Increasing pressure

According to the U.S. General Accounting Office, 10.3 million U.S. workers were classified as independent contractors in 2005. Between 1995 and 2005, there was a 24 percent increase in the number of workers classified as independent contractors. However, a report released by the Internal Revenue Service (IRS) in February estimates at least 15 percent of employers misclassify their workers.

By classifying employees as independent contractors, which sometimes is referred to as "1099ing" based on IRS form 1099 issued to independent contractors, an employer can avoid withholding income taxes, withholding and paying Social Security and Medicare taxes, and paying unemployment taxes on wages paid to employees. According to the IRS, worker misclassification results in the loss of at least $1.6 billion of federal tax revenue each year. Employers who classify all their workers as independent contractors also are not subject to the Family and Medical Leave Act or minimum wage and overtime pay requirements.

A concerted effort

Early in 2007, the IRS announced a renewed effort to identify and punish employers who improperly classify employees as independent contractors. By the end of 2007, the IRS had made good on its promise. In December of that year, FedEx announced the IRS had ordered it to pay $319 million in back taxes, fines and interest in connection with 13,000 ground delivery drivers the IRS believed FedEx had misclassified as independent contractors in 2002.

In the wake of this decision, at least 20 class action lawsuits have been filed by current and former FedEx ground delivery drivers throughout the U.S. who claim they were misclassified by FedEx. In these lawsuits, the ground delivery drivers are seeking hundreds of millions of dollars in lost wages, benefits and expense reimbursements.

The $319 million assessment against FedEx has since been retracted by the IRS, but many of the lawsuits continue. At the beginning of this year, one class action lawsuit filed in California involving 203 FedEx workers was settled by FedEx for $26.8 million. Additionally, the IRS continues to investigate FedEx's classification of its workers in 2002, as well as those from 2004-06.

Similar action is being taken by the IRS and state and local tax and labor agencies across the U.S. This means you could be informed at any time by federal and/or state regulators that your worker classifications will be audited for compliance with current law.

Generally, employers follow the law in drawing the distinction between independent contractors and employees. However, recent reports by the IRS and other labor organizations indicate the number of employers that misclassify their workers as independent contractors is rising, whether because of ignorance of the law or in an intentional effort to save money and gain an advantage over their competitors. Reports also indicate worker misclassification is especially prevalent in the construction industry.

A study conducted in 2004 by the Construction Policy Research Center at Harvard University, Cambridge, Mass., of Massachusetts' construction industry found that about one in four construction employers in the state misclassified their workers as independent contractors compared with only 19 percent of employers in all industries. The study also found that about 45 percent of workers employed by misclassifying employers in Massachusetts' construction industry were improperly deemed to be independent contractors rather than employees.

A comparable study in New York found that 14.8 percent of construction employers in the state misclassified their workers compared with 10.3 percent of employers in all industries.

Penalties

The FedEx case highlights the serious consequences that can result from misclassifying employees as independent contractors. If the IRS reclassifies one of your workers as an employee whom you had previously classified as an independent contractor, you will be liable for income taxes that were not withheld, federal unemployment taxes that were not paid, and your share and the employee's share of Social Security and Medicare taxes that were not paid as a result of the misclassification plus interest.

Under Section 3509 of the Internal Revenue Code, if the IRS finds your misclassification was unintentional but you filed the necessary returns on the employee, you will be assessed a penalty equal to 1.5 percent of the wages paid to the employee and 20 percent of the amount that should have been withheld from the employee's wages for Social Security and Medicare taxes. If the IRS finds you failed to file the necessary returns on the employee and that failure was because of "willful neglect" and not justified by some reasonable cause, the penalties will double.

If the IRS finds you intentionally misclassified employees to evade paying taxes, you may be liable for a fine equal to the total amount of taxes that were not paid or withheld plus $50 per form for failure to file or correct a W-2 with the Social Security Administration that properly classifies your workers. There also is the possibility of a felony tax evasion conviction, which could result in a maximum fine of $100,000 (or $500,000 if your company is incorporated) and/or imprisonment for up to five years.

In addition, you should be aware state labor and taxing agencies are likely to assess and pursue similar civil and criminal penalties for worker misclassification under state law.

Additionally, as the FedEx example demonstrates, you could be exposed to civil lawsuits by workers who believe they are owed overtime pay and other benefits as a result of being misclassified as independent contractors. Under federal law, an employer is required to pay employees overtime wages when they work more than 40 hours per week. Independent contractors, on the other hand, are not entitled to overtime pay under federal law.

Recent federal action

In light of the significant tax revenue lost because of worker misclassification, it is not surprising the federal government has increased its efforts to identify and punish employers who misclassify employees as independent contractors.

In November 2007, the IRS, in conjunction with other federal and state work force agencies, created the Questionable Employment Tax Practices (QETP) initiative to "identify employment tax schemes and illegal practices and increase voluntary compliance with employment tax rules and regulations."

As of July 2008, more than 30 state work force agencies, including those in California, Connecticut, Louisiana, New Jersey, New York, Texas and Virginia, had signed on to share tax data under QETP so federal and state tax auditors can mutually scrutinize independent contractor agreements to identify and punish worker misclassification.

Federal legislation aimed at reducing worker misclassification also could be coming in the near future.

In 2008, H.R. 6111, the Employee Misclassification Prevention Act, was introduced in the U.S. House of Representatives. The bill was meant to strengthen enforcement and penalties against employers who misclassify employees as independent contractors.

The bill sought to impose a maximum fine of $10,000 per violation against employers who "repeatedly or willfully" failed to accurately classify their workers. In instances where an employer misclassified a worker and that misclassification also resulted in a violation of the Fair Labor Standards Act's requirements regarding minimum wage and maximum hours, a worker would be allowed to bring a lawsuit against his or her employer to recover double his or her liquidated damages resulting from the misclassification.

A companion bill, which then Sen. Barack Obama (D-Ill.) co-sponsored, was introduced in the U.S. Senate in 2008, as well.

Neither bill was signed into law, but Rep. Rob Andrews (D-N.J.), a co-sponsor of H.R. 6111, has indicated his intent to reintroduce the bill in Congress this year.

The states

During the past few years, a number of states have followed suit with reforms aimed at addressing the employee misclassification issue. Governors in Massachusetts, Michigan, New Jersey and New York have signed executive orders creating task forces or advisory commissions to study the misclassification problem and strengthen state enforcement efforts. During the 2007-08 legislative session, many states also passed laws intended to reduce this growing problem.

Washington, for instance, passed H.B. 3122, which was introduced for the purposes of "consolidating, aligning, and clarifying … tests for determination of independent contractor status under unemployment compensation and workers' compensation laws."

Under this law, all workers are presumed to be employees unless they meet a strict independent contractor test (which I discuss in more detail later). This law also outlines additional requirements that apply specifically to construction employers.

Other states, such as Colorado and Minnesota, also have enacted laws aimed at the construction industry.

Minnesota Statute §181.723, which became effective Jan. 1, requires all independent contractors working in Minnesota's residential and commercial construction industries to obtain an Independent Contractor Exemption Certificate (ICEC) from the Minnesota Department of Labor and Industry. If a worker does not have an ICEC, he or she will be considered an employee under state tax and work force laws. Those who fail to comply with this requirement are subject to a penalty of up to $5,000 for each violation and, according to the Minnesota Department of Labor and Industry, will be reported to state regulators for additional action.

The IRS test

In light of the recent federal initiatives to crack down on worker misclassification, you should have a good understanding of the current test used by the IRS to determine whether a worker is an employee or independent contractor. Generally, the classification of a worker depends on the degree of control you exercise over that worker. The more control you have, the more likely the worker will be classified as an employee and vice versa.

In the past, the IRS has relied on a common law 20-factor checklist to make this determination. However, the most recent supplement to IRS Publication 15-A (Circular E) "Employer's Tax Guide" indicates a move away from rigidly applying these 20 factors to a test that involves three categories of evidence of employer control with 11 subfactors that help determine a worker's classification. These three categories and their associated subfactors follow:

1. "Behavioral control: Facts that show whether the employer has a right to direct and control how a worker does the tasks for which the worker was hired include the type and degree of:
   1. Instruction the employer gives the worker, including when and where to do the work, what tools or equipment to use, what workers to hire or assist with the work, where to purchase supplies and services, what work must be performed by a specified individual and what order or sequence to follow; and
   2. Training the employer gives the worker
2. Financial control: Facts that show whether the employer has a right to control the business aspects of the worker's job include:
   1. The extent to which the worker has unreimbursed business expenses;
   2. The extent of the worker's investment;
   3. The extent to which the worker makes his or her services available to the relevant market;
   4. How the employer pays the worker; and
   5. The extent to which the worker can realize a profit or loss
3. Type of relationship: Facts that show the parties' type of relationship include:
   1. Written contracts describing the relationship the parties intended to create;
   2. Whether the employer provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay;
   3. The permanency of the relationship; and
   4. The extent to which services performed by the worker are a key aspect of the employer's regular business"

The IRS cautions that "[t]here is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor, and no one factor stands alone in making this determination."

The IRS also notes "factors which are relevant in one situation may not be relevant in another."

Therefore, each individual employer-worker relationship must be evaluated on a case-by-case basis.

The IRS safe harbor

Even if a worker qualifies as an employee under the IRS test, there are certain circumstances in which you can classify that worker as an independent contractor without violating IRS regulations. These circumstances, which commonly are referred to as "safe harbor" rules, are found in Section 530 of the Revenue Act of 1978. Under the safe harbor rules, a worker may be classified as an independent contractor for employment tax purposes only if the employer can show:

• The worker was treated as an independent contractor on all previous federal tax returns.
• All similarly situated workers were treated as independent contractors on all previous federal tax returns.
• The employer has a "reasonable basis" for classifying the worker as an independent contractor rather than an employee.

This reasonable basis can come as the result of judicial precedent, published rulings, technical advice or letter rulings issued to the employer; prior audits of the employer by the IRS in which no worker in a substantially similar position was reclassified as an employee; the fact that a significant segment of the industry traditionally treated similarly situated workers as independent contractors; or any other reasonable basis.

State tests

Unfortunately, there is no standard test used to determine a worker's classification. Each state is free to create and enforce its own definitions for who is an independent contractor and who is an employee.

Eighteen states use common law tests similar to the IRS test. These states include Alabama, Arizona, California, Florida, Iowa, Kentucky, Michigan, Minnesota, Mississippi, Missouri, New York, North Carolina, North Dakota, Ohio, Oklahoma, South Carolina, Texas and Virginia.

Thirty states, including many that have taken recent legislative action to combat employee misclassification, now use some variation of the "ABC test," which generally is stricter than the IRS test. Under the ABC test, a worker only is considered an independent contractor if the following conditions are met:

1. The worker is free from the employer's direction and control in performing the worker's services.
2. The services performed by the worker are outside the usual course of the employer's business or performed away from any of the employer's regular business locations.
3. The worker is customarily engaged in an independent trade, occupation, business or profession.

States applying some variation of the ABC test include Alaska, Arkansas, Colorado, Connecticut, Delaware, Georgia, Hawaii, Idaho, Illinois, Indiana, Kansas, Louisiana, Maine, Maryland, Massachusetts, Montana, Nebraska, Nevada, New Hampshire, New Jersey, New Mexico, Oregon, Pennsylvania, Rhode Island, South Dakota, Tennessee, Utah, Vermont, Washington and West Virginia. Under the ABC test, there is a presumption that a worker is an employee for state tax purposes and that worker can only be classified as an independent contractor if all three conditions are met.

As I mentioned, certain states also have enacted laws specifically intended to reduce misclassification in the construction industry.

For example, the test used by the Washington State Employment Security Department includes the three conditions listed in the ABC test but adds the following four conditions for workers in the construction industry:

1. On the effective date of the contract between the worker and employer, the worker must file a schedule of expenses with the IRS.
2. On the effective date of the contract between the worker and employer or within a reasonable period after the effective date of the contract, the worker must have an active account with the department of revenue, an active account with any other state agencies and a Unified Business Identifier number.
3. As of the effective date of the contract between the worker and employer, the worker must maintain a separate set of books or records that reflects all items of income and expenses of the business that the worker is conducting.
4. As of the effective date of the contract between the worker and employer, the worker must have a valid state contractor registration if the work requires a registration or license.

Prevention

Assuming studies are correct, just being in the construction industry automatically makes a roofing contractor more likely to misclassify an employee as an independent contractor, leaving you open to possible civil and criminal penalties. Although the consequences will be lessened somewhat, good-faith mistakes in worker classification still will result in harsh monetary penalties.

So what steps can you take to lessen the risk of employee misclassification and ensure compliance with the law?

Above all, you should develop a comprehensive understanding of all applicable federal, state and local laws and regulations and the specific tests applied by applicable state and federal agencies for who is an independent contractor and who is an employee. Your employment and tax advisers should be able to help in this respect.

If you are using a contingent work force management company to staff your projects, make sure it understands the current laws, stays abreast of changes in the law and modifies its procedures to ensure ongoing compliance.

After you have a thorough appreciation for all applicable requirements and/or tests, you should perform an internal self-audit to ensure your company's current procedures do not increase the likelihood that your independent contractors are found to be employees by federal and state regulators.

Remember, the key to determining whether a worker is an independent contractor is the degree of control you exercise over the worker. Consequently, to increase the likelihood that your independent contractor classifications will hold up, ensure your independent contractors retain control over the means and methods of work they perform.

Generally, this means the workers should be free to choose when and where to perform their work, what tools or equipment to use, what workers to hire or to assist with their work, and where to purchase supplies and services used in their work.

Additionally, when establishing payment arrangements for your independent contractors, it is preferable to pay on a lump-sum basis rather than by the hour. This will serve as evidence that your independent contractors retain the ability to realize a profit or loss for their work.

Most, if not all, of these issues should be addressed in a well-drafted independent contractor agreement that is signed by all your independent contractors as a condition of employment. The agreement should make it clear the workers are providing their services to you as independent contractors and that you do not have any right to control the way they accomplish their work. The agreement also should clearly place the responsibility of withholding and paying all applicable taxes on your independent contractors.

Of course, given the case-by-case analysis that is necessary to determine a worker's proper classification, the suggestions provided do not constitute an exhaustive list of the steps that should be taken to protect against misclassification and should not be relied on solely to ensure compliance with the law.

You should engage competent, qualified professionals with specific knowledge of all applicable federal, state and local laws to perform periodic assessments of your employment relationships to identify potential worker misclassifications. At the very least, these assessments should be performed biannually. To reduce the risk of misclassification further, consider conducting these assessments on a monthly or even project-by-project basis.

If additional expertise is necessary to determine who is an independent contractor and who is an employee, you may choose to petition the IRS or any applicable state agency to determine your workers' appropriate classifications. For federal tax purposes, IRS Form SS-8 should be submitted for this purpose.

Brian P. McCormick is an attorney with the Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.

WEB
EXCLUSIVE

• Web exclusive: Click below for more information.
• Additional IRS resources