Misclassified Workers (Part II)
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The first part of this article, which appeared in the last issue of the Broadside, looked at the cost differences between hiring employees and using independent contractors, and outlined some of the factors the IRS looks at when examining independent contractor relationships. This article examines some of the consequences of misclassifying workers as independent contractors when they should be treated as employees.
Unfortunately, the most likely time to become thoroughly educated about independent contractor misclassification issues is at an Internal Revenue Service (IRS) audit. By that time it may be too late.
The IRS selects a payer for an audit for a variety of reasons, including random audits, tips from ex-workers or disgruntled competitors, and when industries are the object of a task force investigation. The IRS may be alerted to possible misclassification when a taxpayer claiming independent contractor status files a return showing a single source for an entire year's income, or when the taxpayer's Schedule C is audited for business expenses.
Employers are required to withhold federal and state income tax, social security and medicare taxes (FICA) from employee earnings. That money, along with matching employer FICA taxes, as well as federal and state unemployment taxes, is paid over to the government on a regular basis. If an employer has engaged independent contractors who are later determined to have been employees, the employer may be liable for a 100 percent penalty of the taxes evaded, not withheld or not paid over to the IRS. Surprisingly, the IRS can levy penalties against the employer even if taxes have been paid by the "independent contractors."
This, of course, can be a staggering amount of money. But to make matters worse, some unsuspecting people may also be liable for the penalty if the employer does not have the funds to pay. An officer of the corporation, general partners, an accountant, a bookkeeper, even the company's banker might be held responsible for the unpaid taxes and penalties. The responsible party could even be another corporation, such as a company that hired a contractor who was inappropriately treated as an independent contractor by a contract agency.
There are some relief provisions in the law that apply when an employer has a "reasonable basis" for not treating the worker as an employee. However, as of 1986, Section 1706 of the tax code eliminated those relief provisions for technical service specialists who are employed by third party companies. An employer that directly contracts with a technical service specialist to provide services to itself may still be entitled to "safe harbor" relief provisions.
If the amount you pay to an independent contractor is $600 or more in one tax year, payment must be reported to the IRS on Form 1099, in much the same way that employee income is reported on Form W-2. The IRS imposes penalties for failure to issue a form 1099 when one is required.
If you have paid an independent contractor for services, even if it was under a company name or a D/B/A name and the recipient has a federal business tax ID number, you should issue a Form 1099 to the recipient and file a copy with your annual tax reports.
You are not required to file these tax reports if you are paying an incorporated company for independent contractor services. A federal business tax ID number by itself does not insure corporate status. The company name must end with the words "Incorporated," "Inc.," "Corporation" or "Corp." The words "Company" or "Co.," for example, do not indicate corporate status and a Form 1099 would be required.
More and more, employee misclassification issues are turning up at the unemployment office. Suppose someone who has performed services for a company as an independent contractor, especially for an extended period, files an unemployment claim. If the state unemployment office determines that the "independent contractor" should have been treated as an employee, benefits may be due. There have been many cases in California, and more recently in Massachusetts, where companies have been held liable for the entire ongoing weekly cost of unemployment claims to workers who were paid as independent contractors when they should have been paid as employees.
There can be a danger in using independent contractors to create copyrightable works. When a business pays an employee to produce a "work for hire," the work product is owned by the business. Be sure to execute a separate copyright agreement if you use independent contractors to work on material that you want to copyright.
In many states, the workers' compensation laws hold companies responsible for the entire cost of benefits if a company engages uninsured independent contractors who sustain job-related injuries. For its own protection, every company that engages independent contractors directly or through a third party (such as a contract agency), should require a Certificate of Insurance from each independent contractor or agency to show that coverage is maintained. Alternatively, the company may want to pay an additional premium to its insurance carrier to compensate for uninsured subcontractors.
A Certificate of Insurance, however, can be misleading. If you are given a certificate that shows coverage for all "employees," you must still be concerned about whether coverage extends to the company's independent contractors. A company with only one employee could maintain insurance coverage for "all employees" (i.e., the employee), but have no coverage for, say, 200 independent contractors working for the same company!
Contract placement agencies and other "third party" businesses that assign workers to client companies require special consideration when looking at misclassification issues. The Tax Reform Act of 1986 included a provision, Section 1706, that took away the "safe harbor" provisions that can allow other types of businesses to avoid some or all of the penalties associated with the improper classification of workers.
Clients of contract agencies should pay particular attention to the employment status of contractors assigned to them by agencies. The IRS says that a client company can be held responsible, as the "imputed employer," if a contract agency does not withhold and pay taxes for its workers. Many companies that hire contractors through agencies now insist that the agencies certify that the people assigned to their firms are treated as employees, not as independent contractors, by the agencies.
Businesses that use independent contractors often incorrectly assume that they are not responsible for overtime compensation if the independent contractor works over 40 hours in one week. First, if an independent contractor is being paid on an hourly basis, the chances are very good that you are really dealing with an employee, and that the independent contractor classification is invalid. In addition, state and federal Departments of Labor use their own guidelines (which are different from IRS standards) to determine whether a person should be paid overtime. There have been numerous cases where an independent contractor has been determined to have been eligible for overtime payments when payment was made on an hourly basis.
Business liability coverage does not always extend to independent contractors. You should insist that independent contractors and their agents produce a Certificate of Insurance showing that coverage is maintained and that it extends to the independent contractor. Alternately, your own business liability coverage may extend to independent contractors you pay, but you will need to pay an additional premium based upon the amounts you paid out.
If the IRS determines that someone who has been treated as an independent contractor is really an employee, that person also risks an additional tax liability. Business expenses reported on IRS Schedule C could be disallowed or reclassified as unreimbursed employee business expenses, which can be deducted on IRS Schedule A, but with a downward adjustment that amounts to 2 percent of adjusted gross income for business expenses, and 7.5 percent for medical and dental expenses. Certain retirement programs, such as a Keogh plan, would be disallowed entirely.
In addition, an independent contractor that is reclassified as an employee could claim the right to employee benefits made available to other employees of the business.
Finally, the IRS maintains that even some corporations, especially one-person personal service corporations that perform work for a single business or a small number of businesses, can be determined to have "employee" status when examined on the basis of the 20 factors used on IRS Form SS-8. So businesses must also be cautious about using personal service corporations as independent contractors, especially on a long-term basis.
Brett Randolph, who has been marketing contract technical communications services since 1973, is a partner in Randolph Associates, Inc. in Boston, Mass.