Accommodating Your Employee’s Request to Switch to Independent Contractor Status

You run a small or  medium-sized business, you’re busy, and maybe you haven’t given much thought yet to how the recent changes to the tax laws might affect you or your businesses, when one of your best employees approaches you about switching from employee status to independent contractor status so that she can take advantage of the new tax laws. (My last blog post discussed why employees might want to make that switch.) Your first instinct might be to say sure, why not? For one thing, this is a loyal employee and you like the idea of accommodating her and helping her save money. Additionally, you have always known that there are financial advantages to businesses in hiring independent contractors over employees, most notably that you do not have to pay any FICA taxes on behalf of an independent contractor. And this employee in particular has a good salary and participates in your company’s matching 401(k) plan to the fullest extent. She also has her entire family on the company’s generous (and expensive) group healthcare plan. You also suspect she is planning to have another child and take advantage of the company’s paid maternity leave again. If she becomes an independent contractor, she would not be entitled to any of these employee benefits. Seems like a no-brainer to allow her to switch, right?

Not so fast. While it is true that you would no doubt welcome the opportunity to not have to withhold and pay FICA taxes for her, pay for her and her family’s health insurance, and pay for her to go on another paid maternity leave, if the IRS determines that, for tax purposes, she is really an employee, your company could end up getting hit with a hefty bill in back taxes, and even fines. That’s because under IRS regulations, just because you decide to make someone an independent contractor, doesn’t mean the IRS can’t later deem them an employee for payroll withholding purposes. If this is an employee who primarily works on-site for set hours utilizing company equipment and is under your (or another manager’s) supervision, then this is probably not someone who will be able to qualify as an independent contractor. However, if this person sets her own hours, spends much of her time working off-site, uses her own equipment for which she does not receive reimbursement, and generally works independent of any supervision, then independent contractor status might be something to consider.

But even if the risk of an IRS challenge to her independent contractor status is low, there could be other unintended consequences that result from reclassifying an employee as an independent contractor. Does this employee create anything for you? Does she work on the company’s website, write articles to include in the company newsletter, write software programs for the company or its clients, or work on inventions? As an employee, anything she creates within the scope of her employment is (generally speaking under most states’ laws) automatically deemed to be owned by her employer. Not so for independent contractors. Additionally, if she is subject to a non-compete, that non-compete will either terminate along with her employment status (e.g. if she was under an employment contract that included a non-compete provision) or at the very least will be a lot harder to enforce.

Accordingly, employers need to be careful. Any employer approached by an employee about switching should seek the advice of legal counsel to assess the risks and consequences of doing so.

Erica Intzekostas