The Obama Administration has been talking a lot about "fairness" these days. President Obama has identified this time in history as a "make or break moment for the middle class," and he has made clear that his intent is to "level the playing field" in America. So what does this have to do with your independent contractors?
If you have been paying attention, then you have heard a very similar sentiment coming out of the Internal Revenue Service ("IRS") and the U.S. Department of Labor ("DOL"). These agencies have made clear over and over again that they are looking to generate revenue – both for the Government and for U.S. workers – and that they intend to level the playing field for employers. The Government needs to find ways to raise taxes without raising taxes. One of the key ways they have chosen to do this is to come after your misclassified independent contractors.
The misclassification issue has been discussed many times over the last few years. So why do we need to discuss this again now? Because the IRS and the DOL are renewing their efforts with greater zeal, and legislative efforts to raise the stakes for employers are gaining traction. Thus, as we approach the new year, it is worthwhile to take time to consider what has happened in the past year and what we can expect in 2012. Before doing so, however, let's quickly summarize the issue.
Why All The Fuss About Independent Contractors?
Employers have been benefiting from the use of independent contractors for years. The financial advantages of using independent contractors (as opposed to traditional employees) are unmistakable. Under the federal wage and hour laws, many employees are subject to overtime and minimum wage requirements, while independent contractors are eligible for neither. Further, unlike employees, independent contractors generally are not eligible for employee benefits such as vacation, health insurance, and retirement plans. Businesses also do not have to make FICA contributions; withhold income taxes; worry about workers' compensation; or pay unemployment insurance, social security, or Medicare taxes. Finally, independent contractors generally are not covered by employment discrimination statutes and are not eligible for leave under the Family and Medical Leave Act.
For these reasons, many businesses are quick to classify a worker as an independent contractor. Workers may agree to this classification for a variety of reasons. Many like the idea that they are not an employee, but are in business for themselves. Many prefer to avoid the tax withholdings that come with traditional employment. Others just need the work and are willing to accept whatever terms are proposed.
The problem many businesses experience, however, is that they think it is enough for the worker to agree to be an independent contractor. In actuality, while such an agreement is helpful, it is in no way sufficient to establish an independent contractor relationship. On the contrary, whether a worker qualifies as an independent contractor is a complicated issue. There is no single, uniform test, let alone a single factor, that can be used to determine who qualifies. Indeed, the IRS and the DOL both have their own separate tests which do include common themes, but also differ significantly.
Even as the law stands today, a finding by a government agency that an employer has misclassified an employee as an independent contractor is an expensive proposition. Potential liabilities include:
- Payment of back pay and overtime compensation going back for a period of at least two years, and an equal amount of what the law refers to as "liquidated" damages;
- Payment of the full amount of the employee's income tax which should have been withheld, both the employer and the employee's portions of the FICA tax, plus penalties;
- Damages for failing to provide certain benefits made available to similarly situated employees; and,
- Liability for attorneys' fees, criminal sanctions, and other penalties against the employer and, if the employer is an entity, against its corporate officers personally.
As if the current liabilities were not bad enough, Congress and state legislatures appear committed to upping the ante, and the IRS and the DOL continue to ramp up their enforcement efforts. Let's review what took place in the past year.
2011 In Review
IRS, DOL, and States Join Forces
This past September, the IRS and the DOL executed a memorandum of understanding ("MOU") intended to improve the agencies' coordination on misclassification issues. In addition, the DOL has now signed similar MOUs with 11 separate states (Colorado, Connecticut, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Missouri, Montana, Utah, and Washington). The partnerships enable the agencies to share information regarding worker misclassification and to coordinate enforcement efforts.
These MOUs arose as part of the DOL's "Misclassification Initiative," which now has its own website (www.dol.gov/whd/workers/misclassification/). The DOL has taken the position that misclassification of workers constitutes an attack on the country's middle class and the economy in general. The website states, in part: "The misclassification of employees as something other than employees, such as independent contractors, presents a serious problem for affected employees, employers, and to the entire economy….Employee misclassification also generates substantial losses to the Treasury and the Social Security and Medicare funds, as well as to state unemployment insurance and workers compensation funds.…" The DOL has committed to working together with the IRS and participating states "to reduce the incidence of misclassification" and "help reduce the tax gap." Again adopting the "fairness" angle, the DOL states that its mission is to "level the playing field for law-abiding employers…"
Employee Misclassification Prevention Act
As previously stated, the misclassification problem is not a new issue. Indeed, back in 2007, then Senator Obama sponsored the Contractor Proper Classification Act which died in the Senate the following year. Since then, several bills have been introduced, all designed to increase the risks associated with misclassifying independent contractors and to make it easier to go after businesses that do so. Most recently, on October 13, 2011, Rep. Lynn Woolsey (D-CA) reintroduced the Employee Misclassification Prevention Act ("EMPA").
The EMPA, which was introduced previously in 2010, would impose strict recordkeeping and notice requirements on all businesses. Specifically, under the EMPA, all businesses currently required to keep records of wages and hours worked for employees will be required to maintain comparable records for "non-employees" who provide labor or services. In addition, businesses will be required to provide all workers (employees and non-employees) a written notice informing them how they have been classified and directing them to a DOL website for further information about their rights. Penalties from $1,100 (for first violations) to $5,000 (for repeat or willful violations) per worker would apply for each violation of the notice or recordkeeping requirements, as well as for misclassifying any employee as a non-employee. Additionally, businesses could be liable for triple damages in cases involving willful violations of the minimum wage or overtime laws where the affected employee was misclassified as a non-employee. Finally, the new law would prohibit employers from discriminating or retaliating against workers who exercise their rights under the EMPA.
The Voluntary Classification Settlement Program
It was not all bad news for employers in 2011. In September, the IRS announced a new program entitled the Voluntary Classification Settlement Program ("VCSP"). The purpose of the VCSP is to help employers reclassify non-employee workers as employees without being required to pay substantial back taxes. To qualify, the employer must identify those workers being reclassified and agree to treat them prospectively as employees for all future tax periods. The employer also must enter into an appropriate settlement agreement with the IRS and pay a small portion of the employment tax which otherwise would have been due (specifically, 10% of the amount of employment taxes calculated using the reduced rates of Internal Revenue Code Section 3509(a) for the compensation paid to the reclassified employees for the most recent tax year). The employer will not be liable for any interest or penalties on the payment, and will not be audited for employment tax purposes for prior years with respect to the classification of the identified workers.
Not all businesses are eligible to participate in the VCSP. A participating business must not be under a current audit by the IRS, the DOL, or any state agency regarding classification of the workers in question. Additionally, the business must have consistently treated the workers being reclassified as non-employees during the prior three years, including having filed any required Form 1099s.
By coming forward voluntarily, employers will avoid further employment taxes for the reclassified employees during the period covered by the settlement agreement. However, there is a potential trap for employers. Although the IRS has stated that it will not share information about VCSP applications with the DOL (despite its recent MOU) or with any state agencies, the IRS settlement agreement will not resolve potential employment-related claims (e.g., for minimum wage or overtime violations), which may come from the DOL or from a reclassified employee. In addition, the settlement agreement will not prohibit a state agency from coming after its share of employment taxes.
Employers understandably may wonder if all this talk by the IRS and the DOL is leading to actual action. The answer appears to be "yes." In 2010, the Wage and Hour Division of the DOL collected nearly $4 million in back wages for minimum wage and overtime violations that were a result of employees being misclassified as independent contractors. In 2011, that number has risen to $5 million, reflecting an increase of 500% from fiscal year 2008, when the Division collected approximately $1.3 million. With a full year of the IRS and the DOL working together, legislative action on the horizon, and the full support of the Obama Administration, we can expect this number to continue to rise. With that in mind, if you have not already evaluated your independent contractor relationships, now is the time to do so.
© 2011, Ward and Smith, P.A.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.