Certain ‘strategies’ to avoid worker’s compensation premiums have substantial tax and corporate control risks
Worker’s compensation premiums are a fact of life for all businesses that have employees. Although premiums must be paid for employees, they are not owed for owners of the business, nor are they owed for subcontractors. With the cost of liability insurance and workers compensation premiums going up for some builders, they naturally look for ways to trim their costs. I have heard of some builders who attempt to reduce their liability for worker’s compensation premiums by treating their employees as “subcontractors” or by making their employees “owners” of the business. Both of these strategies have significant financial and corporate control risks.
Simply calling an employee a subcontractor does not make him so. Take for example the contractor with eight to 10 unlicensed “subcontractors” who never work for anyone else and are given a 1099 instead of a W-2. They are essentially employees. In the event of a Washington State Department of Labor & Industries audit this simple characterization of them as subcontractors will not carry the day. Instead, L&I will take a comprehensive look at the entire relationship with the subcontractor in order to determine whether the person is actually an employee. L&I will analyze a number of factors including whether the subcontractor has its own employees, maintains separate accounting records, brings heavy equipment to the job site, has a separate physical business location, is supervised by you, has a previously existing business, files business tax returns and has all appropriate license and registrations.
If L&I determines that your subcontractors are employees, you will have the liability associated with a recalculation in your worker’s comp premiums. While this is bad, this may ultimately be the least of your concerns. There is the possibility that you may also be the subject of a tax audit, which will trigger liability for unpaid state and federal employment taxes, along with penalties and interest. In addition, you have the risk that the former subcontractors, who are now classified as employees, may bring claims against you for overtime (you may not have carefully watched hours worked given that overtime does not apply to subcontractors) or some form of discrimination or sexual harassment claim that they may not have previously had the right to bring.
Making your employees owners presents similar risks. Allocating a minor amount of stock to employees in order to make them owners can be challenged by L&I, with the same downside financial risks set out above. And, even if their status as owners is not challenged, you now have created minority interests in your company. Minority shareholders have significant rights, including the right to demand meetings, bring suit against the majority shareholder for oppression and demand financial and business records. Without an agreement governing the basis upon which the minority shareholder must sell his stock back to the company, there will not be a basis to force the minority shareholder to sell upon his termination from employment.
Recklessly creating “subcontractors” and “owners” in order to save workers compensation premiums may lead to significant liability for back insurance premiums, state and federal employment taxes, exposure to employment discrimination claims and the potential loss of corporate control.
This is not to say that if your employee wants to start his own company and become your subcontractor that you should not accommodate him. You can, but steps need to be taken to make sure he is in fact a subcontractor. Similarly, if you want to allocate ownership interests to some of your key employees you should feel free to do so, but consult with legal counsel to make sure their interest is properly documented and limited to that which you can live with in such a permanent relationship.
Todd Mitchell is a corporate attorney in the Vancouver office of Bullivant Houser Bailey, P.C. He represents businesses and individuals in negotiating and developing commercial ventures and real estate projects. He can be reached via e-mail at email@example.com or by calling 360-693-2424.