Employee misclassification is on the upswing, with both the Internal Revenue Service and state governments taking steps to remedy the situation.
The practice, in which the employer labels the worker as an independent contractor, rather than an employee, allows employers to avoid paying unemployment, Social Security and other taxes, and to avoid paying the minimum wage, vacation time and other benefits.
In addition to the IRS and states cracking down on the practice as a means to enhance their revenue stream, private civil actions are beginning to arise, according to Jeffrey Davine, a partner with Mitchell Silberberg & Knupp. “Employers need to be very aware of how they classify employees, as potential enforcement could put a company out of business,” he said. “If a business misclassifies a worker and the government ultimately finds they should have been an employee, in theory, the business is responsible for paying all taxes they should have withheld, plus the misclassified employee’s share, plus interest and penalties. Multiply that by several employees and several years, and a business could be looking at a devastating tax liability.”
In Alexander v. FedEx Ground Package System Inc., the drivers brought a civil case against FedEx so that they could be reclassified from independent contractors to employees. “The case was brought as a private civil case in a number of states,” he explained. “A trial court in California came out in favor of FedEx. The Ninth Circuit revered. It said they were employees because FedEx exercised a significant amount of control over how they operated as drivers. The court said they were able to dictate the manner and means of how these drivers do their work. In addition to giving these drivers benefits, there are tax implications to the decision. Although the case was a civil action and was not brought by the government, you have to think the IRS and California will be knocking on the FedEx door pretty soon.”
In another private civil case, a number of franchisees have sued Griswold International LLC, claiming that the company bilked them out of more than $3 million in franchise start-up fees by promising a unique independent contractor model for home caregivers that was in fact illegal in many states. The lawsuit is currently before the district court for the Northern District of California.
“The FedEx case was decided under California law, not federal law,” observed Davine. “Having said that, the factors that California and the IRS look at in making a determination are pretty similar. In fact, I’ve never had a case where someone was an independent contractor for federal but not for California purposes. You’re not likely to have someone in a different category in these cases. The vast majority of states are similar to the federal and state analyses, so FedEx has some definite exposure in most or all of the states, assuming they’re treating their workers the same in all the states in which they operate.”
THE LURE OF MISCLASSIFICATION ...
There are numerous reasons to want to classify a worker as an independent contractor, according to Nick Woodfield, principal in The Employment Law Group.
“In order for the [Fair Labor Standards Act] minimum wage and overtime provisions to apply to a worker, the worker must be an employee of the employer, meaning that an employment relationship must exist between the worker and the employer,” he explained. “Workers who are economically dependent on the business of the employer, regardless of the skill level, are considered to be employees, and most workers are employees. On the other hand, independent contractors are workers with economic independence who are in business for themselves.”
These are some of the costs that employers attempt to avoid in classifying workers as
- Paying minimum wages;
- Paying overtime;
- Paying payroll taxes;
- Paying worker’s compensation;
- Paying unemployment;
- Paying Social Security;
- Offering or subsidizing employee
- Offering paid leave;
- Including employees in 401(k) plans; and,
Offering Federal Family and Medical Leave Act unpaid leave.
“By classifying workers as independent contractors, the employer gets out of having to withhold and pay over to the government, and also gets out of having to pay its own share to the government, so there’s a lot of incentives for companies to do this,” said Davine. “The problem is if you get caught, you can be in big trouble.”
And misclassification of workers can not only mean that your client is liable for back payroll taxes — it can also generate professional liability claims against the accountant.
AND THE PRICE
“Many times, accountants are not familiar with the independent contractor/employee distinction, and the IRS or the Department of Labor or Workers Compensation Board comes in and says theyre employees,
not independent contractors,” said John Raspante, senior vice president and director of risk management for liability insurance agency NAPLIA.
“The rules are complex, and subject to multiple review,” he said. “The IRS is very successful in these types of examinations. It’s very common for them to reclassify independent contractors to employees, and the claim that arises can be very material.”
The employee-independent contractor distinction goes back to common law. The IRS has traditionally used 20 common law factors in making its determination. “They condensed those 20 factors into three broad categories,” said Davine. “These are behavioral control, financial control, and the relationship of the parties. They still use the 20 characteristics, but they’ve repackaged them into the three categories.”
“The whole substance of the test is to look at the degree of control by the employer and independence of the worker,” said Timothy Todd, CPA, Esq., a professor at Liberty University School of Law. “So, for example, the IRS considers who controls what the worker does, who pays for expenses, are there written contracts, how long will the relationship last, and how critical is the work performed to the business? It’s a very fact-sensitive determination, and at the margins the answer may not be clear.”
“It may be prudent to file Form SS-8, which allows the IRS to review the facts and do the determination,” said Todd. “If the employer is going to change the classification from independent contractor to employee for future periods, it should look into the Voluntary Classification Settlement Program.”
The VCSP provides an opportunity for taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes.
A GOOD DEFENSE
The distinction as to whether an individual is an employee or independent contractor is crucial in the application of the Affordable Care Act rules, since a non-employee may be excluded, according to Knoxville, Tenn., CPA Edward Gee.
“For several years, the Department of Labor and the IRS and a number of states have had an information-sharing agreement,” he added. “When one of them audits a business on this issue, they share results with the other two. When you settle with one of those agencies you might mistakenly assume that that’s the end of the matter. In reality, it’s just beginning. There are two other wars to fight.”
Florida signed a memorandum of understanding on Jan. 13, 2015, bringing to 16 the number of states that have such understandings in place.
There are defenses an employer may use, according to Gee. “Code Section 3508 is basically the direct seller/real estate salesperson defense. If you meet the requirements, that’s a defense.”
In other situations, Section 530 of the Revenue Act of 1978, which was never added to the Tax Code, provides a “bullet-proof defense,” according to Gee.
To qualify under Section 530, the employer must meet all three of the following requirements: There must be a reasonable basis for not treating the workers as employees; the employer must have treated the workers, and any similar workers, as independent contractors; and the employer must have filed all required federal tax returns, including information returns, consistent with its treatment of each worker as not being employees. For example, if a worker was paid $600 or more, the employer must have filed Form 1099-MISC for the worker.
In order to prove reasonable basis, IRS Pub. 1976 states that the employer can show that “you relied on some other reasonable basis. For example, you relied on the advice of a business lawyer or accountant who knew the facts about your business.”
Gee has built his practice over the past 20 years by providing just such written advice, and together with an attorney has won cases in 30 states defending employers from misclassification charges. “We persuade businesses to actually buy or get a written professional opinion,” he said. “It’s pretty expensive, but the ones who do have an absolute defense.”
“It’s usually a two- or three-day deal,” he said. “To use an old country boy expression, we like to walk on it and plow it.’ It involves an onsite visit for several days, so we can see what the business is like on a day-to-day basis, before we provide the opinion.” AT