Minimize Risk by Properly Classifying Independent Contractors
Does your company hire freelancers, consultants, project workers or “temps” whose earnings you report on an IRS-1099 form? If yes, you have independent contractors. In recent years, state and federal government agencies have invested heavily in ensuring that those independent contractors are properly classified as such and are not merely employees masquerading as contractors.
Why Does it Matter?
In its Fiscal Year 2013 Budget, the Obama Administration committed millions of dollars to continue its initiative to increase investigation into misclassification of employees as independent contractors. At the same time, state governments, feeling that employers are flouting employment laws and seeking to avoid payroll taxes, have prioritized enforcement of independent contractor classification laws.
Companies investigated by the government that have been found to have misclassified employees face thousands of dollars in back wages, unpaid overtime, state and federal back taxes and penalties. Investigations can be spurred by a newly unemployed independent contractor mistakenly filing for unemployment, a tax audit, or a worker complaint to the government. Due to information sharing agreements between the IRS and the Department of Labor – as well as between the federal government and several state governments – an investigation by a single agency can quickly snowball into a wide-ranging enforcement action, resulting in substantial federal and state penalties. Of course, there is also the ever present risk of civil lawsuits by disgruntled former workers who feel they have been misclassified.
Independent Contractor or Employee?
Under federal tax regulations, a worker is an independent contractor if his employer has the right to control or direct only the result of the work and not what will be done and how it will be done. The worker’s status is determined on a case by case basis, but the critical factor is how much control the employer has the right to exert over the worker. Less important are whether the employer actually exerts that control or whether the worker and employer have an Independent Contractor Agreement.
Relevant questions for an employer to ask to determine proper classification include: Will the employer control what the worker does and how he does it? (if the employer sets a worker’s hours and provides a computer and office, he is an employee); has the worker has set herself up independently as an established entity, such as an LLC? (if yes, she is an independent contractor); will the worker perform services that are at the heart of the company’s business? (if yes, she is likely an employee). Thus, if you do - or plan to - set a worker’s work hours, if you have the right to terminate the worker’s employment, if you put the worker on a salary, and if you supply the tools of the trade (including computers and mobile phones), the worker should be considered an employee and not an independent contractor.
Minimizing Risk of Improper Classification
Employers need to be thorough when determining whether a worker is an independent contractor or employee. When creating an independent contractor agreement with a prospective contractor, it is important to be precise about the expectations under the contract. It is imperative that employers be diligent about abiding by the terms of the contract. Avoid exerting excess control over the independent contractor’s employment conditions and ensure the contractor maintains his or her independence. When in doubt, consult your attorney. With regard to worker classification, an ounce of prevention will save pounds of aggravation in the future. The Employment Practices Group at Reger Rizzo & Darnall LLP has considerable experience related to independent contractor classification and associated compliance issues.