Due to the COVID-19 pandemic and the resulting shelter-in-place and related orders, many businesses across America have already shuttered, while others are on the brink of collapse.  In these challenging times, businesses are understandably considering any and all potential solutions to keep their employees on payroll while remaining solvent.  Some employers have even been considering converting their W-2 employees to 1099 independent contractors.  The surface appeal is simple, which is that employers can avoid employment taxes, benefit costs, and overtime compensation, thereby reducing overhead and layoffs while keeping workers at work.  However, reclassifying employees as independent contractors presents significant misclassification risks, particularly in the current climate.

A steadily increasing number of states, including California and New Jersey, use the “ABC Test” for determining whether a worker is an independent contractor or an employee under state wage and hour, labor, and/or unemployment insurance laws.  The ABC Test presumes that a worker is an employee unless the hiring entity can establish each of the following three factors: (1) the worker performs his/her work free from the hirer’s control and direction; (2) the worker performs work outside the “usual course” of the hirer’s business; and (3) the worker customarily engages in an independent established trade, occupation, or business of the same nature as the work performed.  Satisfying each of these factors is no easy feat, and will be practically impossible where a newly reclassified contractor performs exactly the same work for the business as when he or she was an employee, with no other meaningful changes to the terms and conditions of the relationship.

Why worry about independent contractor misclassification?  There are myriad reasons.  States are cracking down on independent contractor misclassification by enacting laws to penalize companies that misclassify their workers.  For example, under New Jersey law, employers are subject to a “misclassification penalty” of up to $250 per misclassified employee for a first violation, and up to $1,000 per misclassified employee for each subsequent violation, as well as a fine of up to five percent of the misclassified worker’s gross earnings over the past year.  In California, willful misclassification of individuals as independent contractors will result in penalties of between $5,000 and $25,000 per violation.  In addition to penalties, in New Jersey, the Department of Labor and Workforce Development (“DLWD”) can issue a stop-work order for misclassification violations that will remain in effect until the agency determines the employer is in compliance.  Employers are subject to $5,000 per day in civil penalties for violating such a stop work order.  The DLWD can also post on its website a list of any persons found to violate any state wage, benefit, or tax law, which will temporarily bar such persons from contracting with any public body until liability for the violation(s) has been resolved, as well as incur reputational harm.

An employer who fails to withhold income taxes for a worker erroneously classified as an independent contractor will also face steep penalties from the Internal Revenue Service, including 1.5% of the employee’s wages, 40% of the FICA taxes (Social Security and Medicare) that were not withheld from the employee, and 100% of the matching FICA taxes the employer should have paid.  Unsurprisingly, the penalties are higher in cases of intentional disregard.

In addition, and perhaps more importantly, workers misclassified as independent contractors can file wage and hour lawsuits seeking unpaid wages, unpaid overtime, and unpaid meal and rest breaks, as well as penalties, interest, and attorneys’ fees.

What should struggling businesses do instead of reclassifying their workers?  As discussed in another EBG blog post here, the federal government recently enacted the Coronavirus Aid, Relief, and Economic Security Act (“CARES”), a $2+ trillion aid and stimulus package, which includes financial assistance and other relief for employers affected by the COVID-19 crisis.  Among other things, eligible employers can access a 50-percent refundable tax credit on the first $10,000 of qualified wages paid to an employee during the crisis and collateral-free forgivable loans to cover payroll costs, mortgage and rent payments, utility payments, and other business purposes.  We discuss other areas that employers should review to potentially improve their financial situation and retain employees here.