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.
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.
Some rare good news from the IRS was that the requirement to report the value of health insurance on W-2s, as required by the Affordable Health Care Act, was postponed from 2011 until 2012. The reprieve was granted to allow more time for employers to put necessary payroll systems and procedures in place. Many, if not most, employers won’t have to worry about it until running their 2012 W-2s in time for distribution by January 31, 2013. There is a slight catch, however, in that employees who terminate during the year technically have the right to request their W-2 form within 30 days of termination. So employers may be on the hook to supply the information much sooner. As you plan for the coming calendar year, don’t procrastinate setting up a system to capture the information as early as possible in 2012 just in case.
Reporting premiums on 2011 W-2s remains optional. It’s a good tool to help educate employees on just how much the employer is paying in health insurance premiums on their behalf. Ordinarily, such “sticker shock” doesn’t hit unless and until an employee terminates without other health coverage options and needs to consider taking on the full cost of the employer’s health coverage through COBRA. At that point they are usually quite shocked and dismayed to learn the full cost of premiums.
The health insurance value reported on W-2s is excludable from income and thus not taxable and, purportedly, that won’t change. But the reporting will help the IRS monitor compliance with coverage mandates for large employers slated for 2014. And the information will help employers know whether their health plan offerings are headed toward being considered “Cadillac plans” which are scheduled to incur excise taxes in 2018.
Last week we discussed the Fair Labor Standards Act (FLSA) requirements regarding pay issues when a workplace is closed due to inclement weather or in relation to a natural disaster. It should be noted that some states have “reporting pay” laws that require a minimum amount of pay for employees when anticipated work is cancelled. If you operate within one or more of the following jurisdictions, you should know that you may have wage obligations that go beyond the FLSA: California, Connecticut, the District of Columbia, Massachusetts, New Hampshire, New Jersey, New York, Oregon, and Rhode Island.
Reporting pay laws vary a great deal among these states so it’s important to understand the details that apply to you. For instance, some states have exceptions for certain industries, some require that employees be scheduled for a minimum number of hours in order to qualify for reporting time pay, some have requirements that apply only to minors, and there are varying requirements regarding both the number of hours that must be compensated and at what rate.
Following is an illustration of how things work in the state of Massachusetts. The reporting time pay obligation under wage law there dictates that “when an employee who is scheduled to work three or more hours reports for duty at the time set by the employer, and that employee is not provided with the expected hours of work, the employee shall be paid for at least three hours on such day at no less than the basic minimum wage.”
So let’s say a store in Massachusetts has two employees earning $10 per hour both of whom start work at 9:00 a.m. Sally is scheduled to work two hours and Sean is scheduled for four. A snow storm has arrived with fury that morning so the store closes after being in operation only an hour and the employees are sent home. Under Massachusetts law all the employees must be paid at their regular rate, in this case $10, for the one hour they actually worked. But Sally would not get paid for her additionally scheduled but not worked hour since the law only covers those scheduled for three or more hours. Sean, on the other hand, must be paid at least $8 per hour, the prevailing minimum wage, for two additional hours, totally the minimum three hours of pay required to be compensated by Massachusetts state law.
Of course union contracts, other employment contracts, or an organization’s own personnel policies may obligate an employer further as well so it’s a good idea to get up to speed on all of your wage obligations before inclement weather hits and be sure payroll staff are properly trained in advance.
The US Department of Labor (DOL) recently launched its first application (app) for smartphones to help employees keep track of work time. Of course employees have always been free to keep their own records, but it is somewhat telling that the DOL has taken this step to encourage employees to independently track hours worked, breaks taken and overtime. Their web site announcement states: “This information could prove invaluable during a Wage and Hour Division investigation when an employer has failed to maintain accurate employment records.”
The new app is available in English and Spanish, may be downloaded for free and is currently compatible with the iPhone and iPod Touch. The DOL says it will explore updates to enable similar versions for additional platforms such as Android and BlackBerry. They are also exploring adding features for such items as tips, commissions, bonuses, shift differentials and the like. So this app is destined to become more robust.
You should consider this development a fair warning with at least three takeaways:
1. Carefully analyze all job descriptions to be sure your exempt/non-exempt designations are proper and justified;
2. Make sure employees diligently follow timekeeping procedures; have them sign off that they have not worked additional time that is not being reported to the employer;
3. Be certain employees understand their position’s exempt/non-exempt designation and know to speak with their manager or human resources if they disagree.
It’s unclear what will happen in legal disputes when employer and employee records disagree. What seems to be clear is that without proper recordkeeping by the employer (such as when a position has been erroneously designated as exempt) an employee’s records will weigh in heavily to determine employer liability. So take steps to make sure your timekeeping procedures and records are as impeccable as they can possibly be.
