Are Your Contractors Actually Employees? Are You Sure?

The misclassification of an employee as an independent contractor can have several serious consequences.  The employer may be liable for years of unpaid federal, state and local income tax withholdings and Social Security and Medicare contributions, unpaid workers’ compensation and unemployment insurance premiums, and even unpaid work-related expenses and overtime compensation. These liabilities, plus interest and penalties, can potentially be huge for businesses that make substantial use of independent contractors.  Another liability risk arises if misclassified employees who are otherwise entitled to coverage under employee benefit plans have not been provided with health, pension, and other employee benefits.  This could lead to litigation, possibly including class action litigation, brought by or on behalf of misclassified employees who were deprived of benefits to which they claim they were entitled.  Finally, the determination of whether an employer is required to provide health insurance coverage under Obamacare depends on whether the employer has over 50 full-time equivalent (FTE) employees.  If an employer does have over 50 FTE employees and does not provide heath care insurance, the employer must pay a per-month “Employer Shared Responsibility Payment” on its federal tax return beginning with the return for 2014.  While the federal government has not expressly so stated, it is reasonable to assume that independent contractors who are determined to have been misclassified employees will be added into a new calculation of the 50 FTE threshold.  In years to come, some employers may find that they are liable for retroactive  “Employer Shared Responsibility Payments”.

There are different routes to a state or federal determination that an employee has been misclassified as an independent contractor.  One way in which regulatory agencies discover independent contractor misclassification is through the unemployment and workers’ compensation claims process. Local claims offices are more frequently issuing initial determinations of “employee” status in benefit claims filed by workers, including individuals who have signed independent contractor agreements or are receiving compensation on a 1099 basis. As a result of the prolonged recession, many workers who previously regarded themselves as independent contractors are nonetheless applying for unemployment benefits – and more claims examiners are finding that such workers have been misclassified and are entitled to unemployment benefits as “employees.” If a business has not paid unemployment contributions to a state fund on behalf of that worker, the initial determination that the worker had been misclassified as an independent contractor, if upheld by an administrative law judge or referee, can have the same effect as an adverse audit. And once a single worker is found to have been misclassified, the business is then often charged for unpaid contributions for “all similarly situated” workers, along with costly penalties and interest.

Twenty-one states have adopted legislation designed to discourage employee misclassification, and most of these state laws include significant penalties. Eighteen other states have proposed bills intended to limit the use of independent contractors or make misclassification more costly.  In addition, the U.S. Department of Labor has hired several investigators to “detect and deter” companies from misclassifying employees as independent contractors and failing to properly pay overtime or afford statutory benefits to workers.   The DOL has also initiated a “Misclassification Initiative” in which it has entered into memorandums of understanding with 13 states to coordinate enforcement efforts and share information between the state and federal agencies about non‑compliant companies.

Another way the issue can be raised is through IRS Form SS-8.  Individuals paid as independent contractors or businesses may file Form SS-8 to obtain an IRS determination of their status as an employee.  If the IRS finds that the individual was misclassified as an independent contractor, it can issue an agreement that would state the individual is responsible for paying only the employee’s part of employment taxes.  This would entitle the individual to a refund, assuming the individual has paid taxes on the basis that he or she was self-employed, and the employer would then be responsible for the employer’s portion of the taxes (and possibly interest and penalties).  It is not hard to see why an independent contractor, if his or her contract was coming to an end, would file a Form SS-8 to obtain a determination of status as an employee in order to, among other things, recover the employer portion of the FICA/Medicare/Social Security tax.   If reclassified as an employee, the individual might then also seek unemployment benefits and sue the company for unpaid employment benefits.

Last but not least, the issue of employee misclassification can also arise during an IRS audit.

So when is an independent contractor actually an employee?  That question is often very difficult to answer.  Even the GAO, in a 2006 report, said, “the tests used to determine whether a worker is an independent contractor or an employee are complex, subjective, and differ from law to law.”  (GAO Report- Employment Arrangements)

Two things are clear, however. First, many state laws that address misclassification of employees as independent contractors create a presumption that an individual is an employee unless the business paying the individual establishes that he or she is not an employee.  And second, the determination of employee misclassification is often made by an administrative agency, which makes it more difficult to challenge the decision because courts often give governmental agencies wide latitude in interpreting their regulations.  With that background, court cases and state laws offer some guidance, but the issue of employee classification remains very subjective.   The U.S. Supreme Court has identified certain factors that should be considered in determining whether a worker is an employee or an independent contractor under the Fair Labor Standards Act (FLSA), which, among other things, establishes a Federal minimum wage and requires that certain employees receive overtime pay at 1-1/2 times the regular wage for hours in excess of 40 in a work week. In general, the Supreme Court held that a worker who meets the FLSA definition of employee is one who is economically dependent on the business he or she serves. In contrast, an independent contractor is one who is engaged in a business of his or her own.   Many state laws describe employment status as a situation where the hiring party has the “right to control the manner and means” by which the worker accomplishes the end product of his or her work.  While these standards are FLSA or state law specific, they do give a point of reference.  The question, then, is what specific factors will a court look at to economic dependency or employer control?    The IRS has stated that it will consider “all information that provides evidence of the degree of control and the degree of independence.”  (IRS Form 15-A- Employer’s Supplemental Tax Guide)  Here are some factors to consider:

Length of Contract.   A contract with an independent contractor typically has a fixed term or it terminates upon completion of a specified project.    An open-ended contract (or no written contract) suggests employment.   Moreover, a contract with an independent contractor, even if it has a fixed term, can suggest employment status if it is renewed many times, thereby creating a long-term relationship with expectations of an indefinite number of contract renewals in the future.

Nature of Work.  An independent contractor typically performs tasks that the company needs to have performed only at certain times or for a special reason, not tasks that are performed by employees of the company as part of the company’s core business.  Moreover, a contractor’s performance objectives are usually described in detail in a written agreement, whereas a vague scope of work, such as “responsibilities as assigned” suggests an employment contract.

Supervising Employees.  Independent contractors typically do not supervise employees.  Such supervision, whether required by the contract or de facto, would suggest employee status.

Hours worked.  Who decides what hours the individual works?  An independent contractor typically sets his or her own hours, even if paid by the hour.  In contrast, an employee must be “at work” during specified periods on specified days.

Exclusivity.  Can the individual do work for other companies?   If not, this would suggest employment, although prohibiting an independent contractor from working for competitors during the term of the contract would not be unusual if trade secrets or technology are involved.

Marketing.  If the individual is an independent contractor, then one would expect the individual to be marketing his or her services so that new work can be found to provide other sources of income when the current contract ends?  Does the individual have a website, business cards and marketing materials?  Has the individual received other requests for work and how has he or she responded?

Expenses.  Does the individual have insurance, at his or her expense, to protect the employer against errors or malfeasance?  Does he or she pay for professional training, conferences and membership in professional organizations?  Who pays for equipment such as laptops, cell phones, tablets, and storage devices that are used off the company’s premises?  An independent contractor would typically pay all or most of these expenses whereas an employee would not.

Reports.  What reports does the individual file?  An independent contractor will typically file periodic progress reports describing tasks performed or progress achieved.  Employees are not usually required to file such reports because they are more closely supervised and their accomplishments are known to their supervisor.

Other.  Can the individual engage subcontractors?  If the individual unilaterally terminates the contract before the end of the term, must the individual pay a penalty to cover the cost to the company of finding another contractor to complete the work?  If the work performed is not satisfactory to the company, must the individual do the work again without additional compensation?  Are there incentives for early completion and penalties for late completion?   Each of these questions, if answered “yes”, would be indicative of independent contractor status.

These are only some of the factors an administrative agency or court might consider and, unfortunately, there is no way to predict how many factors, and the weight given to each, will tip the balance one way or the other.  Suffice it to say that the written contract between the individual and the company is a very important part of the analysis.  If doubt exists as to whether a contract with an independent contractor will survive scrutiny, companies should contact an attorney with a view to possibly amending the contract to add provisions, or clarify existing provisions, in order to reduce the risk of reclassification of the individual as an employee.

The Corporation Secretary

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2013 in review

The WordPress.com stats helper monkeys prepared a 2013 annual report for this blog.

Here’s an excerpt:

The concert hall at the Sydney Opera House holds 2,700 people. This blog was viewed about 20,000 times in 2013. If it were a concert at Sydney Opera House, it would take about 7 sold-out performances for that many people to see it.

Click here to see the complete report.

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The Importance of Entity Management

The link below provides access to a brief article on entity management from CT Corporation, a leading provider of registered agent and other services for legal entities.  We could not have said it better ourselves.  While the advice from CT Corporation applies to both public and private companies, it is small privately held companies that tend to neglect entity management.  It’s not important until it is, and then it is usually too late.

Entity Management

 

 

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Who We Are

Roger Wiegley, founder and CEO of The Corporation Secretary, is a corporate lawyer with over 30 years of experience.  He started The Corporation Secretary three years ago because he felt that there was a gap in both the knowledge and administration of small businesses.  Every day hundreds of new companies are formed as entrepreneurs launch new ideas.   In many cases—perhaps most cases–the founders and managers of these small business do not understand the legal issues surrounding the organization that they have created or plan to create.  Where do they turn for help?  Some seek advice from law firms.  This often proves to be a very expensive alternative.   Another source of guidance is the Internet.  This route is particularly dangerous because the advice is generally too general, too simple, too esoteric or just self-serving.  The companies that will incorporate a business for $99 do not have the resources to try to understand the circumstances of a potential buyer.  They just want the $99.  What happens after that is not their concern.  It is fair to say that many owners of start-ups, despite their original objectives, have not protected their personal assets from liability through the business organization they formed.

What have we learned in three years?  More people than we expected have come to The Corporation Secretary for the formation of business entities.   This is a service that we do not even promote on our website (www.thecorpsec.com) because there is so much competition and, to do the task properly (covering all the steps, discussing all the issues and alternatives, and providing personal service), we are more expensive than the “corporation in can” Internet services (although much less costly than a law firm).   The second thing we discovered is that our clients often need follow-on advice because state governmental agencies show up when they discover a new business in their jurisdiction–tax, labor, etc.  (It’s actually worse if they don’t show up but their requirements apply nonetheless.)  The Corporation Secretary can help with these matters because it knows the business of its clients.  And finally, we have been doing a substantial amount of Internet research for our clients to examine and describe specific laws and regulations in various states.

While The Corporation Secretary does not provide legal services, we are sometimes asked for advice that involves the practice of law.  For this we use an affiliated law firm, The Law Offices of Roger D. Wiegley (www.wiegleylaw.com).   We know that our clients want quality legal services at a reasonable cost.  With that in mind, our law firm affiliate will undertake assignments for a fixed-fee, approved by the client in advance.

 

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Our Delaware Franchise Tax is WHAT ?!?

Delaware has been preeminent as the place for businesses to incorporate since the early 1900s.  Close to a million business entities are domiciled in Delaware, including more than one-half of the corporations that make up the Fortune 500.

Why do corporations choose Delaware?  There are several reasons. First, the Delaware General Corporation Law is one of the most comprehensive, advanced and flexible corporation statutes in the nation.   Second, Delaware’s corporations court, the Court of Chancery, is highly respected because its judges are very knowledgeable and their decisions are well reasoned.  The accumulated body of Delaware court decisions provides clarity and guidance in many of the situations that might arise in the realm of corporate governance or shareholder rights.  Third, the state legislature is diligent about keeping Delaware’s corporation statute current.  And fourth, the Secretary of State’s Office is not at all bureaucratic.  Quite the contrary, it is efficient, helpful and courteous.  As one small example, Delaware was among the first states to accept corporate filings by fax.

Delaware’s large body of corporation laws, including both statutes and court cases, allows a company to avoid lawsuits through better planning.   The law is often much less clear in other states.  Moreover, most corporate attorneys are familiar with Delaware  corporation law in addition to the laws of the particular state where they are admitted to practice. A typical engagement letter from a law firm will say something like, “our practice is limited to the laws of [home state] and the Delaware General Corporation Law.”

For all these reasons, many venture capital firms are more willing to invest in Delaware corporations, and entrepreneurs want to make their new businesses attractive to venture capital firms from the outset.

What are the disadvantages of incorporating in Delaware?  There are two.  First, the Delaware annual filing fee and annual franchise tax is an added expense because most corporations (i.e., those located outside Delaware) must still register as a “foreign” corporation in the state where they are located and and pay annual fees to that state. And second, the annual franchise tax in Delaware can come as a shock if the corporation is formed without adequate planning.

The Delaware annual franchise tax is calculated as follows (this is somewhat over-simplified—the exact calculation can be found at http://corp.delaware.gov/frtaxcalc.shtml):

If the authorized shares have no par value, the franchise tax is $75 for up to 5,000 authorized shares; an additional $150 for the next 5,000 authorized shares; and an additional $75 for each additional 10,000 authorized shares above the first 10,000 authorized shares.  The maximum annual franchise tax is $180,000.

If the authorized shares have a stated par value, the corporation must calculate the “assumed par value”, which is determined by dividing total gross assets of the corporation by the total number of issued shares.  If this assumed par value is greater than the stated par value (which it almost always is), the assumed par value is multiplied by the number of authorized shares.  The result is rounded up to the nearest million, then divided by a million, and then multiplied by $350.  The minimum annual franchise tax is $350 and the maximum is $180,000.

Many entrepreneurs like to start their corporations with a huge number of authorized shares, hoping that they will need these shares for several rounds of future issuance:  founders, new employees, family and friends, angels, venture capital investors and then the IPO.  The problem is that a huge number of authorized shares, if not issued, can result in a very high annual franchise tax for a Delaware corporation, and the tax gets even higher as the gross assets of the corporation grow.  The attached spreadsheet shows the annual franchise tax for a Delaware corporation with 30 million authorized shares (page 1), 10 million authorized shares (page 2) and 1 million authorized shares (page 3), at different levels of gross assets and issued shares.

Delaware Franchise Tax Examples

The lesson here is that it can be very expensive for a Delaware corporation to authorize shares and not issue them.  In most cases it would be better to start out with a small number of authorized shares and then later amend the certificate of incorporation to increase the number of authorized shares when a new issuance is planned.

The Corporation Secretary

 

 

 

 

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Obamacare: Required Notice to Employees

Under Obamacare, employers subject to the Fair Labor Standards Act must provide a “Notice of Coverage Options” to each employee, whether full-time or part-time and regardless of whether the employer is covered by an employer health care plan.  The purpose of this Notice is to inform employees that they may obtain health insurance through their state’s Health Insurance Marketplace. With respect to employees who are current employees before October 1, 2013, employers are required to provide the notice not later than October 1, 2013.  For each new employee hired on or after October 1, 2013 the notice must be given at the time of hiring.  For 2014, the Department of Labor will consider a notice to be provided at the time of hiring if the notice is provided within 14 days of an employee’s start date.

Employers Subject to the Requirement

Generally, the Fair Labor Standards Act applies to employers that have annual sales or receipts of $500,000 or more.  More information is available through the Department of Labor Wage-and-Hour Division’s FLSA compliance tool.

Content of the Notice

The Department of Labor (“DOL”) published temporary guidance on May 8, 2013  (Technical Release 2013-02) describing the content of the required Notice.

The Notice must inform each employee of the existence of a new Marketplace as well as contact information and a description of the services provided by the Marketplace. The notice must also inform the employee that the employee may be eligible for a premium tax credit under section 36B of the Code if the employee purchases a qualified health plan through the Marketplace; and a statement informing the employee that if the employee purchases a qualified health plan through the Marketplace, the employee may lose the employer contribution (if any) to any health benefits plan offered by the employer and that all or a portion of such contribution may be excludable from income for Federal income tax purposes.

The Department of Labor proves a model Notice for employers that offer a health plan   (Model Notice With Employer Plan)  and a model Notice for employers that do not offer a health plan (Model Notice without Employer Plan).    Employers may create there own version of the Notice provided that it meets the content requirements described above.

Delivering the Notice

The notice must be provided in writing, free of charge, in a manner calculated to be understood by the average employee. It may be provided by first-class mail. Alternatively, it may be provided electronically if the requirements of the Department of Labor’s electronic disclosure safe harbor are met.  Generally, those requirements are:

  • actual receipt of transmitted information (e.g., using return-receipt or notice of undelivered electronic mail features, conducting periodic reviews or surveys to confirm receipt of the transmitted information);
  • protection of the confidentiality of personal information relating to the individual’s accounts and benefits (e.g., incorporating into the system measures designed to preclude unauthorized receipt of or access to such information by individuals other than the individual for whom the information is intended);
  • the electronically delivered documents must be prepared and furnished in a manner that is consistent with the style, format and content requirements applicable to the particular document (e.g., attaching a PDF version of a document to an email); and
  • notice must be provided to the employee, in electronic or non-electronic form, at the time a document is furnished electronically, that apprises the individual of the significance of the document when it is not otherwise reasonably evident as transmitted (e.g., the attached document describes changes in the benefits provided by your plan) and of the right to request and obtain a paper version of such document.

Typically, electronic notices would be provided via the company email system.

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Officers of a Company can be Personally Liable for the Company’s Failure to Collect or Remit Sales Taxes

Under most state tax laws, the tax authority of the state has the option to pursue collection of unpaid sales taxes against any individual who has the authority within a company for the collection and remittance of the tax.  These so called “corporate officer liability” statutes have been in existence for many years but, for the most part, were rarely enforced.  Most states have re-labeled these statutes as “responsible party” statues to make it clear that owners and others can be personally liable even if they are not officers of the company.

Generally, states use “responsible party” laws to impose personal liability on individuals only if they cannot collect from the company itself.  The most frequent cases involve insolvency or dissolution of the company before all sales taxes are paid.  With many states now experiencing revenue shortfalls, some state tax authorities are now aggressively pursuing responsible parties when they cannot collect from the company.  This issue is also more important today because the Internet has raised some difficult questions on when sales taxes must be collected for Internet sales.

A recent Tax Appeals case in New York demonstrates this problem of responsible-person liability very well.   New York Tax Law states that “every person required  to  collect any [sales] tax  imposed by this article shall be personally liable for the tax imposed, collected or required to be collected.” Thus, liability may include not only those taxes actually collected, but also those taxes the company was obligated to collect but did not.  In other words, the requirement to remit sales tax applies whether or not the tax was ever collected.  Moreover, a responsible party is anyone with a duty to act, not just the person who was assigned the responsibility to remit the taxes.

According to the New York Tax Regulations, this question of “duty to act” is to be resolved “in every case on the particular facts involved.” The regulation further states that “[g]enerally, a person who is authorized to sign a corporation’s tax returns or who is responsible for maintaining the corporate books, or who is responsible for the corporation’s management, is under a duty to act.”  A 1990 New York Tax Appeals case established that identifying the person under a duty to act requires an inquiry into “whether the individual had or could have had sufficient authority and control over the affairs of the business to be considered a responsible officer or employee.”   The following factors were found relevant in the sales and use tax area: the individual’s status as an officer, director, or shareholder; the individual’s authorization to write checks on behalf of the corporation; the individual’s knowledge of and control over the financial affairs of the corporation; the individual’s authorization to hire and fire employees; whether the individual signed tax returns for the corporation; and the individual’s economic interests in the corporation.

In the recent New York Tax Appeals case, petitioner was the CEO, a director and a shareholder of a public company. He acknowledged that he was responsible for the day-to-day management of the company but said he relied on the CFO and outside accountants to manage the financial affairs of the company. However, he had access to the company books and records and had the authority to write checks. He also had the authority to hire and fire employees. Based on these facts, he was held to be personally liable for payment of sales taxes owed by the company.

Some Practical Advice

  •        Make sure that all “trust fund” taxes (sales and use taxes and payroll withholding) are paid when due. This may seem obvious, but a business may end up with a large tax bill, including penalties, simply because it did not realize that a transaction was a taxable event.  The danger lies in a tax audit, where the tax authority may recharacterize a transaction or relationship as taxable, and this often occurs in the context of sales and use taxes or withholding taxes. For example, independent contractors may be recharacterized as employees, upon whose wages are due state and federal withholding, FICA, and FUTA.
  •        Consult with an experienced tax advisor to ensure that all relevant taxes are being collected and remitted properly.
  •       When entering into a new business venture, determine up front who will be responsible for collecting and remitting taxes. Do so in writing—in a shareholder or partnership agreement, corporate bylaws, or an employment agreement.
  •      Upon discovering a tax problem, take steps to rectify the problem in order to avoid personal liability and do so while the company is solvent.  The worst of all worlds is to ignore the problem, only to find years later that the company does not have enough money to cover past due taxes and penalties.
  • If faced with a responsible person questionnaire, give serious thought to how—and whether—to complete it. The tax department may have its eye on the statute of limitations and want to identify potential responsible parties early in the audit before any statute of limitation period expires. Once these people are identified, the department can ask for statutory waivers.  (In New York, the three-year statute of limitations for companies does not apply in the determination of the personal liability of responsible parties.)
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