Can I Reduce Costs by Reclassifying Employees as Independent Contractors?

February 5, 2015

From a simply mathematical perspective, your business’s costs could go down if the amount workers receive in direct compensation as independent contractors remained the same as what they took home in a paycheck. But reclassifying employees as independent contractors is a risky move that might invite a payroll tax audit and ultimately cost your business much more in penalties and fines. On the other hand, reclassifying independent contractors as employees is not risk free, either. No cause for despair, however — there actually is a correct choice, but making it requires more than a look at the bottom line.

What is the Difference Between an Employee and an Independent Contractor?

This is a question that has reached near-theological complexity, but the basic issue is control. If you control how the worker performs his or her task, that worker is probably an employee. If not, the worker is probably an independent contractor. Historically, the IRS looked at 20 factors to determine which category a worker fit into. No one factor was dispositive, and the IRS has now shifted its focus in a more holistic direction. The Department of Labor and state agencies may use slightly different criteria. Nonetheless, the twenty factors are not a bad place to start as a way to appreciate the complexity of the issue. The questions include:

  • Must workers comply with instructions about when, where, and how they are to work?
  • Does the employer train the worker?
  • Does the success of the business depend on the services rendered by the worker or are those services ancillary?
  • Must the services be performed personally by the worker?
  • Does the employer hire, supervise and pay additional people assisting the worker?
  • Is it a continuing relationship, or is the expectation of a continuing relationship?
  • Are there set hours of work?
  • Is the worker expected to work full-time?
  • Is the worker expected to work on the employer’s premises?
  • Does the employer set the order or sequence of tasks?
  • Does the worker prepare regular oral or written reports?
  • Is payment based on some period of time – by the hour, week, or month?
  • Does the employer pay business or traveling expenses?
  • Does the employer furnish tools or materials?
  • Does the employer have the right to discharge the worker?
  • Do workers have the right to end their relationship with their principals at any time without incurring liability?
  • Does the worker invest in facilities that are not typically maintained by employees in order to do the work?
  • Does the worker realize profits or losses?
  • Does the worker have other clients?
  • Does the worker make his or her services available to the general public?

A “yes” to the first 16 questions (or a “no” to the last 4) suggests an employer/employee relationship.

As the list indicates, a worker is not necessarily an independent contractor just because he or she works from home. Correct classification can become a fairly nuanced decision that requires weighing many factors. Frankly, working relationships are not static either, so the correct classification may change over time.

Why Does the Classification Make a Difference?

Employees can be much more expensive for employers than independent contractors. If a worker is an employee, the employer must withhold federal income tax and FICA taxes on the employee’s wages, pay the employer’s share of FICA taxes and the FUTA tax, state taxes and workers compensation premiums.  Employees may be entitled to unpaid family leave under federal law, health insurance under the Affordable Care Act and the protection of a variety of antidiscrimination laws. Then there are additional state law protections. Under California law, for example, employees may be entitled to paid sick leave.

None of this applies to independent contractors, so employers have a considerable financial incentive to prefer them. That comes at the price of control and so may not always be appropriate. There are also stiff penalties for misclassifying workers as independent contractors.

The Penalties

The IRS penalties vary with whether the misclassification appears to be willful or not, but include a factor for the wages that should have been paid to the employee, plus back withholding. The Department of Labor can seek criminal prosecution as well as civil fines, and there are additional state fines. Both federal agencies and many states have become more aggressive in policing proper classification.  An employer who is thinking about reclassifying employees as independent contractors should consider this carefully.

Reclassifying Independent Contractors as Employees

Sometimes, of course, the nature of an employment relationship changes and a worker who began as an independent contractor may now be performing tasks in a way more like an employee. An employer in that situation simply has to initiate a formal hiring process, as with any other new employee.

More likely, however, this move is a response to a mistaken classification that the employer decides to rectify in an attempt to avoid enforcement action. An employer who discovers an error may apply to participate in the IRS’s Voluntary Worker Classification Settlement Program (or VCSP) by filing IRS Form 8952 and paying a reduced penalty.  An employer must execute a VCSP closing agreement, re-classify the workers prospectively and pay an amount effectively equal just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. In order to qualify for this program, an employer must:

  • Have consistently treated the workers in the past as nonemployees,
  • Have filed all required Forms 1099 for the workers for the previous three years,
  • Not currently be under employment tax audit by the IRS, or within an affiliated group of businesses under audit, and
  • Not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers, or contesting the re-classification in court.

Although reclassification as an employee usually benefits workers, some may actually be resistant to the change, as for example, when the worker is attempting to avoid wage garnishment. This is not a sufficient reason for the employer to avoid reclassification where it otherwise appears warranted.

Another approach, where the proper classification is genuinely unclear, may be to change the nature of the working relationship prospectively so that the worker is more clearly an independent contractor.  There must genuinely be a change that extends beyond having the worker formally acknowledge that he or she is an independent contractor, although that may be a sensible part of the process.

Reclassifying an Employee as an Independent Contractor

This can also be a legitimate move, but, as above, something in the nature of the working relationship must have genuinely changed. It may be the result of downsizing or the employee may request it in order to pursue other ventures. Reporting both W-2 and 1099 income for the same worker in the same year may attract IRS and Department of Labor scrutiny, however, so the employer should be prepared to defend the reclassification in the event of a payroll tax audit.

Keep in mind that this move involves terminating the employee. That may trigger any number of financial consequences, including the requirement to pay out unused sick days or accrued vacation time. The former employee may become entitled to unemployment compensation.  It is also possible that he or she may simply go and find another job and become unavailable to do contract work for the former employer.

This is Too Complicated. Can’t I Just Hire Temps?

Hiring temporary workers is not a bad idea for employers who are unsure about future staffing needs. In California, however, this may not necessarily relieve an employer from the consequences of a staffing agency’s misclassification of the worker as an independent contractor. Under Assembly Bill 1897, which became law in 2014, a business that employs 25 or more workers and obtains the services of at least five workers through a labor contractor will share civil liability and legal responsibility with the labor contractor for payment of wages, safety and workers’ compensation.  California employers, therefore, should perform some due diligence into the staffing agency’s employment practices.

Correctly classifying your workers can be a fairly complicated process, particularly in the light the changing nature of employment, with workers who telecommute, bring their own equipment to the office and use personal social media for work purposes. It is important to get it right, though.

Misclassifying independent contractors as employees can lead to unnecessary expenses. Misclassifying employees as independent contractors can lead to hefty penalties, fines and even criminal prosecution. Both state and federal agencies have become more diligent in examining classification issues, even in the absence of employee complaints.

Changing a worker’s status, even when the change is completely justifiable, can prompt an audit, and so should not be undertaken without a full appreciation of the potential consequences.  If this is a choice your business is considering, even if that choice is prompted by an effort to rectify a past mistake, it would be worth reviewing your options with your business attorney and or human resources professional.

Employment Law Page


Anne Wallace is a New York lawyer who writes extensively on legal and business issues. She also teaches law and business writing at the college and professional level. Anne graduated from Fordham Law School and Wellesley College.

Get Business Legal Updates

Please provide your full name.
Please provide a valid email address.
We respect your privacy, and we will never share your information. Unsubscribe at any time.

Related Publications

The US National Labor Board (NLRB) recently asked for commentary on the standard for proving independent contractor status under federal law. The question arose due to a request by the Atlanta Opera, an employer, to review an immediate decision that makeup artists, wig artists, and hairstylists are employees of the Atlanta Opera, and not independent…

February 15, 2022

What are the worst legal mistakes we see made by small businesses? We refer to them as the “Dirty Dozen.” Check out this article and make sure you don’t commit these costly blunders:

June 9, 2021

Nasir and Matt discuss Amazon’s creative move avoid having to hire drivers as employees and why it hasalready gotten sued.

November 4, 2015

While Uber may be receiving the lion’s share of the attention on the topic, there has been no shortage of court rulings, IRS audits, and labor decisions on the issue of workforce misclassification. With a noticeable shift towards government agencies determining certain personnel are employees, it has made it increasingly difficult for employers to feel…

October 6, 2015

Nasir and Matt discuss the rise of telecommuting in the workforce and relay some pros and cons for both employees and employers.

September 14, 2015

On September 1, the U.S. Court for the Northern District of California held that a group of California Uber drivers could bring a class action to determine whether they are employees or contractors. The specific issue has to do with payment of tips that were not passed on to them, but the suit may eventually…

September 10, 2015

Nasir and Matt discuss working as a freelancer and what both employees and employers must know to make sure it is done correctly.

February 11, 2015

You can’t argue with success! I can. Uber is a five-year old company now valued more than 72 percent of any Fortune 500 company. I actually love the concept of Uber: it is disruptive, filling a need, an uber startup, and Uber’s latest round of funding raising $1.2 billion at a $41 billion valuation is a confirmation of…

December 9, 2014

Nasir and Matt close out the week by talking about the Starbucks’ promotion that resulted in untendedbuy one get one free offers. The guys then answer, “Can I have one of my employees also be a contractor for special events?” Here is the image of the coupon and the tweet exchange with Starbucks from@daveraleigh.

November 21, 2014

Nasir and Matt kick off the week by discussingApple’s assertion that itcannot crack into user’s devices under the new operating system. They also answer, “Would like to find out if on-call, temporary Registered/Vocational Nurses who are paid “Per Visit” in a home care agency can be classified as “Independent Contractor”? They usually work for other…

September 22, 2014

Nasir and Matt discuss the IRS looking into taxing free lunches provided by Silicon Valley companies. The two then answer, “I’m a franchisor, can I be held responsible for labor law violations of my franchisees if I don’t know about it?”

September 12, 2014

Hiring an independent contractor rather than an employee can be a good choice for small businesses.  Usually it is a short-term arrangement designed to accomplish a single task, with no need for the employer to control exactly how the task gets done.  One of the collateral benefits of this kind of work arrangement is that…

June 10, 2014
Legally Sound Smart Business cover art

Legally Sound Smart Business

A business podcast with a legal twist

Legally Sound Smart Business is a podcast by Pasha Law PC covering different topics in business advice and news with a legal twist with attorneys Nasir Pasha and Matt Staub.
Apple Podcast badge
Google Podcast badge
Spotify Podcast badge

Latest Episodes

November 21, 2023

In this episode, Nasir Pasha and Matt Staub explore the legal implications of Artificial Intelligence in the business world. They delve into the most talked-about issue of 2023: AI and its impact on the legal landscape. Although AI isn’t necessarily a new topic, it has many unanswered questions in the legal world. Nasir and Matt…

July 12, 2023

In this episode, Attorney Nasir Pasha and Attorney Matt Staub delve deep into the complexities of mass layoffs and offer valuable insights, real-life examples, and practical advice to employers grappling with the aftermath of such challenging situations. Nasir and Matt emphasize the critical importance of effective communication when executing mass layoffs. They stress the need…

January 9, 2023

As the COVID-19 pandemic swept across the globe, businesses scrambled to adapt to the new reality it presented. In this blog post, we dive into the case of Goldman Sachs, a financial services giant, to examine their response to the crisis and the lessons other businesses can learn from their return-to-office strategy. From prioritizing employee…

October 28, 2022

Full Podcast Transcript NASIR: Finally, my two favorite worlds have collided – both the law and the chess – right here at Memorial Park in Houston, Texas. Windy day. We have some background noise – ambient noise. What are the two worlds that collided? Well, Hans Neimann has sued Magnus Carlsen for defamation in one…

September 26, 2022

Through a five-round championship bout, Matt travels to Texas from California to determine which state is better for business. Will it be a knockout with a clear winner or will it go to the scorecards?

July 7, 2022

Whether you are buying or selling a business, the transaction goes through the same steps. However, they are viewed from different perspectives. Sellers may not want to fully disclose all the blind spots while Buyers will want otherwise. Nasir and Matt battle it out in this Buyer vs. Seller to determine who has the advantage!…

May 12, 2022

When it comes to Restrictive Covenants, employers are fighting to keep their company safe while employees may use them to their advantage. Keep listening to find out if the Employer or the Employee wins this battle. Round 1: Trade Secrets A company’s trade secrets encompass a whole range of information and are one of the…

February 14, 2022

The Supreme Court rejected the nation’s vaccine mandate. Businesses with 100 or more employees are NOT required to have their employees vaccinated or go through weekly testings. However, this policy remains in effect for health care facilities. In this episode of Legally Sound | Smart Business, the team sat down to discuss their thoughts on this ruling.

December 1, 2021

In this episode of Legally Sound | Smart Business by Pasha Law PC, Nasir and Matt cover the Business of Healthcare. There is more to the healthcare industry than just doctors and nurses. Many Americans have health insurance to cover their yearly needs, but most Americans are not aware of what really goes on behind…

October 12, 2021

In our latest episode, Nasir and Matt are covering the legal issues on Social Media. The average person spends most of their day on social media, whether they are scrolling for hours or publishing their own content. However, just because you publish your own content on Instagram does not equate to you owning that image….

September 28, 2021

What is a Non-Disclosure Agreement, and when do I need one? In this episode, Nasir and Matt shares why you need to use Non-Disclosure Agreements, basic facts about NDA’s, and discuss about the infamous Jenner-Woods story. Having the right Non-Disclosure Agreement in place not only protects you and your business, but it also makes the…

June 16, 2021

Covered in this episode of Legally Sound Smart Business are some typical business mistakes blunders small businesses often make and how to avoid them. Blunder #1: Copying and pasting agreements It may sound like a good idea at the time, but this blunder comes with hidden pitfalls. Having an attorney draft terms that are specific…

February 4, 2021

How you terminate an employee can make the difference between a graceful transition to avoidable negative outcomes like a dramatic exit or even a lawsuit. We gathered a panel of experts and asked them – is there a “right way” to fire an employee? We would like to thank our guests for this episode: Amr…

December 2, 2020

The COVID-19 pandemic has turned nearly every aspect of life on its head, and that certainly holds true for the business world. In this episode, Matt and Nasir explain how the early days of the pandemic felt like the Wild West and how the shifting legal playing field left a lot open to interpretation and…

November 16, 2020

After plenty of ups and downs, our buyer has finally closed on the purchase of their business. While we’re marking this down in the ‘wins’ column, it never hurts to review the game tape. In this final episode, our hosts, Matt Staub and Nasir Pasha, return to the deal almost a year later to reflect…

September 15, 2020

The ink is drying on the signature line and things are looking great for our buyer. After so much hard work, the finish line is in sight and the cheering within ear shot.   Though the landlord is still serving friction, things seem safe to move forward and for now, our buyer will be keeping…

July 31, 2020

Though things are coming along well, the journey would not be interesting if it was purely smooth sailing. After our buyer opens escrow, they are forced to push the closing date back when suddenly a letter from an attorney was received claiming the business, we are buying has a trade mark on the name!  Now…

June 12, 2020

With frustration at an all-time high and professionalism at an all-time low, our friend the Buyer has “had it” with the Seller and quite frankly their lack of knowledge. At present our Buyer is rightfully concerned that the latest misstep from our loose-lipped Seller will threaten not only the entire operation of the businesses but…

May 11, 2020

As we go deeper into the buying process, we start to uncover more challenges from our seller and encounter some of the wrenches they are tossing our way. When we last left off in episode three our team was knee deep in due diligence for our buyer, had already penned and signed the Letter of…

April 4, 2020

One word–interloper! When a new mysterious broker enters the transaction and starts to kick up dust, Nasir and Matt take the reins. The seller signed off on the letter of intent (see episode 2), yet this “business broker” serves only friction and challenges by refusing to send financials, whilst demanding more of a firm commitment…

April 4, 2020

Just as most stories and deals start out, everyone is optimistic, idealistic and full of hope for clear skies. It’s a perfect outlook with a perfect setup for the ups and downs yet to come. Peek further behind the curtain and into the first steps of buying a business: the letter of intent. After the…

April 4, 2020

When a savvy buyer hears opportunity knocking to purchase a prime positioned business, she decides not to go it alone and taps in the professionals to help navigate what could potentially be a fruitful acquisition. “Behind the Buy” is a truly rare and exclusive peak into the actual process, dangers, pitfalls and achievements, that can…

August 7, 2019

GrubHub is subject to two “matters of controversy” that have likely become common knowledge to business owners: “fake” orders and unfriendly microsites.

May 28, 2019

In this podcast episode, Matt and Nasir breakdown the legal issues of the subscription industry’s business on the internet. Resources A good 50-state survey for data breach notifications as of July 2018. California Auto-Renewal Law (July 2018) Privacy Policies Law by State Why Users of Ashley Madison May Not Sue for Data Breach [e210] Ultimate…

March 12, 2019

In recording this episode’s topic on the business buying process, Matt’s metaphor, in comparing the process to getting married probably went too far, but they do resemble one another. Listen to the episode for legal advice on buying a business.

December 3, 2018

Nasir and Matt return to discuss the different options available to companies looking to raise funds through general solicitation and crowdfunding. They discuss the rules associated with the various offerings under SEC regulations and state laws, as well as more informal arrangements. The two also discuss the intriguing story about a couple who raised over…

July 24, 2018

Flight Sim Labs, a software add-on creator for flight simulators, stepped into a PR disaster and possibly some substantial legal issues when it allegedly included a Trojan horse of sorts as malware to combat pirating of its $100 Airbus A320 software. The hidden test.exe file triggered anti-virus software for good reason as it was actually…

April 17, 2018

Attorneys Matt Staub and Nasir Pasha examine Mark Zuckerberg’s congressional hearings about the state of Facebook. The two also discuss Cambridge Analytica and the series of events that led to the congressional hearings, the former and current versions of Facebook’s Terms of Service, and how businesses should be handling data privacy. Full Podcast Transcript NASIR:…

March 10, 2018

The Trump presidency has led to a major increase in ICE immigration enforcement. It’s critical for business owners to both comply with and know their rights when it comes to an ICE audit or raid. Nasir, Matt, and Pasha Law attorney Karen McConville discuss how businesses can prepare for potential ICE action and how to…

February 5, 2018

New years always bring new laws. Effective January 1, 2018, California has made general contractors jointly liable for the unpaid wages, fringe benefits, and other benefit payments of a subcontractor. Nasir and Matt discuss who the new law applies to and how this affects all tiers in the general contractor-subcontractor relationship. Click here to learn…

January 2, 2018

With a seemingly endless amount of new mattress options becoming available, it is unsurprising that the market has become increasingly aggressive. As companies invest in more innovative solutions to get in front of customers, review sites, blogs and YouTube videos have moved to the forefront of how customers are deciding on their mattresses and how…

December 7, 2017

In recent months explosive amounts of high profile allegations of sexual harassment, assault, and varying acts of inappropriate behavior have transcended every sector of our professional world. With a deluge from Hollywood and politics, and the private workforce, accusations have inundated our feeds and mass media. This harassment watershed has not only been felt within…

November 16, 2017

If you are not familiar with the EB-5 program started in 1990 to give green cards to certain qualified investors in the United States, then you may not have been alone a few years ago. Currently, the EB-5 program has since exploded since its inception and now hits its quotas consistently each year. The program…

October 10, 2017

Government requests come in multiple forms. They can come in as requests for client information or even in the form of investigating your company or your employees. Requests for Client Information General Rule to Follow Without understanding the nuances of criminal and constitutional law and having to cite Supreme Court cases, any government requests for…

August 24, 2017

Nasir and Matt suit up to talk about everything pertaining to employee dress codes. They discuss the Federal laws that govern many rules for employers, as well as state specific nuances in California and other states. The two also emphasize the difficulty in identifyingreligious expression in dress and appearance, how gender-related dress codes have evolved…

June 28, 2017

Nasir and Matt discuss the life cycle of a negative online review. They talk about how businesses should properly respond, how to determine if the review is defamatory, the options available to seek removal of the review, how to identify anonymous reviewers, whether businesses can require clients to agree not to write negative reviews, and…

June 7, 2017

On this episode of the Ultimate Legal Breakdown, Nasir and Mattbreak down social media marketing withguests Tyler Sickmeyer and Kyle Weberof Fidelitas Development. They first discuss contests and promotionsand talk about where social media promotions can go wrong,when businesses are actually running an illegal lottery, and the importance of a soundterms and conditions. Next, they…

April 3, 2017

On this episode of the Ultimate Legal Breakdown, Nasir and Matt go in depth with the subscription box business. They discuss where subscription box companies have gone wrong(4:30), the importance of a specifically tailored terms and conditions(6:30), how to structure return policies (11:45), product liability concerns (14:45),the offensive and defensive side of intellectual property (19:00),…

February 1, 2017

Nasir and Matt discuss the suit against Apple that resultedfrom a car crashed caused by the use of FaceTime while driving. They also discuss howforeseeable use of apps can increase liability for companies. Full Podcast Transcript NASIR: Hi and welcome to Legally Sound Smart Business! I’m Nasir Pasha. MATT: And I’m Matt Staub. Two attorneys…

January 5, 2017

The guys kick in the new year by first discussing Cinnabon’s portrayal of Carrie Fisher as Princess Leia soon after her death, as well as other gaffes involving Prince and David Bowie. They alsotalk about right of publicity claims companies could be held liable for based on using someone’s name or likeness for commercial gain.

December 22, 2016

Nasir and Matt discuss the recent incidentat a Victoria’s Secret store where the store manager kicked out all black women after one black woman was caught shoplifting. They then each present dueling steps businesses should take when employees are accused of harassment.

December 8, 2016

Nasir and Matt return to talk about the different types of clients that may have outstanding invoices and how businesses can convert unpaid bills to getting paid.

November 10, 2016

After a long break, Nasir and Matt are back to discuss a Milwaukee frozen custard stand that is now revising it’s English only policy for employees. The guys also discuss how similar policies could be grounds for discrimination and what employers can do to revise their policies.

October 6, 2016

The guys discuss the new California law that allows actors to request the removal of their date of birth and birthdays on their IMDB page and why they think the law won’t last. They also discuss how age discrimination claims arise for business owner.

September 29, 2016

Nasir and Matt discuss the racial discrimination claims surroundingAirbnb and how it’s handled the situation. They also discuss some practical tips for businesses experiencing similar issues.

September 8, 2016

Nasir and Matt discuss whyAmazon seller accounts are getting suspended and banned without notice and how business owners can rectify this situation through a Corrective Action Plan.

August 25, 2016

Nasir and Matt talk about the accusations surroundingfashion giant Zararipping off the designs of independent artists like Tuesday Bassen and howsmaller companies can battle the industry giants.

August 18, 2016

Nasir and Matt discuss Brave Software’s ad replacing technology that has caught the eye of almost every national newspaper and has a potential copyright infringement claim looming. They also welcome digital marketing expert Matt Michaelree to speak on the specifics of what Brave is attempting to do and whether it has the answers moving forward.

July 28, 2016

Nasir and Matt discuss the sexual harassment lawsuit filed by Gretchen Carlson against Fox CEO Roger Ailes. They also talk aboutthe importance of sexual harassment training and properly handling such allegations in the office.

July 15, 2016

Nasir and Matt talk about the changes at Starbucks that have led to many disgruntled employees and customers.

We represent businesses.
That’s all we do.

Oh, and we love it.

We love our work. We love reviewing that lease for your new location. We thrive on closing that acquisition that nearly fell through. We’re fulfilled when we structure a business to grow, raise capital, and be legally protected.

We focus on developing close relationships with our clients by being like business partners. A partner who provides essential, personalized, proactive legal support.

We do all of this without utilizing the traditional billable hour model. You pay for the value we bring, not the time spent on calls, emails, and meetings.

Our team is made up of attorneys and staff that share these values and we are retained by clients who want the same.

Pasha Law PC operates in the states of California, Illinois, New York, and Texas.

Meet Our Team

Fractional General Counsel Services

Pasha Law Select offers the expertise of a high-end general counsel legal team for every aspect of your business at a fixed monthly rate. Pasha Law Select is deliberately designed to allow our legal team to be proactive, to anticipate, and to be comprehensive in serving our clients. To be great lawyers, we need to know our clients. We can’t know our clients unless we represent a select number of clients in the long-term. This is Pasha Law Select.

Learn More