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Legal Subcontracting vs Illegal Subcontracting

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A recent article on subcontracting reminded me of the need to clarify to folks once again in the EP Industry that there is a proper method of legal subcontracting, and there is a commonly used method that is improper and illegal, that undoubtedly increases the liability risk to the prime contractor as well as the protectee or principal! 

We are generally hired to keep an individual and their company/brand out of harm’s way, so why would it even be a consideration to expose them to increased liability?

Legal vs Illegal

Illegal? That’s a strong word! Breaking the law! Ouch! Yes, it hurts, but here is the truth; there is a legal and proper manner in which a business or individual must operate, and then there is the opposite. You either have proper, or you have improper! That sounds better and softer, right? It is either right or wrong. Sorry, but we cannot mince words here as there are potentially serious consequences!

As someone who has worked in the Security industry for more than 40 years and has operated a licensed Security/PI agency in multiple states providing Security Services for more than 30 years, I felt compelled to talk about this topic again to clarify some of the issues regarding independent contractors (IC) and employee (1099 vs W2) status as it pertains to our industry. 

I do know that many companies hire and pay people as independent contractors, some correctly and legally, and some incorrectly or illegally (which is known as “misclassification of an employee”) and subject to possible severe penalties and fines. 

There are some who are paid as independent contractors but are really an employee, and some folks insist on being paid as independent contractors, even though they technically are an employee. What I will do here is clarify the legal subcontracting requirements for a company that pays, and for the individual/company that is paid. And I will cover state licensing requirements for Security providers.

Company That Pays

Starting with the company that pays others, the first consideration is that they are a legally established security business and that means they are properly set up to function as a state-licensed business, they have properly registered their business name (if using a name other than their own, called a DBA-“doing business as” or an “assumed name”), they are licensed as required by the state, they keep books of financial transactions and file taxes as required, and are insured. To be clear, we are talking about being properly licensed to operate in each state you are doing business in.

If someone has an LLC (Limited Liability Company), it does not necessarily mean they are operating appropriately, and I would encourage all who do business with another business to ensure they are properly licensed and they function legally. As most states require a license to conduct security services, the company should be licensed by the state they operate in, and they should conduct their business as is required which may require their employees to be trained and register according to the state requirements.

New York State for example requires a Security firm to have either a “Watch Guard and Patrol” or “Private Investigators” license issued by the NYS Department of State Division of Licensing Services, and all employees must submit to a background investigation, be fingerprinted, attend state-required training approved by the Department of Criminal Justice Services (DCJS), and be registered with the state as an approved guard. To be armed requires additional training. This is similar in Virginia, California, and many other states.

Legal subcontracting companies are required to provide their employees a workplace free from hostilities, discrimination, abide by state and federal EEOC and labor laws, and must pay a portion of their employees federal and state income tax, social security, Medicare, and disability and unemployment insurance, as well as collect from the employee their contributions and income tax. And they will report to the IRS their income and deductions on a W2 form at the end of each fiscal year.

IRS Employment Responsibilities

The IRS first considers someone who works for a company to be an employee unless they meet the requirements to be an Independent Contractor. The IRS originally had a 20 question “right to control” test, but have now reduced it to 3 general considerations:

  1. The worker is not under the control of the employer for the performance of work.
  2. The work must NOT be within the usual course of the employer’s business.
  3. The worker must be “customarily engaged” in an independent trade or business that is the same as the work performed for this employer.

All three of these factors must be met for the worker to be considered as an independent contractor. Of course, in addition to these three, they must be licensed to operate according to the state they are working in, just as is the primary company that is paying.

In order to better understand the details of what is being evaluated, here are some of the points used in the original 20 question test: actual instruction or direction given to the worker by the employer, if specific training by the employer is required, if the hours of work is specified, if reports must be submitted, if expenses are reimbursed, and if there is an exclusivity of the work performed, to name a few of the questions considered.

There are common law considerations used to determine the degree of control an employer has over a worker which are often used in civil cases, such as behavioral; does the company control or have the right to control what the worker does and how the worker does his or her job? Financial; are the business aspects of the worker’s job controlled by the payer? And the type of relationship; are there written contracts and is the work performed a key aspect of the business?

If for example, I am a computer specialist and your computer isn’t working and you want me to fix it, I schedule an appointment, I come in and fix your computer without supervision, I am an independent contractor and you pay me and all is good.

Misclassification of Employees

Because misclassified employees are often denied access to critical benefits and protections they are entitled to by law, such as minimum wage, overtime compensation, family and medical leave, unemployment and disability insurance, and safe workspaces, states have increased their lookout for misclassified employees and are fining and penalizing employers who misclassify workers. 

Employers who misclassify employees as independent contractors without a reasonable basis for doing so may be held liable for the employment taxes and benefits that they did not properly pay the employee, and generally, an audit will be conducted, and the employer will have to make good on all employees not properly paid for the past 7 years.

Because of the significant difference in benefits paid to an employee and an independent contractor, many companies force those who should be an employee into being an independent contractor. 

However, there are serious consequences to companies that improperly pay employees as IC’s which include wage law violations such as unpaid overtime, all the employer taxes not paid, worker compensation violations, unemployment shortfalls, I-9 violations, Anti-Discrimination violations, and many more plus penalties and interest.

If a company is suspected of improper pay (based on a complaint or suspicions raised within an agency), typically it will be audited. The IRS can go back 7 years (you can only go back 3 years) and if they determine that the reason for the misclassification was fraudulent, the company owner could face criminal charges and prison. I always remind folks that it is legal to avoid taxes, but illegal to evade taxes.

Company or Individual Being Paid

So now we will look at an individual or company being paid as an independent contractor (IC), which can be done correctly and legally, or incorrectly or illegally. There are also some who are being paid involuntarily as an IC (the payer insists on paying as an IC rather than an Employee), and some volunteer or insist on being paid as an IC. The first concern, does the work being done requires a license, or that the individual must meet certain state requirements for training and registration?

If an individual has the state license and meets the requirements to perform the work being done for the payer, then it is considered legal subcontracting, and the individual can be paid as an IC (the payer is the contractor, and the payee is a subcontractor). That’s considered to be perfectly fine and legal subcontracting.

The contractor will issue a 1099NEC (non-employee compensation form, formally a 1099MISC) to both the individual and the IRS, to report all income paid during the calendar year. This is a business and not a personal payment. A note here, if an individual uses a company name or has an LLC or Inc., that does not make them a legal subcontracting company that can provide licensed services without a license.

However, if the individual does not have the state-required license, they cannot work as an independent contractor. They must be hired as an employee and meet all the state requirements to be registered (and trained as required) with the employer and state.

I know many employers who require their workers to become an LLC and then pay them as an IC, but if they have control over the worker, they legally are an employee and are responsible to pay employer taxes and benefits as well as unemployment and disability insurance.

legal subcontracting

IC Responsibilities

The misclassification of an employee is more serious for the employer than it is for the employee, but someone who works as an independent contractor and is not properly licensed can also find themselves in hot water too. Operating without a required security license is usually considered a crime, especially in a post 9/11 world.

At a minimum, an IC must file and pay federal self-employment tax, typically at 15.3% which covers 12.4% for social security and 2.9% for Medicare, and this does not include federal or state income tax. This may need to be paid quarterly, and the state may require payments as well.

If an individual is truly an IC, they are self-insured (or have an insurance policy that covers liability or workman’s compensation). So often I hear that a contractor tells an IC that they will be covered under the contractor’s insurance, but that generally is not the case. Insurance companies are extremely strict and will not pay another company under the policy for one specific company. Be careful here as you could be injured while working and not be covered.

Another concern for independent contractors is paying anyone other than their self, they must be a legal subcontracting employer and file W2’s for all their employees, which requires payroll deductions as required by law.

Someone who is technically not a licensed and legal subcontracting business, cannot pay someone else as an independent contractor too. As you can see, this can become quite a legal nightmare. Be careful who you work for and are paid by and make sure they are completely legal and insured.

Borrowing a License?

Another common comment I get from some when asked if they are licensed is that they are “using someone else’s license”. My response is usually, “so you can borrow someone else’s driver’s license to drive a car”? It’s like that! No, you cannot borrow or work under someone else’s license using two different company names, or billing a client using one name, while the license is in another person’s name!

If you are going to “use someone else’s license”, the business you do has to be under their license. They will be the licensee, responsible to the client for their actions, their insurance, and their liability, and the billing should be done under their name!

Think about it! Borrowing a license? Really? You are putting the client at risk as well as the licensee. You are either operating legally and jumping through all the hoops or you are not. And how about someone licensed in say Virginia, doing business in New York without a license?! Is that ok? I don’t think so. Do the right thing and be properly licensed!

Illegal Operators vs Legal Operators

Those who operate legally have more overhead as they properly pay all the required fees and collect state sales tax, etc. Those who do not operate legally can offer lower prices because they are not operating legally, which is problematic for legal subcontracting companies.

We often get calls asking what our rate is, and then after giving our rate, we see a posting in social media announcing a possible assignment, and we see those operating illegally posting, hey contact me with a PM! Yeah, contact me with a private message so I can give you my rates lower than those operating legally because I don’t operate legally!

When a licensed and insured company uses independent contractors, and there is some type of incident or accident, the insurance company will not cover liability or indemnity of the independent contractor, because the insurance company has no reason to cover them, because they are “Independent”! One misnomer we hear from folks working “1099” is that. If anything happens, I will be under their insurance! This is absolutely not the case at all.

Closing Comments

Clients hire security providers to reduce and minimize their risk. They expect the company or individual they hire to be properly licensed, trained, insured, as required by law, and they expect everyone that the individual or company to also be completely legal and paid properly as required by law. If a security company is hired to protect and minimize risk to a client who is not properly operating, are they not exposing the client to greater risk and liability? Indeed, they are!

State licensing requirements are generally there for public trust, so that someone working in the security field has been properly vetted and trained, and a client hiring a security firm can trust that the firm is operating appropriately. Those who circumvent the licensing laws are operating illegally, and they are exposing the client to greater risks on multiple levels. As protection professionals, it is imperative to operate legally and above board on all levels.

I can say here that I am not a purist and have made mistakes, costly mistakes. Minor infractions are dealt with typically with a fine and life goes on. Some infractions are more serious. I have paid the price for not paying employees properly. I have been fined by the state and the IRS too (with interest!). Based on these life lessons, I work hard to be as compliant as possible, and another reason why I feel compelled to encourage others to not make serious and costly mistakes.

My encouragement for all Security Professionals, those providing Security personnel or Executive Protection Agents, suck it up and set themselves up legally and jump through all the state and federal legal hoops and requirements. Yes, it is a royal pain, but it’s the right thing to do.

Conclusion

When hiring a subcontractor, ask the following:

  1. Copy of their state license to operate a security service and is it in the name of the business that they are operating under.
  2. Is the state license for the state in which you need the service?
  3. Ask for a copy of their Certificate of Insurance (COI) and is it in the name of the business that they are operating under
  4. Ask that you be added as an additional insured (standard request)
  5. Ask if their personnel are properly registered with them as employees if required by the state or do they use independent contractors (1099)?
  6. If they are working 1099, is the personnel they contract as independent contractors properly licensed and insured?

I know that this may be painful for many, but this is the reality of the security profession. Suck it up and do the right thing!

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