Employee vs. Independent Contractor: Protecting Your Company

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1 Attorney Stephen A. DiTullio DeWitt Ross & Stevens S.C. 2 E. Mifflin Street, Suite 600 Madison, WI (608)

2 Background Facts & Statistics 60% of all businesses use independent contractors (ICs). More than 10 million individuals classified as ICs are currently in the workforce (Bureau of Labor Statistics, 2010) making up 7.4% of the workforce. General definition ICs are workers who are in business for themselves, and contract to perform services for another business. Background Facts & Statistics (cont.) According to the IRS, approximately $54 billion in tax revenues are lost annually because of IC misclassification. Federal Department of Labor estimates 30% of companies misclassify workers. 2

3 Need to collect taxes will drive government to increase enforcement efforts on worker misclassification. Background Facts & Statistics (cont.) General Characteristics ICs, not the employer, control how and where the work is accomplished; ICs typically use their own equipment and supplies; Works with numerous clients, not just one company (in certain states, this is critical); Pays his/her own taxes and files government forms; Obtains his/her own benefits; Secures his/her own insurance. 3

4 Reasons for Using ICs Employee expenses (payroll taxes, health insurance, vacations, retirement benefits, and life and disability insurance) add between 20 and 45 percent to total payroll costs. Thus, an IC ever at a higher hourly rate may actually save money for the employer. ICs do not receive the same legal protections provided to employees under federal, state, and local law. As such, contracting with ICs can eliminate or reduce exposure to lawsuits and governmental claims. Reasons for Using ICs (cont.) ICs can provide a level of flexibility that employees cannot. An IC can be hired for a specific project without the business facing significant legal exposure and time consuming processes that are involved in hiring, laying off, and/or firing an employee. Using an experienced IC can save a business both the time and expense for training an employee. ICs can provide greater flexibility to allow an employer to expand and contract its workforce as needed in a less expensive manner. Avoids unionization issues. 4

5 Federal and State Law Involved It isn t just the IRS interested in this classification issue. Federal law (ERISA) on employee benefits. State law on worker s comp. State law on unemployment comp. State law on employment taxes. Other federal and state laws. Only 1 in 4 court decisions find an IC classification is appropriate. 5

6 Be prepared for more investigations DOL and IRS have hired hundreds of investigators and enforcement staff as part of its Misclassification Initiative. DOL and IRS will share information. Certain industries under the microscope e.g., hospitality, restaurants, health care, construction. 6

7 IRS announced in 2010 that it would commence extensive reviews of 6,000 companies over the next three years, and will share information it finds with DOL and state government. IRS 20 factors (from common law) Historically used by IRS 1. Instructions: worker required to comply with instructions is usually employee. 2. Training: giving a worker training usually indicates employee status. 3. Integration: integration of worker into business ops may mean employee. 4. Personal Services: if services must be rendered personally, maybe employee. 7

8 IRS 20 factors (from common law) 5. Hiring/Supervising/Paying: does the worker hire, supervise, and pay assistants. 6. Continuing Relationship: how long is the working relationship. 7. Set Hours of Work: does the worker set his/her own hours. 8. Full Time Required: must the worker devote substantially full time to the work. IRS 20 factors (from common law) 9. Working on Employer s Premises: where is the worker performing the work. 10. Order or Sequence: who determines the order or sequence of the work. 11. Oral or Written Reports: must the worker submit regular reports. 12. Payment by Hour, Week, Month: regular payment points to employee status. 8

9 IRS 20 factors (from common law) 13. Payment of Business Expenses: who pays the worker s business/traveling expenses. 14. Furnishing Tools and Materials: who provides tools and materials to worker. 15. Significant Investment: does worker have significant investment in facilities. 16. Realization of Profit/Loss: IC can generally realize a profit or loss. IRS 20 factors (from common law) 17.Working for More Than One Firm: ICs often work for multiple firms at same time. 18.Making Services Available to Public: ICs are often available to general public. 19.Right to Discharge: right to discharge worker suggests employee status. 20.Right to Terminate: if worker can end relationship without liability, may not be IC. 9

10 New IRS Test: Right to Control Test The IRS has recently created a three factor test so that the 20 factors are not mechanically applied: 1. Behavior control (facts illustrating a right to direct or control how the task is performed). Behavioral control includes instructions on when and where to work, what tools to use, where to purchase supplies or services, whether and which assistants may be utilized, whether prior approval is needed before taking action, and what routines, patterns, order, or sequence to follow. The more detailed the instructions, the more likely that an employer employee relationship exists. 2. Financial control (facts illustrating a right to direct or control how the business aspects of the job are handled). Financial control factors include whether the worker has made a significant investment in the business, whether expenses are reimbursed, the opportunity for profit or loss, the method of payment, and whether the services are available to others. 3. Relationship of the Parties (facts showing how the parties perceive their relationship). Factors relevant to the relationship of the parties include their intent as expressed in a written contract, whether a W 2 form is filed, whether the worker is incorporated, the receipt of employee benefits, the manner in which the relationship may be terminated, and the expected duration of the relationship. Safe Harbor Section 530 of the Revenue Act of 1978 creates a safe harbor permitting an employer to treat a worker as an independent contractor for employment tax purposes, regardless of the worker s actual status under the common law test, if the following 3 requirements are met: 1. consistently treated the workers (and similarly situated workers) as independent contractors; 2. complied with Form 1099 reporting requirements with respect to the tax years at issue; and 3. had a reasonable basis for treating the workers as independent contractors. 10

11 Safe Harbor What is a reasonable basis? 1. federal judicial precedent or administrative rulings including published revenue rulings, and technical advice memoranda or private letter rulings issued to that employer; 2. prior audits of the taxpayer; 3. long standing (at least 10 years) industry custom or practice in a significant segment (25%) of the industry; and 4. other reasonable bases such as reliance on advice provided by an accountant or attorney when the treatment of the workers as independent contractors began. Congress introduced a bill to eliminate the Safe Harbor. No action taken yet, but may be reintroduced. 11

12 Voluntary Classification Settlement Program (VCSP) New IRS program announced late in 2011 Would allow businesses to voluntarily reclassify workers who currently receive 1099s. Company must make a minimal payment covering past payroll tax obligations. Payment would be 10% of employment tax liability that may have been due on compensation paid during most recent tax year. Participation would eliminate interest and penalties on liability. Also would exempt companies from an employment tax audit for prior years of possible worker misclassification. If your company likely fails the 20 factor test, at least consider VCSP. BUT also consider Safe Harbor under Section

13 The Risk of Using ICs Government audits Worker s Comp Division DWD Unemployment Comp Division DWD Internal Revenue Service or DOR EEOC Department of Labor The Risk of Using ICs (cont.) Businesses are subject to a myriad of federal and state governmental audits of their employment relations and employee benefits practices. 13

14 The Risk of Using ICs (cont.) The number of audits conducted by the federal DOL regarding wage and hour practices has steadily increased. IRS is increasing enforcement measures. Audits can result in a reclassification of ICs as employees and assess back taxes, interest, and penalties. Risk is Likely to Increase Employee Misclassification Act. Federal legislation may be coming in the future Introduced by four U.S. Senators, including President Obama when he was a Senator. To be enforced by IRS and DOL. EEOC like proceeding with investigation by IRS. 14

15 Risk is Likely to Increase (cont.) Employer will cover costs if employee successfully challenges status. Investigation sharing of information arrangement between DOL and IRS with IRS mandated to perform an overall audit and notify the DOL. Possible elimination of current IRS safe harbor provision. Civil penalties. Top 10 Recommendations for Using ICs: 1. Use written agreements While not a guarantee, it is very helpful to tip the balance in favor of holding that a worker is an IC and not an employee. Caution: Be very careful with language used (i.e. do not refer to wage or salary, but rather payment or settlement; do not refer to an employee handbook; refrain from language, policies, or terms that appear to be employment like. For example, do not include language indicating that the IC relationship can end due to job misconduct or poor performance. Rather, simply retain the right to end the IC relationship without notice, if at all possible.) 15

16 2. The ICs should determine where and how to accomplish a job. 3. Obtain ICs taxpayer ID numbers. The worker should fill out and sign IRS Form W 9, request for taxpayer information number, before the job is started. Maintain this document in your files, but do not file with the IRS 4. Contract with incorporated ICs. Incorporated ICs are much less likely to be viewed as employees compared with sole proprietors who are running unincorporated one person operations. 5. Require invoices for payment. Do not pay ICs on a weekly, bimonthly, or monthly basis on the same schedule as your employees. Instead, require an invoice for payment, and then make a payment as you would with any other outside vendor. 16

17 6. Never enter into a non compete with an individual IC in regard to your competitors (regarding clients might be okay). Such an agreement on its own likely will be viewed as indicative of an employment relationship. Note: Probably fine for a business IC. 7. Specify in contracts and letters that the IC is not eligible for employee benefits and is not covered by your liability, health or worker s compensation insurance. Do not provide ICs with new hire paperwork or Employee Handbooks. 8. ICs should provide their own equipment and office space. If your business provides equipment and/or office space to your IC, it is more likely that he/she will be classified as an employee. However, if the needs of your business are such that you must provide ICs with equipment or office space, you must charge them for these items. It is also recommended that the IC should be required to sign an equipment or office space rental agreement. 17

18 9.Be consistent in your use of ICs. The work performed by your actual employees should be different than work performed by ICs. For example, you would not want to use both employees and ICs as bookkeepers. 10. Keep good records. Establish a file containing the IC s contract, all invoices, copies of 1099 forms and any other information demonstrating that the worker is operating an independent business. This could include correspondence on the IC s letterhead, business cards, records of insurance coverage from the IC or a thirdparty insurer, and any correspondence from the IC s employees. Maintain your IC file separate from your employee personnel files. Also, if possible, have a separate manager handling the ICs than someone handling employees such as in the HR Department. 18

19 An Overview of Audits Federal: IRS, DOL State: DWD, DOR Violations unintentional or otherwise of employment laws. An Overview of Audits (cont.) What do they look at? Job descriptions Job duties Payroll records Employee benefit records Personal inspection of your facility Conduct interviews with employees Pay records Work permits Other records 19

20 An Overview of Audits (cont.) The audit may not be confined just to the subject matter of the employee complaint. It would not be uncommon for the investigator to ask the employer questions on other employment practices to ensure compliance in all areas with the agency s jurisdiction. The audit often requires several visits and follow up interviews before it is completed. An Overview of Audits (cont.) Upon completion, the employer will receive formal notification of any violations, the reasons for the violations, potential penalties and other enforcement actions. The business has the right to appeal an audit investigator s findings. 20

21 Minimizing Risks of Audits Regardless of the agency, there are common steps that a business can take to either avoid a government employment audit or minimize the risk: 1. Understand and comply with the laws and regulations that apply to your business. Minimizing Risks of Audits (cont.) 2. Conduct a comprehensive internal audit of your employment practices (e.g., job descriptions, payroll practices, employee benefits practices, actual job duties of employees, and the display of posters that are required under federal and state law). 3. Ensure that your HR and Accounting professionals and managers fully understand the aspects of applicable law. 21

22 Minimizing Risks of Audits (cont.) 4. Ensure that your employment documents and IC documents are well organized, separate, complete, and up to date. 5. Review state and federal laws and understand that there may be differences between the two particularly in the wage and hour area. An employer is obligated to follow the law that is most beneficial to the employee. The length of time that the audit takes depends on the size of the employer, the condition of the records and the number of problems encountered. Cooperation with auditor is generally recommended. 22

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