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.