I love a good play on words. But my least favorite play on words is the “oxymoron.” In business, where it is best to avoid being clearly misunderstood, oxymora should be avoided. Perhaps the one oxymoron that should be avoided at all cost is the term “1099 employee.”

Employers use the term to designate independent contractors, freelancers or others whom they engage to provide services similar to those performed by their employees but whom they pay on a 1099 basis. However, the term 1099 employee is an oxymoron just like “jumbo shrimp” or “cruel kindness.” An individual is either an independent contractor legitimately paid on a 1099 basis or a common law employee paid on a W-2 basis — just as something cruel can’t ever really be kind an employee can never be paid on a 1099 basis.

Until now apparently the risk of a government agency auditing with any deliberate speed must have seemed to be low, because the approach is widespread. All that is soon to change, however, once the federal government begins to audit employers to determine whether they have to pay penalties under the “pay-or-play” requirements of the Affordable Care Act.

Also see: "2015's top 50 large-group brokers in the U.S., part 1."

As I hope everyone knows by now, the pay-or-play penalties apply if one of an employer’s full-time employees obtains subsidized coverage on an exchange. Potential penalties are:

  • $2,000 (indexed) multiplied by the number of all full-time employees reduced by the first 30 (80 in 2015) if an employer does not offer insurance to at least 95% (70% in 2015) of its full-time employees and their children (the “A Penalty”) or
  • $3,000 (indexed) multiplied by each full-time employee who obtains subsidized coverage on the exchange if the insurance offered is not affordable (the “B Penalty”)

Clearly one key element on audit will be whether an individual is an employee of an employer. The final regulations implementing the pay-or-play rules confirm that the federal agencies will use a common law employee approach to determine whether an individual is an employer’s employee.

In general, according to the Internal Revenue Service, employee status is based on the degree of control on, and independence of, an individual in the context of the relationship. How an employer designates the individual (e.g., as an independent contractor) is not a key factor. In fact, an employer’s argument that their classification of a 1099 employee should be respected because it’s how the employee is classified will go over like a lead balloon.

Significant risk

The risk of misclassification under the ACA could be significant. Take, for example, an employer with 1,000 full-time employees who also employs 55 independent contractors or so-called 1099 employees who provide services similar to those performed by their employees. Over a three-year period the employer offers affordable insurance coverage to 100% of its full-time employees (and their children).

The employer’s belief that it is insulated from either of the pay-or-play penalties is seriously funny and a bit misplaced. Why? Because, on audit, it is likely that the federal government will find the fifty-five 1099 employees to be common law employees. Upon that determination, the employer will be found to have offered coverage to only 94.5% of its full time employees, thus potentially tripping the A Penalty.

If any one of the 55 independent contractors obtained subsidized coverage on an exchange in each of the three years on audit, the employer would pay a penalty equal to at least $6,150,000 ((1,055 -30) X $2,000 X 3) even though they thought they were offering coverage to 100% of their full time employee workforce. An employer’s protestation that they didn’t realize these 1099 employees would be treated as common law employees will be met with deafening silence from the federal government.

Also see: "2015's top 50 large-group brokers in the U.S., part 2."

And note that even if the 1099 employees make up less than 5% of the employer’s workforce, those 1099 employees who are not offered coverage and who obtain subsidized coverage on the exchange can still trip the B Penalty.

That employers misclassified employees as independent contractors or 1099 employees is old news to the federal regulators — widespread use of 1099 employees is basically an open secret. They know that it happens and they know to look for it. It could get pretty ugly pretty fast for employers who use even a small number of 1099 employees. Engaging competent counsel now to assess who is an employee and who is not and taking appropriate steps now to avoid a penalty later is awful good advice.  

Marathas is managing partner of Marathas Barrow & Weatherhead LLP, a Boston-based employee benefits, executive compensation and employment law firm that services clients across the country. Marathas is one of the most sought-after advisers on the requirements of the Affordable Care Act. He is co-author of the leading employer resource book on the subject, The New Health Care Reform Law: What Employers Need to Know (6th Edition). Reach him at pmarathas@marbarlaw.com.

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