Worker Classification: Implications and Guidance for Business Owners

Various employers are tempted to treat workers as independent contractors instead of employees in order to escape payroll tax and benefit obligations attendant with employee status, especially when considering the implications of the new Patient Protection and Affordable Care Act.  However, the classification of “independent contract” or “employee” of a worker by an employer must be weighed against the potential liability of a successful challenge by the Internal Revenue Service (“IRS”).

Many are unfamiliar with the protracted court battle Microsoft had with the IRS over its worker classification, the conflict began back in 1990, when the IRS moved to reclassify workers to employee status who had previously been treated as independent contractors by the software giant.  In the case, Vizcaino v Microsoft Corp, (CA-9), U.S. Court of Appeals, 9th Circuit, 94-35770, 10/3/96, the Ninth Circuit held that not only were free-lance programmers and other workers converted to temporary status by Microsoft considered employees, but that the class of workers so reclassified would include even part-time workers who were never reclassified by Microsoft or treated as independent contractors.  What this meant to Microsoft was not only a hefty increase in payroll taxes, but all reclassified workers became eligible to be retroactively included in the corporation’s pension and stock purchase plans.  In December of 2007, FedEx suffered a similar blow when the IRS assessed them with more than $300 million in payroll taxes, as a result of only one year of reclassifying ground/home delivery drivers from independent contractor to employee status.  In addition, many companies cannot be certain that workers obtained from a third-party provider will not be reclassified - even if a company has remitted its employment tax liability to the employment agency, it may still be on the hook for amounts not forwarded to the IRS by the provider.

Independent contract workers often raise the specter of a challenge by all sorts of interested parties who may benefit from a reclassification.  Often, it is the independent contractors, themselves, who initiate the challenge at the behest of union organizers or the encouragement of state agencies administering disability and unemployment benefits.  Misclassification of a workers’ status may even result in a violation of the Statement of Financial Accounting Standards (“SFAS”) Section 5, which addresses reporting contingent liabilities for those with audited financial statements.

Before rushing into a classification that may turn out to be problematic, care should be taken to understand the major distinctions between independent contractors and employees.  The IRS has adopted such an unwieldy set of rules for companies and their accountants, that Congress has recently proposed the Fair Playing Field Act of 2014 in order “to issue prospective guidance clarifying the employment status of individuals for purposes of employment taxes and to prevent retroactive assessments with respect to such clarifications.”  H.R. 4503, April 28, 2014.

Taxpayers overwhelmingly have not been successful in maintaining independent contractor status for their workers when challenged by the IRS.  To maximize the likelihood that a worker will not lose his employment designation, companies may find comfort in the safe harbor provisions of Section 530 of the Revenue Act of 1978, as amended by Section 1122 of the Small Business Job Protection Act of 1996, which permits independent contractor status for workers if the company relies on:

In the event the employer cannot rely on Section 530, they may apply the 20-factor test adopted by the IRS and found in Revenue Ruling 87-41 to determine whether a worker is an employee or independent contractor.  They are:

All of these tests demonstrate how precarious worker classifications can become in the event the IRS decides it disagrees with an employer’s classification of service providers.  Not only is retroactive application of a change in worker classification possible, penalties and interest are likely also to be assessed.  Add to this the potential liability for pension and health benefits, it is apparent that careful application of the rules is imperative; and an attorney should be engaged to help business owners and managers navigate this difficult area of the law.