The Misclassification of Independent Contractors: A Costly Mistake

Over 10.3 million workers are currently classified as Independent Contractors. Recent studies indicate that nearly half of the individuals currently working as independent contractors are misclassified and are actually, in the eyes of the law, employees.

Over the past few years, the misclassification of independent contractors has been brought to light, not only at the federal level, but at the state level as well. Willful and accidental misclassification of workers as independent contractors reduces the amount of unemployment tax collected by states and the amount of workers’ compensation insurance premiums paid into state funds. Additionally, it can result in less federal income tax collection as those on independent contractor status “write off” items that would not otherwise be deductible and/or fail to file and pay federal income taxes. Many lawsuits have been initiated, and have cost companies millions of dollars in liabilities.

Liabilities and Lawsuits

With the rapid growth of independent contractors, tax authorities are now taking an aggressive stand in ensuring compliance with regulations regarding independent contractors. The General Accounting Office has estimated that unpaid taxes by the self-employed amount to a $20 billion annual tax loss. A 2008 study by four states identified over 2 million individuals who were misclassified as independent contractors. In response to this, both federal and state taxing agencies are now allocating significant resources to recover that money.

Even if there is no new legislation that imposes additional penalties and obligations on the employer related to independent contractors, current law provides significant punishment.

Motivation For Classification of Workers as Independent Contractors Due to perceived cost savings, companies have embraced the use of temporary workforces such as independent contractors. A temporary workforce can offer flexibility in workforce size, decrease contributions to employment taxes and employee benefits plans, and reduce obligations and expenses related to labor law. Individuals have embraced being classified as independent contractors for a number of reasons including a wish to write off expenses that would otherwise not be deductible, the impression that they have more flexibility and sometimes the fairly routine higher “wage” paid to independent contractors by companies.

As more companies have chosen to move some of their workload to independent contractors, it is important for hiring managers and workers to gain an understanding of the legal distinction between employees and contractors and the potential risks involved in using 1099 independent contractors.

Characteristics of an Employee

Employees devote substantially all of their work time to one employer. They rely on the employer for work direction, are paid on an hourly or salary basis, are paid for any expenses incurred out of pocket on behalf of their employment and get their training from the employer. An employee cannot lose money by being employed.

Characteristics of an Independent Contractor

An independent contractor would not normally devote their full time efforts to one employer. They should not be paid on an hourly or salary basis, but instead should be paid on a project basis. Independent contractors should own their own business, be able to provide proof of such ownership such as by providing a Federal Identification Number and as an owner, be in a position to “lose” money by providing their services to a company. That is, they should not be reimbursed for expenses, should not be provided training to do the job, and should be under a contractual relationship with a company that includes a recitation that they are responsible for their own taxes, workers’ compensation and profitability. These 1099 independent contractors should not receive company benefits (medical, dental, vacation, pension, etc.), and should be entirely self-directed.

The IRS uses a 20-point test to determine if a person can be classified as an independent contractor. They look at the relationship of the person to the company using the points above to make the determination. Various state agencies use similar criteria to determine if a relationship between a worker and a company can pass muster as an independent contractor.

Unintentional Misclassification

Unintentionally misclassifying an employee (and the employer filed a Form 1099) limits an employer’s liability for income taxes to 1.5% of the employee’s wages. The employer’s liability for FICA taxes that should have been paid by the employee would be limited to 20% of that amount. Unfortunately, the employer would have no rights to recover from the employee what is due to the IRS. If an employer has not filed any information returns, such as the Form 1099, that were required, the percentage amounts are doubled. The employer must pay 3% for federal withholding and 40% of the employee’s portion of FICA in addition to the employer’s share of FICA. Additionally, the employer would still be liable for its share of FICA and unemployment taxes. Interest and penalties could be assessed by the IRS, but only on the amount of the employer’s liability. The employer’s liability includes the percentage of tax that should have been withheld. For example, interest for failure to collect FICA would be based on the employer’s share of FICA plus the 20% of the tax that should have been withheld from the employee.

Intentional Misclassification

Intentionally misclassifying an employee could result in the following employer liabilities – The full amount of income tax that should have been withheld (with an adjustment if the employee has paid or does pay part of the tax) – The full amount of both the employer and employee share for FICA (but might receive an offset if the employee paid FICA self-employment taxes) – Interest and penalties, computed on far larger amounts than in the case of an unintentional misclassification. As many organizations have already discovered, the cost of misclassifying workers can be staggering. These organizations include such companies as Microsoft, which paid $97 million to settle a suit that began as the result of an IRS audit of its independent contractors and Time Warner, which recently settled a suit with the Department of Labor. In 2008, UPS agreed to a $27 million settlement with a group of 203 workers they had misclassified as independent contractors. Notably, $12.5 million of the settlement went for attorney’s costs and other fees, so it is certain that attorneys will find this a fruitful area to seek class actions on behalf of individuals.

Protecting Your Company

The definition of who is an independent contractor can vary not only between different states but also by different state agencies within the same state. And, remember, the IRS generally assumes a worker is an employee unless companies can prove they are not.

Given the magnitude of the adverse consequences that can be linked to misclassification of workers, a compliance system is vital, especially in organizations with a large workforce. Some companies try to protect themselves with written contracts claiming the contractor’s independence from the company. In addition, as important as it is to have this contract in place, companies should not make the mistake of solely relying on this. Regardless of what is written in the contract, the IRS and state tax authorities will make companies prove that their 1099 wage earners are truly independent.

A good compliance system should include a method of internally auditing the proper classification of all potential independent contractors and preparing and maintaining a file documentation system for all independent contractors, who are determined to be truly “independent.” It is imperative that the arrangements with those workers be set up properly, or the company will be at risk. If it is determined that some arrangements are misclassified, it is important to quickly change the relationship to employee to limit the liabilities that are associated with misclassification.

Other compliance measures could include the IRS 20 Point Control Test. In the IRS Control Test, a company must examine the relationship between the worker and the business. All evidence of control and independence in this relationship should be considered. The facts that provide this evidence fall into three categories: behavioral control, financial control, and the type of relationship itself.

It has become a standard practice in the new economy that when the head count goes down, the temporary worker count goes up. Used wisely, these workers can be an integral part of a business plan.

To help ensure that your company is among those that are prepared, educate your internal workforce on the laws, install a compliance system that works and execute it appropriately. Alternatively, a company can seek guidance from an expert that understands FLSA or other employment classification guidelines. But with bills such as the Employee Misclassification Prevention Act, and others that will certainly be introduced and pushed through, using these types of workers can also prove to be a nightmare if a company is ill prepared.