Are Your Contractors Actually Misclassified Employees? The IRS Wonders.

Federal and state tax authorities and labor officials are taking a renewed interest in the misclassification of employees as independent contractors.  Often, the question arises in the context of contractors performing construction work but the very same issues apply to consultants and other service providers.

It is not uncommon for companies, especially small companies, to retain individuals as consultants, rather than hire them as employees, because the amount and duration of work is hard to predict or because their remuneration is based on equity or revenue participation.   These arrangements should be reviewed with care because misclassification of employees can be very costly to the employer.

If the IRS or state tax authority finds that a consultant or contractor should have been classified as an employee and a retroactive reclassification is imposed, the company can be liable for unpaid income taxes as well as Social Security, Medicare and unemployment taxes that were not withheld during the period in question, plus penalties and interest.  Officers of the company can even be held personally liable for some of these payments.

In addition, failure to provide workers’ compensation insurance under state law can result in an assessment for unpaid premiums, plus penalties on a per-day or per-worker basis, depending on the state.  Some states have laws that allow a workers’ compensation board or agency to issue a “stop work order”,  which prevents a company from engaging in business operations until it pays all penalties and brings itself into compliance.

In this era of state and federal budget deficits, the search for misclassified employees has become a growing trend.  President Obama’s budget for 2011 includes a $25 million “Misclassification Initiative” that calls for cooperation and information sharing between the Labor Department and the Department of the Treasury to address this issue (and, not coincidentally, raise revenue).

Adding to the above, in some circumstances misclassification can result in lawsuits against the company by misclassified employees under the Fair Labor Standards Act for failure to pay minimum wages and overtime, which can result in payment of the amounts claimed, plus liquidated damages in an equal amount, plus attorney’s fees.  Individuals who should have been classified as employees might also sue for employment benefits they did not receive, such as pension contributions or health care premiums, and expenses for which they were not reimbursed.

There are several tests to determine whether an individual is an independent contractor or an employee.

The IRS uses a 20-factor test to determine employment status.  While there is no precise number of factors that tip the balance one way or the other, and there are no “weights” assigned to individual factors, the more factors in the “employee” column, the more likely it is that the contractor will be reclassified.   Paraphrasing, the IRS finds that the following factors are indicative of an employer-employee relationship:

  1. training provided by the company;
  2. close supervision, i.e., instructions from the company on how tasks should be performed;
  3. providing services as a contractor that are similar to or integrated with the tasks performed by employees;
  4. clerical and administrative support provided by the company;
  5. prohibiting delegation or subcontracting by the contractor;
  6. a long-term relationship;
  7. fixed hours;
  8. requiring the individual to work full-time for the company;
  9. requiring the individual to work only on the company’s premises;
  10. requiring the individual to perform tasks in a certain order;
  11. requiring the individual to provide reports to management;
  12. payment by the hour, day or month or on a commission basis;
  13. payment by the company of all expenses incurred by the individual;
  14. tools and equipment provided by the company;
  15. little or no investment by the individual in his or her “business”;
  16. little or no risk on the part of the individual with respect to profit or loss;
  17. working exclusively for the company;
  18. absence of advertising or other public promotion of the individual’s services;
  19. right of the company to terminate the individual “at will”; and
  20. right of the individual to terminate the relationship without penalty.

This 20-factor test is based on decisions of courts over the years.  The case law is not so detailed, of course.   Instead, the emphasis of the courts has been on the nature of the individual’s business.  Has he or she worked for others, conducted marketing and acted the way an independent business person would be expected to act?  Or has the individual been devoted to one company with no expectations of other work?

There is a separate test under the Fair Labor Standards Act to determine if a misclassified employee is entitled to minimum wage and overtime.   Five factors are considered, with the focus being on the question of whether the individual is economically dependent on one company by choice.  The five factors are (1) the degree of control exercised by the company, (2) the extent of the relative investments by the individual and the company, (3) the degree to which the individual’s opportunity for profit or loss is determined by the company, (4) the skill and initiative required in performing the job, and (5) the permanency of the parties’ relationship.

It is possible that different results would be reached under the different tests above on the same set of facts.

Minimizing the risk

As in all matters of tax and regulatory compliance, it is best to be cautious, particularly now in this era of whistleblowing statutes and enhanced enforcement.  Caution means more than adding a clause to a contract.  It is fine to say that it is the intent of the parties that the individual providing services will be deemed an independent contractor, not an employee, but that statement does not count for much if the IRS or Labor Department concludes that the real intent of the employer was to avoid taxes or labor regulations or the administrative burdens associated with either.

Demonstrating the contractor’s independence is not entirely a matter of the actions taken by the company receiving services, even though the company is most at risk.  Indeed, the extent to which the company controls all the indices of the arrangement, such as imposing new contract wording on the “contractor” as a precautionary measure, the more difficult it will be to argue that this is not an employer-employee relationship.

If an individual wants to be an independent contractor, either because he or she wants the freedom associated with independence or because permanent employment is not available, it would be a good idea to offer prospective clients an arrangement that will help the client avoid tax and regulatory scrutiny.   For example, the independent contractor should consider forming a corporation or a single-member limited liability company and offering services through that legal entity.   This defuses the employer-employee issues and it also provides a benefit to the contractor, who, without such an entity, is exposed to personal liability if the recipient of the services later claims that the contractor acted negligently or breached the contract.    It would be even better if the contractor had a website, business cards and a business bank account, all of which are relatively inexpensive.

In the contract describing the arrangement between the service provider and the company, a few clauses are of particular important in the context of “employee vs. independent contractor”.  For example, the contract should not require the contractor to work exclusively for the company.  Quite the contrary, it would be a good idea to expressly state that the arrangement is non-exclusive, although there may be restrictions preventing the contractor from working for the company’s competitors while in possession of the company’s trade secrets.

In the IRS 20-factor test, payment by the hour, week or month can be indicative of an employer-employee relationship.   This view is open to question.  Most companies hire lawyers, accountants, consultants and other service providers on an hourly basis, and many companies outsource services such as IT, data storage and financial management for a monthly fee.  Of course, most of these service providers are organization, not individuals, so the issue of employment status does not arise, but the point remains that it is hard to draw conclusions about the status of a service provider from the fact that the service provider’s compensation is based on units of time.  More important is the nature of the services and the autonomy of the contractor in providing those services.  The issue of “control” probably has more weight than the list of 20 factors suggests.  There is no need to emphasize in the contract that the contractor will work under the close control of a named company employee.   Every independent service provider knows that clients can be demanding and even controlling, even in the absence of such provisions in the contract.  Inserting “control” language adds little but it might indicate to the IRS that there is an employee-employer relationship.

Similarly, the arrangement should not require the contractor to work “full time”.  If a contractor is paid by the hour or upon meeting project milestones, the amount of work and the time available will dictate the commitment needed from the contractor.  Why raise a red flag for the IRS or labor officials by using words like “full time”?

Finally, the termination provisions in a contract are important and relevant to the 20-factor test.  Apart from termination based on contract default or insolvency of the other party, it would not be customary to see a unilateral right of termination without advance notice in a contract with between a company and an independent service provider  (excluding professional services).  The company needs notice, perhaps 60 or 90 days, to find a replacement for the terminating service provider.  Conversely, one would expect to see a provision granting the service provider a chance to complete unfinished tasks or a payment for transition services or a termination fee.

Of course, every situation is different and contract provisions must make commercial sense in the relevant circumstances.  The point, however, is that an agreement for services from a non-employee, if not thoughtfully drafted, can be a damning piece of evidence in the eyes of tax or labor officials, particularly if the service provider is acting in his or her individual capacity.

The Corporation Secretary

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