If you haven’t heard the ever increasing buzz about worker misclassification yet, you will. The issue of whether a worker should be classified as an independent contractor or an employee is a hot topic and getting hotter all the time. Subscribers to HRSentry, can easily and quickly access our newly created online training and accompanying slides on the topic, along with a host of relevant resources. For others, the following provides key information to help you assess what you need to know and the steps you should take.
There are many parties interested in proper worker classification ranging from the IRS to the U.S. Department of Labor (DOL) to state governments to workers themselves. It’s much cheaper for employers to use independent contractors over employees because they avoid paying the following: employer portion of payroll taxes, workers’ compensation and unemployment insurance premiums, overtime payments and the expensive benefits that often go along with hiring employees.
On the flip side, there’s a growing risk if you misclassify employees as independent contractors, especially if you do so willfully. In addition to the possibility of owing back pay (if minimum wage requirements haven’t been met) and overtime, you could also face paying: back taxes, including the employee portion; penalties and interest; fines; retroactive employee benefits; costs of staff time and effort; and possible legal fees if faced with going to court. Additional costs, less quantifiable but important nonetheless, include negative publicity for your organization and possible employee morale issues.
Even inadvertent misclassification can be expensive but imposed fines and penalties grow increasingly severe the more willful the nature of the violation. Both state and federal governments are paying greater attention to this issue than in years past. The IRS and DOL have even teamed up with eleven states (thus far) to share information and resources in a joint effort to uncover violations. So there’s strong incentive these days for employers to do their best to get it right.
The IRS makes is clear that there is no magic formula or simple test as to whether or not a worker is an independent contractor. They emphasize that each case is fact specific. In general, however, the best place to start is to consider whether you, the employer, have the right to control, not just the outcome but also how the worker performs the work. Whether or not you actually exercise this right is irrelevant to the worker’s status. There are many times, for instance with highly experienced employees, when organizations provide little guidance or oversight. The real question is whether or not you have the right to do so.
How does the IRS decide upon the degree of control an employer has over how the work is performed? It comes down to looking at a number of factors that comprise three main categories: Behavioral Control, Financial Control, Type of Relationship. Remember, no one factor is decisive as circumstances differ; the totality of the situation must be evaluated. IRS guidance is abundant on their web site.
You should also take a look at the DOL’s Economic Reality Test. This test relates to whether the Fair Labor Standards Act (FLSA) applies. The seven factors it contains overlap those that the IRS looks at and likewise consider whether or not the worker has a bona fide business that does not provide services integral to yours. Be sure to familiarize yourself with all seven factors of this test in addition to IRS guidance.
So how do you prove that someone is indeed an independent contractor and not your employee? The best documentation shows that the person has a bona fide business quite separate from yours; that control over how the person does the work resides with the worker; that the work being contracted is not an integral part of what your business provides and the worker is free to make a profit or loss and be hired by others. Keep a vendor file for each independent contractor just as you would for any other vendor or supplier, such as the folks who deliver your coffee supplies or service your copier machines. Here are some important items that should be kept in that file:
A written contract—Always a good idea, the contract should outline the nature of the relationship, although saying the person is an independent contractor doesn’t make it so. Indicate the project’s expected results, the fee and date(s) of completion. Note that you don’t control how the results are achieved; the worker uses his/her own equipment/tools; is free to hire others without your approval and that the person provides liability insurance to his/her workers, and is not eligible for benefits with your company. Note that the person has their own business and tax I.D. number. Make sure it is signed by both parties and create a new contract if the worker takes on a new project for you. Each project should have a separate contract.
Proof of a real and separate business—Keep any letters on business stationery, business cards, brochures, or newspaper advertisements. With so much done electronically these days, print off a copy of an appropriate page of the worker’s web site, online advertisement of services or copies of emails detailing services offered.
Invoices—Every payment to an independent contractor should be based on an invoice. The worker should never submit expense reports to you as that would point toward the person being an employee. The worker’s mileage or purchase of equipment or supplies should be part of their own business expenses, not yours. Keep every invoice and make sure it ties in with the Form 1099 you issue to the person for that calendar year.
Form W-9—Obtain this form when hiring an independent contractor and make sure it is filled out properly. If the person does not check the box exempting him- or herself from tax withholding, you are legally obligated to withhold taxes at 28%. An independent contractor should check the box file their own self-employment taxes on their own.
Due to lots of bad practices that organizations got away with in the past, businesses may think they are classifying workers correctly when they are not. Increasing scrutiny demands that the facts of each situation be reviewed. Here are some common red flags to watch for:
After an employee terminates, you hire the person back to do work that resembles their old job, even on a temporary, project basis;
If an intern is doing actual work, not just shadowing or learning; be sure to check DOL Fact Sheet #71 for the six criteria related to interns. In order to not pay interns minimum wage and overtime, all six criteria must be met.
When you provide the equipment, supplies or office space the worker uses;
If the worker replaces one of your employees or supervises any of your employees;
If the worker receives any benefits or perks your employees receive, gets paid on a regular basis, or submits expense reports;
If the relationship is ongoing and long-term;
If a supervisor hires a worker and pays the person through Accounts Payable unbeknownst to human resources or payroll.
The last item happens more often than you might think, especially in larger organizations, but all organizations are vulnerable without proper communications and procedures in place. If the person administering payroll also issues 1099s and is thus aware of all workers, misclassification can be avoided. But if your organization is too large for that, make sure there are good channels of communication among payroll, accounts payable and human resources and train managers to get approvals from human resources when engaging any worker.
A final caveat is that state laws may differ from federal laws in important ways. It’s possible for a worker to be classified as an independent contractor for IRS purposes, yet, by state definition, require workers’ compensation or unemployment insurance premiums paid on his or her behalf. So be sure to check your state laws as well! Subscribers to HRSentry may simply search on the term independent contractor to pull up helpful federal resources and relevant state resources as well.
It’s not uncommon for employers to consider someone a consultant, freelancer or outside contractor when that person would be deemed an employee by IRS or Department of Labor standards. Honest mistakes do occur of course; but some employers may consider the illegal but real financial incentives to deliberately misclassify workers, i.e. to avoid payroll taxes, unemployment and workers compensation premiums, overtime pay and benefits costs. However, if your organization is audited and found to be guilty of misclassification, the back pay, back taxes and fines and penalties, in addition to all the resources expended during an audit, can be enormous. Combined with the possibility of opening the organization up to additional future scrutiny, it’s just not worth it.
Newly increased focus by the IRS, in partnership with a number of state authorities, is making misclassification a riskier prospect than in years past. So how can you be sure your organization is classifying workers correctly? IRS guidance says to look at the worker/organization relationship and consider the amount of control the organization exerts vs. the amount of independence the worker has. The following common law guidance comes from the IRS web site and provides links to factors you should consider under each category:
Facts that provide evidence of the degree of control and independence fall into three categories:
1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job? 2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.) 3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There 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. Also, factors which are relevant in one situation may not be relevant in another.
The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally, to document each of the factors used in coming up with the determination.
Keep in mind that there are other considerations as well such as the DOL viewpoint for purposes of the Fair Labor Standards Act (FLSA) and state legal standards for unemployment or workers’ compensation purposes. But the IRS links above are a great place to start to help you feel confident about proper classification.
If you come to realize you are not in compliance, seriously consider taking advantage of the IRS’ new Voluntary Classification Settlement Program (VCSP.) Details on the VCSP are forthcoming in Part 2 of this blog.
On the heels of several natural disasters across the nation and with winter weather just around the corner, at least for folks in northern climes, now’s a good time to prepare for the inevitable questions related to time off that inclement weather inevitably brings. Of course it’s vital to avoid running afoul of the Fair Labor Standards Act (FLSA) so bear in mind the disparate legal requirements related to exempt vs. non-exempt employees.
Staff should always be considered non-exempt unless they meet a series of salary and duties tests for one of the exemptions laid out under the FLSA. More information is available on the US Department of Labor (DOL) Wage and Hour Division’s compliance page. Nonexempt employee protections under the FLSA include being paid at least at the prevailing federal or state minimum wage rate, whichever is higher, as well as being paid at an overtime rate of one and one half times the regular rate of pay for any work hours that exceed 40 in one workweek.
But keep in mind that the FLSA does not require employers to provide paid sick, vacation, holiday or personal leave. Of course if you do have policies providing such leave, you need to follow them. There’s nothing worse for an employer than having policies and not following them. That said, for nonexempt staff, the FLSA says that an employer is not precluded from lowering an employee’s hourly rate, provided the rate paid is at least the minimum wage, or from reducing the number of hours the employee is scheduled to work. And the FLSA does not require employers to pay non-exempt staff for hours they have not worked.
So, when inclement weather hits and you close your workplace, you are permitted under the law (assuming you don’t have a policy in place to the contrary) to deduct pay from non-exempt employees’ paychecks commensurate with the reduced work time. Likewise, if you keep your workplace open but a non-exempt staff person does not make it in due to the weather, you are allowed by law to deduct those hours not worked from their pay, again personnel policy to the contrary notwithstanding. Note that if you do make such deductions from pay, be sure to apply them to non-exempt staff across the board to avoid discrimination claims. And there’s one more caveat: in today’s plugged in world, employees often perform work remotely from personal computers and electronic devices such as smartphones. Even if they are just checking email, you must count such work done remotely as time worked.
The paragraph above outlines what is permitted under the FLSA, but there may be lots of reasons for employers to choose to be more generous and pay non-exempt employees for time off related to a disaster or inclement weather, especially if the loss of work hours is based on the employer’s decision or on severe and unusual circumstances beyond employees’ control. Important issues to consider include employee morale, retention, loyalty and engagement as well as the culture, core values and mission of your organization.
What about exempt staff? You are not permitted to reduce an exempt employee’s predetermined weekly pay without jeopardizing their exempt status except under limited circumstances. However, you are permitted to reduce their accrued sick, vacation or other leave bank, even if the reduction is less than a full day and even if the absence is directed by the employer due to lack of work; however, the exempt employee must still be paid their predetermined weekly salary in any week in which any work is performed. Note that the full salary must be paid: even if the leave bank is exhausted; if it becomes or goes further into the negative; even if the employer does not have a bona fide benefits plan at all; and even when the leave is required by the employer due to inclement weather according the the DOL Wage and Hour Division Opinion Letter FLSA2005-41.
So take some time now to establish the leave policies your organization needs or to review those you already have in place, including inclement weather and disaster policies. Make sure they are in compliance with the FLSA and that they support your culture, goals and mission.
The US Department of Labor (DOL) is stepping up efforts to crack down on the misclassification of workers as independent contractors rather than as employees. According to its press release, the DOL, in partnership with the IRS, has signed memorandums of understanding (MOU) with agencies or officials in 11 states (Connecticut, Maryland, Massachusetts, Minnesota, Missouri, Utah, and Washington, Hawaii, Illinois, and Montana, and New York.) The intent is to provide better information sharing as well as enforcement efforts aimed at employers that misclassify workers.
There is a strong financial motivation for employers to hire independent contractors rather than employees in the avoidance of a number of expenses: social security and Medicare taxes, unemployment and workers’ compensation premiums, overtime pay and employee benefits. Yet, classifying workers as independent contractors should always be done carefully, particularly in light of heightened scrutiny. There are somewhat different standards related to the Fair Labor Standards Act (FLSA) and used by the IRS. Under the FLSA, courts have looked at the following factors:
1. The extent to which the services rendered are an integral part of the principal’s business.
2. The permanency of the relationship
3. The amount of the alleged contractor’s investment in facilities and equipment.
4. The nature and degree of control by the principal.
5. The alleged contractor’s opportunities for profit and loss.
6. The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
7. The degree of independent business organization and operation.
The IRS looks at the degree of control and independence the worker has related to the following three categories:
1. Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
2. Financial: Are the business aspects of the worker’s job controlled by the payer? (these include things like how worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc.)
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.?) Will the relationship continue and is the work performed a key aspect of the business?
Employers would be well-advised to review both sets of standards in relation to its hiring of independent contractors. Further guidance is available at IRS.gov and DOL.gov.
The Fair Labor Standards Act (FLSA) is one of the broadest of employment laws in that it affects almost every employer and employee in the nation. If you missed HRSentry’s webinar last week, I’d like to give you a synopsis of some of the essentials. Of course, just as it was impossible to cover everything about the FLSA via a 60 minute webinar, it’s impossible to cover everything about that webinar here. But we’ll list a few items to help you “know what you don’t know” so that you can check further to make sure you’re in compliance:
The minimum wage is $7.25 per hour but if your state’s minimum wage is higher, the law is explicit that you need to pay the higher wage.
Be sure to analyze every position in your organization regarding its Exempt or Nonexempt status. HRSentry, by the way, helps you do that and create legally compliant job descriptions that document the proper exemption through it’s Job Descriptions Made Simple tool which links to the US Department of Labor’s fact sheets.
Familiarize yourself with the term, “regular rate of pay”, as outlined by the FLSA. This rate may or may not coincide with an employee’s hourly rate. There may be extra payments (e.g. nondiscretionary bonuses, sales commissions, piece work, etc.) which must be included when you calculate the overtime premium of 1.5 times the employee’s regular rate of pay.
Familiarize yourself with what must be included in an employee’s number of “hours worked.” Often you must include: training time, travel time that coincides with the employee’s work hours (even if the travel occurs during days when the employee would not normally work, such as a weekend for a Monday through Friday employee,) breaks of less than 20 minutes, meal times of less than 30 minutes, waiting time, time for “donning and doffing” of clothing and safety equipment, certain “on call” time and more. Perhaps most important to note: you must pay for all time worked, even if it has not been authorized and you have a policy requiring pre-authorization. You may, of course, discipline an employee who has violated a policy; however, if the time has been worked, you must pay for it.
You must provide break times for a nursing mother whenever she needs to express breast milk for her child up to the child’s first birthday. You also must provide a private place for her to do so that is not a bathroom. It’s interesting to note that Exempt employees are not covered by this protection. But I think it’s well worth it to treat all nursing mothers the same.
There’s always more to learn about the Fair Labor Standards Act and we’ll continue to provide you with tips and information. There’s also lots of great information on the US Department of Labor’s website as well as through HRSentry’s FLSA Kit, found under the HR Topic Modules link within its HR Resources.
