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The Misclassification of Independent Contractors – A Costly Mistake
InSeptember of 2008, then-Senator Barack Obama, along with Senators Kerryand Kennedy, introduced the Employee Misclassification Prevention Actinto Congress. This bill would have amended the Fair Labor StandardsAct (FLSA) to require employers to keep records of non-employees whoperform labor or services. It would also have provided a specialpenalty for employers who misclassify employees as non-employees.Although this and similar bills did not pass during the lastlegislative session, new versions are very likely to be reintroduced inthis new session. There is significant support for passing a bill ofthis nature and should one of the bill versions make it to PresidentObama’s desk, it will likely be signed into law.
Over 10.3million workers are currently classified as Independent Contractors.Recent studies indicate that nearly half of the individuals currentlyworking as independent contractors are misclassified and are actually,in the eyes of the law, employees.
Over the past few years,the misclassification of independent contractors has been brought tolight, not only at the federal level, but at the state level as well.Willful and accidental misclassification of workers as independentcontractors reduces the amount of unemployment tax collected by statesand the amount of workers’ compensation insurance premiums paid intostate funds. Additionally, it can result in less federal income taxcollection as those on independent contractor status “write off” itemsthat would not otherwise be deductible and/or fail to file and payfederal income taxes. Many lawsuits have been initiated, and have costcompanies millions of dollars in liabilities.
Liabilities and Lawsuits
Withthe rapid growth of independent contractors, tax authorities are nowtaking an aggressive stand in ensuring compliance with regulationsregarding independent contractors. The General Accounting Office hasestimated that unpaid taxes by the self-employed amount to a $20billion annual tax loss. A 2008 study by four states identified over 2million individuals who were misclassified as independent contractors.In response to this, both federal and state taxing agencies are nowallocating significant resources to recover that money.
Even ifthere is no new legislation that imposes additional penalties andobligations on the employer related to independent contractors, currentlaw provides significant punishment.
Motivation For Classification of Workers as Independent Contractors
Dueto perceived cost savings, companies have embraced the use ofcontingent workforces such as independent contractors. A contingentworkforce can offer flexibility in workforce size, decreasecontributions to employment taxes and employee benefits plans, andreduce obligations and expenses related to labor law. Individuals haveembraced being classified as independent contractors for a number ofreasons including a wish to write off expenses that would otherwise notbe deductible, the impression that they have more flexibility andsometimes the fairly routine higher “wage” paid to independentcontractors by companies.
As more companies have chosen to movesome of their workload to independent contractors, it is important forhiring managers and workers to gain an understanding of the legaldistinction between employees and contractors and the potential risksinvolved in using 1099 independent contractors.
Characteristics of an Employee
Employeesdevote substantially all of their work time to one employer. They relyon the employer for work direction, are paid on an hourly or salarybasis, are paid for any expenses incurred out of pocket on behalf oftheir employment and get their training from the employer. An employeecannot lose money by being employed.
Characteristics of an Independent Contractor
Anindependent contractor would not normally devote their full timeefforts to one employer. They should not be paid on an hourly or salarybasis, but instead should be paid on a project basis. Independentcontractors should own their own business, be able to provide proof ofsuch ownership such as by providing a Federal Identification Number andas an owner, be in a position to “lose” money by providing theirservices to a company. That is, they should not be reimbursed forexpenses, should not be provided training to do the job, and should beunder a contractual relationship with a company that includes arecitation that they are responsible for their own taxes, workers’compensation and profitability. These 1099 independent contractorsshould not receive company benefits (medical, dental, vacation,pension, etc.), and should be entirely self-directed.
The IRSuses a 20-point test to determine if a person can be classified as anindependent contractor. They look at the relationship of the person tothe company using the points above to make the determination. Variousstate agencies use similar criteria to determine if a relationshipbetween a worker and a company can pass muster as an independentcontractor.
Unintentional Misclassification
Unintentionallymisclassifying an employee (and the employer filed a Form 1099) limitsan employer’s liability for income taxes to 1.5% of the employee’swages. The employer’s liability for FICA taxes that should have beenpaid by the employee would be limited to 20% of that amount.Unfortunately, the employer would have no rights to recover from theemployee what is due to the IRS. If an employer has not filed anyinformation returns, such as the Form 1099, that were required, thepercentage amounts are doubled. The employer must pay 3% for federalwithholding and 40% of the employee’s portion of FICA in addition tothe employer’s share of FICA. Additionally, the employer would still beliable for its share of FICA and unemployment taxes. Interest andpenalties could be assessed by the IRS, but only on the amount of theemployer’s liability. The employer’s liability includes the percentageof tax that should have been withheld. For example, interest forfailure to collect FICA would be based on the employer’s share of FICAplus the 20% of the tax that should have been withheld from theemployee.
Intentional Misclassification
Intentionally misclassifying an employee could result in the following employer liabilities
Thefull amount of income tax that should have been withheld (with anadjustment if the employee has paid or does pay part of the tax)
Thefull amount of both the employer and employee share for FICA (but mightreceive an offset if the employee paid FICA self-employment taxes)
Interest and penalties, computed on far larger amounts than in the case of an unintentional misclassification.
Asmany organizations have already discovered, the cost of misclassifyingworkers can be staggering. These organizations include such companiesas Microsoft, which paid $97 million to settle a suit that began as theresult of an IRS audit of its independent contractors and Time Warner,which recently settled a suit with the Department of Labor. In 2008,UPS agreed to a $27 million settlement with a group of 203 workers theyhad misclassified as independent contractors. Notably, $12.5 million ofthe settlement went for attorney’s costs and other fees, so it iscertain that attorneys will find this a fruitful area to seek classactions on behalf of individuals.
Protecting Your Company
Thedefinition of who is an independent contractor can vary not onlybetween different states but also by different state agencies withinthe same state. And, remember, the IRS generally assumes a worker is anemployee unless companies can prove they are not.
Given themagnitude of the adverse consequences that can be linked tomisclassification of workers, a compliance system is vital, especiallyin organizations with a large contingent workforce. Some companies tryto protect themselves with written contracts claiming the contractor'sindependence from the company. In addition, as important as it is tohave this contract in place, companies should not make the mistake ofsolely relying on this. Regardless of what is written in the contract,the IRS and state tax authorities will make companies prove that their1099 wage earners are truly independent.
A good compliancesystem should include a method of internally auditing the properclassification of all potential independent contractors and preparingand maintaining a file documentation system for all independentcontractors, who are determined to be truly "independent." It isimperative that the arrangements with those workers be set up properly,or the company will be at risk. If it is determined that somearrangements are misclassified, it is important to quickly change therelationship to employee to limit the liabilities that are associatedwith misclassification.
Other compliance measures could includethe IRS 20 Point Control Test. In the IRS Control Test, a company mustexamine the relationship between the worker and the business. Allevidence of control and independence in this relationship should beconsidered. The facts that provide this evidence fall into threecategories: behavioral control, financial control, and the type ofrelationship itself.
It has become a standard practice in thenew economy that when the head count goes down, the contingent workercount goes up. Used wisely, these workers can be an integral part of abusiness plan.
To help ensure that your company is among thosethat are prepared, educate your internal workforce on the laws, installa compliance system that works and execute it appropriately.Alternatively, a company can seek guidance from an expert thatunderstands FLSA or other employment classification guidelines. Butwith bills such as the Employee Misclassification Prevention Act, andothers that will certainly be introduced and pushed through, usingthese types of workers can also prove to be a nightmare if a company isill prepared.
The Misclassification of Independent Contractors – A Costly Mistake
InSeptember of 2008, then-Senator Barack Obama, along with Senators Kerryand Kennedy, introduced the Employee Misclassification Prevention Actinto Congress. This bill would have amended the Fair Labor StandardsAct (FLSA) to require employers to keep records of non-employees whoperform labor or services. It would also have provided a specialpenalty for employers who misclassify employees as non-employees.Although this and similar bills did not pass during the lastlegislative session, new versions are very likely to be reintroduced inthis new session. There is significant support for passing a bill ofthis nature and should one of the bill versions make it to PresidentObama’s desk, it will likely be signed into law.
Over 10.3million workers are currently classified as Independent Contractors.Recent studies indicate that nearly half of the individuals currentlyworking as independent contractors are misclassified and are actually,in the eyes of the law, employees.
Over the past few years,the misclassification of independent contractors has been brought tolight, not only at the federal level, but at the state level as well.Willful and accidental misclassification of workers as independentcontractors reduces the amount of unemployment tax collected by statesand the amount of workers’ compensation insurance premiums paid intostate funds. Additionally, it can result in less federal income taxcollection as those on independent contractor status “write off” itemsthat would not otherwise be deductible and/or fail to file and payfederal income taxes. Many lawsuits have been initiated, and have costcompanies millions of dollars in liabilities.
Liabilities and Lawsuits
Withthe rapid growth of independent contractors, tax authorities are nowtaking an aggressive stand in ensuring compliance with regulationsregarding independent contractors. The General Accounting Office hasestimated that unpaid taxes by the self-employed amount to a $20billion annual tax loss. A 2008 study by four states identified over 2million individuals who were misclassified as independent contractors.In response to this, both federal and state taxing agencies are nowallocating significant resources to recover that money.
Even ifthere is no new legislation that imposes additional penalties andobligations on the employer related to independent contractors, currentlaw provides significant punishment.
Motivation For Classification of Workers as Independent Contractors
Dueto perceived cost savings, companies have embraced the use ofcontingent workforces such as independent contractors. A contingentworkforce can offer flexibility in workforce size, decreasecontributions to employment taxes and employee benefits plans, andreduce obligations and expenses related to labor law. Individuals haveembraced being classified as independent contractors for a number ofreasons including a wish to write off expenses that would otherwise notbe deductible, the impression that they have more flexibility andsometimes the fairly routine higher “wage” paid to independentcontractors by companies.
As more companies have chosen to movesome of their workload to independent contractors, it is important forhiring managers and workers to gain an understanding of the legaldistinction between employees and contractors and the potential risksinvolved in using 1099 independent contractors.
Characteristics of an Employee
Employeesdevote substantially all of their work time to one employer. They relyon the employer for work direction, are paid on an hourly or salarybasis, are paid for any expenses incurred out of pocket on behalf oftheir employment and get their training from the employer. An employeecannot lose money by being employed.
Characteristics of an Independent Contractor
Anindependent contractor would not normally devote their full timeefforts to one employer. They should not be paid on an hourly or salarybasis, but instead should be paid on a project basis. Independentcontractors should own their own business, be able to provide proof ofsuch ownership such as by providing a Federal Identification Number andas an owner, be in a position to “lose” money by providing theirservices to a company. That is, they should not be reimbursed forexpenses, should not be provided training to do the job, and should beunder a contractual relationship with a company that includes arecitation that they are responsible for their own taxes, workers’compensation and profitability. These 1099 independent contractorsshould not receive company benefits (medical, dental, vacation,pension, etc.), and should be entirely self-directed.
The IRSuses a 20-point test to determine if a person can be classified as anindependent contractor. They look at the relationship of the person tothe company using the points above to make the determination. Variousstate agencies use similar criteria to determine if a relationshipbetween a worker and a company can pass muster as an independentcontractor.
Unintentional Misclassification
Unintentionallymisclassifying an employee (and the employer filed a Form 1099) limitsan employer’s liability for income taxes to 1.5% of the employee’swages. The employer’s liability for FICA taxes that should have beenpaid by the employee would be limited to 20% of that amount.Unfortunately, the employer would have no rights to recover from theemployee what is due to the IRS. If an employer has not filed anyinformation returns, such as the Form 1099, that were required, thepercentage amounts are doubled. The employer must pay 3% for federalwithholding and 40% of the employee’s portion of FICA in addition tothe employer’s share of FICA. Additionally, the employer would still beliable for its share of FICA and unemployment taxes. Interest andpenalties could be assessed by the IRS, but only on the amount of theemployer’s liability. The employer’s liability includes the percentageof tax that should have been withheld. For example, interest forfailure to collect FICA would be based on the employer’s share of FICAplus the 20% of the tax that should have been withheld from theemployee.
Intentional Misclassification
Intentionally misclassifying an employee could result in the following employer liabilities
Thefull amount of income tax that should have been withheld (with anadjustment if the employee has paid or does pay part of the tax)
Thefull amount of both the employer and employee share for FICA (but mightreceive an offset if the employee paid FICA self-employment taxes)
Interest and penalties, computed on far larger amounts than in the case of an unintentional misclassification.
Asmany organizations have already discovered, the cost of misclassifyingworkers can be staggering. These organizations include such companiesas Microsoft, which paid $97 million to settle a suit that began as theresult of an IRS audit of its independent contractors and Time Warner,which recently settled a suit with the Department of Labor. In 2008,UPS agreed to a $27 million settlement with a group of 203 workers theyhad misclassified as independent contractors. Notably, $12.5 million ofthe settlement went for attorney’s costs and other fees, so it iscertain that attorneys will find this a fruitful area to seek classactions on behalf of individuals.
Protecting Your Company
Thedefinition of who is an independent contractor can vary not onlybetween different states but also by different state agencies withinthe same state. And, remember, the IRS generally assumes a worker is anemployee unless companies can prove they are not.
Given themagnitude of the adverse consequences that can be linked tomisclassification of workers, a compliance system is vital, especiallyin organizations with a large contingent workforce. Some companies tryto protect themselves with written contracts claiming the contractor'sindependence from the company. In addition, as important as it is tohave this contract in place, companies should not make the mistake ofsolely relying on this. Regardless of what is written in the contract,the IRS and state tax authorities will make companies prove that their1099 wage earners are truly independent.
A good compliancesystem should include a method of internally auditing the properclassification of all potential independent contractors and preparingand maintaining a file documentation system for all independentcontractors, who are determined to be truly "independent." It isimperative that the arrangements with those workers be set up properly,or the company will be at risk. If it is determined that somearrangements are misclassified, it is important to quickly change therelationship to employee to limit the liabilities that are associatedwith misclassification.
Other compliance measures could includethe IRS 20 Point Control Test. In the IRS Control Test, a company mustexamine the relationship between the worker and the business. Allevidence of control and independence in this relationship should beconsidered. The facts that provide this evidence fall into threecategories: behavioral control, financial control, and the type ofrelationship itself.
It has become a standard practice in thenew economy that when the head count goes down, the contingent workercount goes up. Used wisely, these workers can be an integral part of abusiness plan.
To help ensure that your company is among thosethat are prepared, educate your internal workforce on the laws, installa compliance system that works and execute it appropriately.Alternatively, a company can seek guidance from an expert thatunderstands FLSA or other employment classification guidelines. Butwith bills such as the Employee Misclassification Prevention Act, andothers that will certainly be introduced and pushed through, usingthese types of workers can also prove to be a nightmare if a company isill prepared.
Joe
