Know the risks of worker misclassification
Oct 3, 2011
With both federal and state governments strapped with rising debts and decreasing tax revenues, government compliance agencies are looking to employers who misclassify workers as independent contractors as a source of relief.
Both the 2008 and 2010 congressional sessions introduced legislation that would have required stricter documentation of worker status, increased penalties for misclassified workers, and developed cooperation between the IRS, the Department of Labor, and state agencies. Although the legislation failed to pass, it is essential that employers understand the rules of classifying workers as employees or independent contractors, and the consequences of misclassifying them.
By classifying workers as independent contractors rather than employees, employers generate labor cost savings by not having to pay unemployment insurance, workers’ compensation, payroll taxes, and health and welfare benefits.
State governments claim they have lost millions in tax revenues, workers’ compensation premiums, and unemployment compensation payments due to employers erroneously classifying employees as independent contractors rather than employees. In most cases the misclassification of an employee as an independent contractor is done for one of three reasons: (1) cost savings to the employer, (2) to keep up with competitors who are misclassifying employees as independent contractors, or (3) not understanding the law.
Since the end of 2009, Maryland’s Department of Labor has been enforcing the Workplace Fraud Act of 2009 (the Act) that affected primarily those employers in the construction and landscaping industries that use independent contractors. However, all Maryland employers need to be familiar with the Act because all employers are covered under the law for unemployment insurance purposes.
The Act creates a rebuttable presumption that all workers, including bona fide independent contractors, are employees. An employer must show that the individual is free from control and direct over the performance of the work, that the individual is customarily engaged in an independent business or occupation of the same nature as that involved in the work, and that the work performed by the individual is outside of the usual course of business of the individual.
Maryland employers, under the Act, who incorrectly classify an employee as independent contractor can receive penalties of up to $1,000 per misclassified employee and higher amounts if the employer knowingly violated the Act.
For over 70 years, since the passage of Fair Labor Standards Act of 1938, classifying workers as independent contractors vs. employees has been discussed both in the public arena and the court system. The Internal Revenue Service (“IRS”), the Department of Labor (“DOL”), and courts have issued guidance to employees for correctly classifying their workers. The IRS uses a 20-rule test detailed in IRS Revenue Ruling 87-41; the DOL uses a seven-point test, while the courts have established a widely-accepted five-part test known as the “economic reality” test.
In determining whether the person providing a service is an employee or independent contractor, the degree of control and independence the individual has is the most important factor. Employers need to consider document the answers to such questions as: Who controls what the worker does? Who controls how the worker does his or her job? How does the worker get paid? Is the worker reimbursed for expenses? Who provides the tools / supplies the worker needs to perform his or her duties? Are there written contracts or benefits typical of what employees receive?
The IRS and various states are not waiting for Congress to pass stricter legislation. In February 2010, the IRS began conducting audits focusing on employment tax issues of an estimated 6,000 large and small employers in different industries. Several states have passed laws restricting employers from classifying workers as independent contractors in certain industries, and fining those that do. Many other states have started their own employment tax audits or other initiatives designed to stop employee misclassification.
Employers have grappled with the independent contractor / employee classification issue for years. With the increased scrutiny by the IRS and state agencies during the last year, employers need to review their worker classification procedures and documentation.
While the financial benefits of employee misclassification remain, the increased scrutiny from the government – which includes the possibility of an audit, back taxes, interest, and large penalties – should prompt employers to revaluate their procedures, documentations and hiring practices.
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