07/21/2014 04:45 pm ET Updated Sep 20, 2014

Reclassifying Employees: Risky Business

As companies explore cost-saving measures, some may be tempted as reclassify employees from full time, W-2 employees to consultants or independent contractors. Doing so can save a company significantly on taxes and benefits. Additionally, some companies have used the conversion as a vehicle to reduce the company's total workforce in an attempt to exempt it out of various other legal requirements, such as certain federal leave acts and the Affordable Care Act.

Conversion requests may also come from employees themselves, whether they seek tax advantages, a flex time schedule, the ability to work from home or for reduced hours.

However, unless there has been some change in the work, the supervision and in the employee's reporting obligations to superiors or others in the company, a company can unwittingly expose itself to significant risk in making this decision. Each state has adopted its own set of factors in determining who can be classified as an employee and the factors involved in determining whether the position is one that can technically be classified as being held by an independent contractor and the ultimate determination of whether someone is an employee or an independent contractor falls to the states. While factors vary from state to state, some overarching themes include:

  • The line of work (more specifically, whether the independent contractor's business is the same as the company's, or whether it is a special service that is being farmed out; accounting, legal and public relations are common examples)
  • Special skills required for the work and authority and control exerted by the principal (in other words, whether the person is self-directed, or reports to someone)
  • Whether the contractor has other clients for whom she performs this type of work
  • The duration and permanence of the relationship (in general, independent contractors are retained for a special project or for a set term, whereas employees continuously service the company's needs)
  • Structure of the pay
  • The source of instrumentalities for the performance of the work (such as whether supplies, materials, hardware provided by company or by the contractor)
  • Facts specific to the independent contractor (whether the outside consultant is a separate legal entity with its own offices, equipment, EIN, business license, and bank accounts, or whether she is an individual doing the same things in the same manner as when she was employed, but receiving a 1099 at year-end instead of a W-2).

In short, the change in classification cannot be an end-run around taxes or other legal obligations, and the company must be able to justify the reclassification to independent contractor by some change to the job function, responsibilities, oversight and site.

The mistake can be a costly one. Knowingly or not, both the company and the employee risk penalties imposed by a state for misclassification of work -- and many cash-strapped states actively pursue offenders. Penalties range from mild in some states, to severe in others. For example, the penalty in the State of California is currently $25,000, plus any tax differential. The IRS also imposes penalties for such violations above and beyond those levied by the states. And, depending on the scope or severity of the violations, there may also be consequences imposed on the company by the state Employment Development Department or the U.S. Department of Labor.

In an abundance if caution and to ensure compliance with state and federal law, both companies and consultants should consult with their attorneys to protect against these and other costly risks, particularly as both states and the IRS have begun to actively pursue those believed to be skirting the law.

The foregoing is provided for informational purposes only, is not an advertisement, does not constitute legal advice or legal opinion, and does not create an attorney-client relationship. The content may not apply to the specific facts or a particular matter. You should not act or rely on any information contained in this article without first seeking the advice of an attorney licensed to practice in your jurisdiction.