back taxes.

Given that Emily’s responsibilities and schedule are unlikely to change, making her a contractor while her job scope remains the same, could invite IRS scrutiny.

The Risks of Switching from W-2 to 1099

In their excitement to come to what they thought was a mutually beneficial agreement, Brandon and Emily overlooked the risks involved by making such a drastic change in her employee status.

Let’s take a look at what some of the risks are, for both employer and employee, in switching a W-2 worker to a 1099 contractor.

Risks for the Employer

Brandon may think he’s found a loophole, but the truth is that he’s venturing into dangerous legal territory.

It’s A Tax Year Red Flag

Issuing both a W-2 and a 1099 to the same individual in the same tax year is often seen as a red flag by the IRS. This dual-status increases the likelihood of an audit, putting Brandon at risk for penalties and back payments.

The Legal Consequences are Costly

Misclassifying an employee as an independent contractor can have severe legal and financial consequences, including: owing back taxes, retroactively providing employee benefits, and even potential lawsuits.

Risks for the Employee

Emily, didn’t consider that the initial financial gain from her new “raise” may soon be overshadowed by long-term disadvantages.

“The Benefits Backfire”

Brandon offered health insurance, retirement plans, and paid sick leave as her employer. Emily, as a young and generally healthy person, shrugged it off at the time. When she does have to cover these out-of-pocket expenses as an independent contractor, her ‘raise’ might not seem so lucrative.

New FICA Tax Responsibility

In her new role, Emily would be responsible for covering both the employee and employer portions of FICA taxes (Social Security and Medicare). These added expenses could eat into the ‘raise’ she’s so excited about.

No More Employee Protections

By switching to contractor status, Emily loses many of the protections afforded to employees, such as minimum wage guarantees and wrongful termination safeguards, which she may come to regret in the future.

The Benefits Don’t Outweigh The Risks

While converting a W-2 employee to an independent contractor might look like a clever financial workaround, the associated benefits don’t outweigh the risks.

As we saw with Brandon and Emily, the arrangement can end up being problematic for both the employer and employee, exposing them to legal issues and unfavorable financial outcomes. Consulting legal and tax advisors is crucial before making such a pivotal change in employment status.

If you find yourself facing such a dilemma, contact us  for a professional evaluation. Navigating employment classification is complicated and fraught with pitfalls that could cost you, and your employees, dearly down the line.

ClearPath is a leading Human Resources Outsourcing company focusing on assisting employers to leverage the independent contractor labor market. We’re committed to helping business owners stay compliant and minimize the risks associated with their contingent labor requirements.

No Legal Advice Intended. This article includes general information about legal issues and developments in the law. Such materials are for informational purposes only and may not reflect the most current legal developments. These informational materials are not intended, and must not be taken, as legal advice on any particular set of facts or circumstances. You need to contact a lawyer licensed in your jurisdiction for advice on specific legal issues.