Independent Contractor? Misclassification is not worth the Financial Risk

Small businesses have always had to maintain lean personnel costs. Depending more on part time workers is an effective way of controlling costs. The use of temporary or leased employees is on the rise and regulators are increasingly suspicious that these arrangements may be bad-faith tax and/or benefit avoidance tactics.
In its last comprehensive misclassification study, the Internal Revenue Service estimated that 15% of employers misclassified 3.4 million workers as independent contractors resulting in an estimated tax loss of $1.6 billion in Social Security tax, unemployment tax, and income tax. A preliminary analysis conducted in 2006 found that under-reporting attributed to misclassification is markedly higher than the $1.6 billion estimate.

Contractor

What does it all mean? Make sure you are classifying independent contractors correctly! Since employment relationships produce more taxes and state revenues so expect a renewed focus on independent contractor designations. August 2009, the US Government Accountability Office submitted a report to Congressional Requestors, that there would be improved coordination, outreach, and targeting to ensure better detection and prevention of misclassification.

Common Law Test for Employment
Under the “common law” test a worker is an employee if the purchaser of that worker’s service has the right to direct or control the worker, both as to the final results and as to the details of when, where, and how the work is done. Control need not actually be exercised in order to create an employment relationship; rather, if the service recipient has the right to control, an employment relationship can be demonstrated. Remember the label used by the company is immaterial, when a company is audited the facts of the relationship, not its name, is what really counts.

Legal Risks Associate with Misclassification
The tax liabilities are the peskiest of legal risks associated with misclassification of independent contractors.
• Federal Tax Liability – Employers are liable for income tax that should have been withheld. If an employee still pays taxes, the employer may apply for relief, however penalties and interest may still apply. Penalties equal to 100% of unpaid federal income and FICA tax can be imposed on those who willfully fail to collect and pay over taxes. Criminal penalties are also possible.
• Unemployment Insurance Tax – Responsibility for unemployment insurance taxes apply and penalties in the form of accrued interest may apply depending on the state. An IRS or state audit can be triggered by a former contractor that files for unemployment benefits when unemployment insurance was not paid.
• State Workers’ Compensation Taxes – An independent contractor relationship would not require payment of such a tax, however if there is an employment relationship shown penalties in the form of accrued interest may apply depending on the state.

Get the Relationship Right
There are 3 ways to establish and participate in independent contractor relationships:
• Don’t use an independent contractor when you really want an employee. Enter into an independent contractor relationship only when there is no desire to direct or control the service provider. If there is that desire to direct or control make sure other factors preclude the existence of an employment relationship.
• Contract with businesses not individuals. Ensure that independent contractors have established and are conducting themselves as independent businesses. For example, the presence of a business license, insurance and tax compliance are ways to tell. Let the contractor develop its own forms, administrative procedures, and invoicing systems.
• Permanent relationships with independent contractors should not exist. Avoid relationships with independent contractors that exclusively serve the company and its customers. Don’t even think about treating them like employees by allowing them to do the same work, providing training, furnishing tools, uniform and equipment.

Expect a dramatic increase of enforcement efforts as states grapple with shrinking budgets. Recognizing that the efforts to reduce misclassification of workers, has the potential to not only improve workers lives but raise billions of dollars in new revenue for cash strapped states.
EE Staff

This weekly tip and blog post is not intended for use as a source of legal advice. Seek legal counsel for these and any other personnel matters.

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