Member Columns

By: Chip Dillman, CPA, CFE, senior audit manager at Greer & Walker, LLP, (704) 377.0239 or cdillman@gwllp.com. or visit our website, www.greerwalker.com.

MAKING THE RIGHT CALL: WHEN IS A WORKER AN INDEPENDENT CONTRACTOR OR AN EMPLOYEE?

In today’s environment of increasing costs for healthcare, materials, fuel and labor, companies may be tempted to classify workers as independent contractors instead of employees.  The cost savings to the employer can be substantial, providing unscrupulous employers with a significant cost advantage against their more law abiding competitors.  By classifying a worker as an independent contractor, an employer can avoid a multitude of payroll and unemployment taxes, healthcare costs, and employee benefits associated with classification as an employee.  Additional cost savings could be realized as the administrative burden of filing and remitting those taxes is borne by the worker and not the employer.  Workers improperly classified as independent contractors are further penalized by having to pay higher F.I.C.A. (social security) taxes, and generally are ineligible to participate in many employee benefit programs such as profit sharing and health care benefits, and other workplace protections such as workers’ compensation coverage, minimum wage and overtime protections, and family and medical leave enjoyed by employees. 

The determination of the employment status of an individual worker is based upon the substance of the relationship between the worker and the company.  The courts have considered many factors in determining the proper classification of a worker.  These factors fall into three main categories, which are behavioral control, financial control and the type of relationship between the worker and the company.  Behavioral control includes facts that indicate whether the company has a right to direct and control the worker on such things as when, where and how to work, what tools or equipment to use, where to purchase supplies and services, and the work order sequence to follow.  Financial control includes facts that indicate whether the company has a right to control certain business aspects of the worker such as the availability of the worker to perform similar services for others in the marketplace, method of payment, and the ability of the worker to realize a profit or loss for work performed.  The type of relationship includes facts such as the existence of written contracts between the parties, receipt of employee type benefits by the worker and the permanency of the relationship.  The proper classification of workers is critical and may not always be a clear cut decision.  Companies that are unsure of the proper classification of an individual worker or a class of workers can complete IRS form SS-8. 
           
The misclassification of workers, while saving money for companies, costs the government in the form of uncollected revenues.  A study by PricewaterhouseCoopers estimated that the federal government lost approximately $35 billion in unpaid taxes between 1996 and 2004 due to worker misclassification.  Recently, members of Congress have proposed two pieces of legislation designed to close this “tax gap”, by amending laws currently in place.
           
The Employee Misclassification Prevention Act of 2008 (H.R. 6111), currently in the House Ways and Means Committee, would amend the Fair Labor Standards Act (FLSA).  It would require employers to keep records on the worker’s classification, notify the worker in writing of their classification and their right to challenge such classification, and provide information to the worker regarding the Department of Labor’s website containing further information about workers’ rights under the law.  Additionally, information sharing between the DOL and IRS on actual cases of misclassification would be allowed and targeted audits of employers in industries that frequently misclassify workers would be required.  The Act would also impose a fine of $10,000 per violation for an employer who “repeatedly or willfully” misclassified workers.  If an employer’s misclassification of a worker results in violations of the FLSA’s requirements governing maximum hours or minimum wage, the misclassified worker is entitled to recovery at double their liquidated damages.

The additional record keeping requirement provides an audit trail to government auditors and will make it easier for them to identify misclassified workers.  Companies in the construction industry can expect more audits and more focus by government auditors on this issue.  Owners must be certain that they are properly classifying their workers, or any potential short-term cost savings will be wiped out by fines, penalties and interest.

The Taxpayer Responsibility, Accountability, and Consistency Act (H.R. 5804), currently in the House Ways and Means Committee, would amend the Internal Revenue Code by adding a new section to the Code.  Section 3511 would replace Section 530 and include new rules pertaining to the classification of workers as independent contractors and the allowable basis for doing so.  Section 3511 would limit the basis under which an employer could reasonably determine that a worker is an independent contractor.  Section 3511 would also shift the burden of proof regarding the proper classification from the IRS to the taxpayer. 

H.R. 5804 would also allow workers to petition the IRS for a review of their classification and would prohibit retaliation against a worker for filing such a petition.  H.R. 5804 would also require the Treasury Department to issue an annual report on worker misclassification.  The annual report would include information on the quantity and type of enforcement actions against employers found to be misclassifying workers, the relief obtained resulting from such actions, an estimate of the number of employers misclassifying workers, the number of workers affected, and the industries involved, the impact on the Federal tax system, and the outcomes of the petitions filed under Section 3511.  Finally, H.R. 5804 would increase the penalties associated with filing incomplete or incorrect tax return information, whether intentional or unintentional.

The improper classification of workers has been an issue for many years now and, as the proposed legislation indicates, these misclassifications may result in more severe consequences for employers in the near future.  Should H.R. 6111 and H.R. 5804 not be passed into law, other similar legislation is on the horizon.