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.
Previously, we discussed the importance of classifying your workers properly, whether independent contractors or employees. Greater attention is being paid by the IRS, as well as a number of states, as to whether employers are misclassifying their workers; at the same time, the IRS has created the Voluntary Classification Settlement Program (VCSP) to allow employers to come into compliance relatively painlessly. Here’s the gist of how it works:
Under the VCSP, an employer that wants to reclassify one or more workers as employees going forward must complete an application form (Form 8952) 60 days in advance of the date it wishes to make the change. Note that, to be eligible, the employer must have consistently treated the workers in question as non-employees and must have filed all required Forms 1099 for the workers for the previous three years. Additionally, the employer must not be under current IRS audit by the IRS nor can it be under audit by the U.S. Department of Labor (DOL) or a state agency regarding the classification of such workers.
If accepted into the program, the employer:
will pay 10% of the amount of employment taxes calculated under the reduced rates of section 3509(a) of the Internal Revenue Code (IRC) for the compensation that was paid to the worker(s) for the most recent tax year;
will not be liable for any interest and penalties on the payment;
will not be audited for employment tax purposes for prior years with respect to the worker classification of the worker(s.)
Note that the IRS indicates that completing Form 8952 does not trigger an audit even if you are not accepted into the VCSP. You might, of course, be audited for other reasons but should not fear that completing the application will increase your chances. (See the IRS web site for additional FAQs.) Who needs the worry of failing an IRS or other worker classification audit? The VCSP is an excellent opportunity for employers wishing to come into compliance going forward and allay those fears.
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.
The Congressional “super committee” failed to reach a deal last week so we still don’t know whether the employee contribution to social security of 4.2%, initiated in 2011, will hold beyond year end or whether it will revert to 6.2% come January 1st. Year end is always crunch time for payroll and human resources departments so that uncertainty just adds another item to the list you need to keep track of.
You’re probably already in the midst of myriad benefits and payroll changes and will soon be engaged in year end wrap up, preparing for numerous payroll entries in the new year and the testing of and preparation for W-2s. On top of that, the upcoming holiday season may alter payroll, direct deposit and tax payment deadlines. You can’t control everything, of course, but when you anticipate and deal with as much upfront as you can, you’ll have that much less stress throughout the year end process. For example, one of the best things you can do at the beginning of the calendar year is set up payroll fields that have annual dollar limits with pre-set cutoff amounts so you’ll never have to worry about refunding overpayments. Establishing payroll and HR checklists goes a long way to help you stay on task; if you need help starting a checklist, subscribers to HRSentry can access a helpful list by entering “year end” in the search box from the home page.
In that anticipatory vein, let your employees know what to expect as well. The more they understand about their benefits, taxation and other items that affect them, the happier they’ll be and the less you’ll have to deal with complaints and disappointed staff members. Here are a few tips to help your employees:
Remind folks of remaining paid holidays for the rest of this year as well as holidays for the coming year so they and their managers can plan ahead. If you have a “use it or lose it” vacation policy, remind employees how much they have left to help them avoid disappointment.
If your employees receive taxable benefits, let them know upfront that they will be taxed so there are no surprises. Remember that cash and cash equivalents such as gift cards are always taxable. And if you provide benefits such as term life insurance greater than $50,000, adoption benefits or personal use of a company car, make sure you comply with and help your employees understand any tax implications.
If your organization has health flexible spending accounts (FSA) through a Section 125 Plan, remind employees that they must use their funds by December 31 (or a later date if your plan has a grace period) or forfeit them. Also remind them of the date by which they must submit claims. Let your employees know about 2012 IRS limits on HSA contributions and retirement plan contributions so they can make adjustments in their elections. There’s excellent IRS guidance to help you find those 2012 retirement plan limits in one place. For HSA contribution limits, click here.
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.
