MMC, Inc. HR Tip March 2010 Volume 2 Issue 3

IRS Crackdown on Classification

Written by: Michele O'Donnell, M.S. Human Resources Management

Independent Contractor or Employee?

The answer to this question is one that is being looked at very closely by both federal and state governmental agencies. If answered incorrectly by an employer, the door could be opened to serious consequences. Over the past year, various federal and state agencies have indicated they will begin to more seriously investigate employee classification issues - with emphasis on workers misclassified as independent contractors instead of employees. The Internal Revenue Service (IRS) began intensive audits of 6,000 randomly selected employers in February of this year. The key objective of the IRS audits is to determine whether employers are attempting to save on taxes and legal risks by incorrectly classifying workers as Independent Contractors and recover any lost revenue.

The U.S. Government Accountability Office (GAO) recently reported that employee misclassification “could be a significant problem with adverse consequences,” as it reduces the amount of tax revenues that flow into federal and state governments. This is because Independent Contractors are not covered by most employment laws (as they are not considered “employees”) and payroll taxes are not assessed against monies paid to them. The Federal government estimates that between 1996 and 2004 it lost an estimated $34.7 billion in tax revenue due to the misclassifications of Independent Contractors. In 1984, the IRS did a study and estimated about 15% of employers nationally misclassified a total of 3.4 million workers as Independent Contractors. A 2005 Bureau of Labor Statistics (BLS) report indicated approximately 10.3 million workers or 7.4% of the workforce were classified as Independent Contractors.

The IRS provides guidance on how to determine if a worker is truly an Independent Contractor and this standard is high. Please follow this link for IRS Guidance on the proper classification of workers. There are legitimate Independent Contractors currently working; however, there are a great many workers that are, in fact, misclassified employees. The penalties for this misclassification can be severe. It is important to note that even if a worker asks to be an Independent Contractor or agrees to this classification in writing, they are not an Independent Contractor unless they meet the criteria established by the IRS.

The Taxpayer Responsibility, Accountability, and Consistency Act of 2009 was introduced in Congress last year and it allows individuals classified as independent contractors to petition the IRS to determine their correct classification. As it stands today, an employer or a worker can ask for an IRS analysis utilizing IRS Form 88: Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. If passed, the current proposed legislation would expose employers with independent contractors to an increased chance of investigation and more severe monetary penalties. According to Mark Schoeff, Jr., the Department of Labor (DOL) is allocating $25 million (in their proposed budget for fiscal year 2011) in a joint initiative with the Department of the Treasury to specifically investigate and target employers that misclassify workers.

It is important to also note that many states have passed laws aimed directly at the misclassification issue. Currently, Illinois, Colorado, Maryland, Massachusetts, New Jersey and New Mexico have passed laws that target the construction industry, as it has been an industry rife with misclassification issues. An Illinois construction contractor received a fine of $328,500 in December 2009 for incorrectly classifying 18 workers as independent contractors instead of employees. Other states have enacted task forces specifically created to find instances of misclassification.

Experts agree that the best defense against misclassification is for companies to look beyond independent contractor work agreements, analyze the actual work that is being done by the worker, and perform continual rigorous internal evaluations of pay practices. As the old saying goes “If it walks like a duck, quacks like a duck, and looks like a duck, it must be a duck.” If a worker classified as an independent contractor looks like an employee, works like an employee, and is under the same controls as an employee, the more likely they will be determined to be an employee. The more you treat a worker like an employee, the more they will be considered an employee, especially in this era of heightened scrutiny. Failure to classify workers correctly can be quite costly. In addition to assessment of payroll taxes and penalties, employers may face insurance considerations such as workers compensation premiums. The misclassification of workers also opens the door to private causes of action from workers such as back pay, overtime pay, lost benefits and liquidated damages.

Articles you might also be interested in:

• California Worker Classification
• Exempt v.s. Non-Exempt: Common Misclassification Mistakes

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