Should your workforce be populated with consultants or employees? As a federal government contractor, it is critical to understand the distinction between the two and the impact of each choice when pursuing new business and when performing on contracts.

Many government contractors, particularly small business concerns, seek to use the services of consultants or independent contractors, as a means of avoiding the high cost of maintaining regular employees.

There is, however, a significant difference between a “1099 employee” and a “W-2 employee”, and many contractors mistakenly misuse the two terms. The discussion below helps to outline the difference and provide the reasons for utilizing the two personnel classifications.

A. CONSULTANTS OR INDEPENDENT CONTRACTORS

A consultant, or independent contractor, is a subject matter expert, who is not an official employee of a company. Independent contractors are typically assigned to a specific project, and are free to perform work on the project using methods and techniques of their choosing. They receive assignments from a company representative and submit invoices for their labor. They perform the work based on their education and experience, and should not take direction from a company official except to determine the final work product desired. When pricing proposals, a consultant is classified as, or equivalent to, a subcontractor, and is priced as an Other Direct Cost (ODC) – not a direct labor cost to a contract – in the proposal and within invoices during project execution.

Generally, by Feb. 28 each calendar year, a company must send to the consultant an IRS Form 1099-MISC, Miscellaneous Income, because consultants must pay their own income taxes and FICA/FUTA/SUTA, as applicable. Consultants are not entitled to benefit from the contractor’s employee fringe benefits or overhead materials, unless working at the company facility temporarily using a desk and routine office equipment and supplies.

In the price proposal, the fringe benefits indirect cost rate is applied to a base of direct labor employees only – not to consultants. It would be considered a false claim if fringe benefits purportedly paid to consultant “employees” were included in invoices to the government, when actual coverage is not applicable and benefits to the consultant are not provided.

A useful tool to help determine whether an individual should be classified as a consultant or an employee is to use the IRS “20 Factor Test on Employment Status”. This test helps to clarify whether sufficient control is present to establish an employer-employee relationship.

Small business concerns must be careful, when responding to a domestic preference set-aside Request for Proposal (RFP), if the Limitation on Subcontracting clause is included, which usually requires the contractor to perform more than 50% of the cost of labor with its own employees. If the contractor is considered small under a particular North American Industry Classification System (NAICS) Code, based upon the number of employees, then only employees of the concern may be counted.

B. EMPLOYEES

An individual is an employee of a company, whether full-time or part-time, when they are entered on the contractor’s official employment and payroll system, and the individual works in the service of an employer under an express or implied contract of hire, under which the employer has the right to control the details of work performance.

The employer has several responsibilities that apply to employees, which are not applicable to consultants. Examples include OSHA safety requirements, correct Fair Labor Standards Act (FLSA) classification, ERISA requirements that specific employees are entitled to health and welfare benefits, the Medical Leave Act, the Civil Rights Act, and many more. Individuals classified as employees may be direct charged to a contract.

Company employees are provided with an IRS Form W-2, Wage and Tax Statement by Jan. 31 of each year, which reflects their employee status. Only employees are included the calculation, when accounting for the 50% of the contractor’s cost of labor, which must perform work under the Limitation of Subcontracting clause, or are counted toward a correct self-certification of business size.

The employer/prime contractor is also responsible for withholding FICA/FUTA/SUTA taxes for the employee as well as income taxes. Such withholding is not applicable to consultants, who must pay their own taxes.

Proper classification of personnel and correct classification of employees under the FLSA is absolutely critical. A misclassification can result in fines and penalties, and possibly suspension and debarment, as a result of false claims or false statements violations. Don’t risk incurring adverse circumstances. Properly classify personnel in your accounting system and on the contract. If you are uncertain about what is the best for your circumstances, let us know and we can help. Particularly with sequestration looming, you need to be prepared.

Tom Petruska is president of Contracts Unlimited Inc. consulting firm specializing in assisting small and medium-sized businesses secure government contracts. Services include proposal preparation, contract formation and administration and preparation and management of GSA schedules.