In the past three years, a third of all states in the nation have passed legislation seeking to curtail the misuse of the independent contractor classification. But, despite congressional studies finding that misclassification contributes to the federal and state tax gaps and deprives misclassified employees of workplace protections, Congress has not made independent contractor legislation a national priority until this year. Now, the second of two bills has been introduced in Congress that will not only discourage businesses from continuing to issue Form 1099s to workers who are not legitimate independent contractors, but also will impose obligations on businesses to inform individuals they treat as independent contractors how to challenge their classification.
While the other shoe may be about to drop on companies that may be misclassifying employees as independent contractors, Congress has tempered this latter bill by including a limited form of amnesty for businesses that have had a reasonable basis for past misclassifications. More importantly, the two federal bills, if enacted, would not end the use of independent contractors; businesses may continue to use them if they satisfy the legal tests for independent contractors under federal and state laws. This article discusses timely alternatives to the costly and often unacceptable alternative of reclassifying independent contractors as employees.
The Fair Playing Field Act of 2010
The latest bill, The Fair Playing Field Act of 2010, was introduced on September 15, 2010, in both the Senate (as S. 3786) and House (as H.R. 6128). The bill would close what the sponsors of the legislation, Sen. John Kerry (D-Mass.) and Rep. Jim McDermott (D-Wash.), refer to as a “tax loophole allowing businesses to misclassify workers as independent contractors.” According to Sen. Kerry, a “safe harbor” in the tax laws that has existed since 1978 “creates an unfair environment for businesses that play by the rules and an unfair environment for workers.” The White House immediately endorsed the Fair Playing Field Act, just as quickly as it endorsed the Employee Misclassification Prevention Act, which was introduced in both houses of Congress this past April.
The so-called loophole that the Fair Playing Field Act seeks to close is Section 530 of the Revenue Act of 1978. That law currently affords businesses a safe harbor to treat workers as independent contractors for employment tax purposes if the company has had a reasonable basis for such treatment and has consistently treated such employees as independent contractors by reporting their compensation on Form 1099s. This safe harbor was reportedly used most recently by FedEx in escaping a $319 million back tax assessment by the IRS related to FedEx’s classification of its Ground Division drivers as independent contractors. Although the IRS concluded that such drivers were common law employees, it withdrew its assessment based on the protection afforded FedEx under Section 530.
In its findings, the bill recognizes that “many workers are properly classified as independent contractors,” but “in other instances, workers who are employees are being treated as independent contractors.” After noting that Section 530 was intended to be an “interim measure,” the findings state that this safe harbor had become permanent. Therefore, “in the interest of fairness and in view of many service recipients’ reliance on current section 530,” the Fair Playing Field Act would direct the Secretary of the Treasury to issue guidance to workers and businesses on a prospective basis only.
Going forward, the Fair Playing Field Act would eliminate the continued use of the Section 530 safe harbor. It would require the Secretary of the Treasury to issue regulations or other prospective guidance clarifying the employment status of individuals for federal employment tax purposes. The act would also prohibit the IRS from making retroactive assessments for past unpaid taxes in cases in which the business consistently treated the worker involved as an independent contractor and filed Form 1099s each year for the worker, unless the business had “no reasonable basis for not treating such individual as an employee.”
The bill sets forth “one method of satisfying the [reasonable basis] requirement” – if the business acted in reasonable reliance upon (A) judicial precedent, published rulings, technical advice, or a letter ruling issued to the business; (B) a past IRS audit of the business in which there was no assessment attributable to individuals holding positions that were substantially similar to the worker in question; or (C) a long-standing recognized practice of a significant segment of the industry in which such individual was engaged. The Fair Playing Field Act defines a “significant segment of the industry” as no more than 25 percent of the industry, and clarifies the term “long-standing recognized practice” as not requiring the business to show that the practice continued for more than ten years.
The act would also:
- eliminate the reduced penalty provisions of the Tax Code for failure to withhold income taxes and the employee’s share of FICA taxes in cases in which the business did not have a reasonable basis for treating a worker as an independent contractor
- require businesses who use independent contractors “on a regular and ongoing basis” to provide them with a written statement informing them of their federal tax obligations, notifying them of the employment law protections that do not apply to them, and telling them how they can seek a determination of their status from the IRS, and
- exclude certain skilled workers (engineers, designers, drafters, computer programmers, systems analysts, and the like), who were not eligible for the safe-harbor protection of Section 530, from the prohibition on retroactive tax assessments.
The safe-harbor provisions of Section 530 and the Fair Playing Field Act only apply to the classification of workers as independent contractors under the federal employment tax laws. The bill has no application to state tax laws or federal and state workplace laws, which would be unaffected by passage of the Fair Playing Field Act.
The Employee Misclassification Prevention Act (EMPA)
Congress has, however, introduced labor legislation dealing with misclassification of employees as independent contractors. The EMPA bill was introduced on April 22, 2010 by the Senate (as S. 3254) and House (as H.R. 5107). It would amend the Fair Labor Standards Act (FLSA), the federal law mandating the payment of minimum wage and overtime for employees who work more than 40 hours in a work week, creating a new labor law offense: misclassification of an employee as an independent contractor.
EMPA would also impose strict record-keeping and notice requirements upon businesses with respect to workers treated as independent contractors, expose such businesses to fines of $1,100 to $5,000 per employee for each misclassification, and double the liquidated damages provisions under the FLSA for violations of the minimum wage or overtime provisions. Once enacted, businesses can anticipate that they will be confronted with an onslaught of private actions by workers claiming they are misclassified “employees.” A detailed analysis of EMPA can be found at http://www.pepperlaw.com/publications_update.aspx?ArticleKey=1770.
The Senate Committee on Health, Education, Labor and Pensions (HELP) wasted little time in holding a hearing on EMPA. On June 17, 2010, HELP, headed by its Chairman Tom Harkin (D-IA) and Ranking Member Michael B. Enzi (R-WY), led a hearing by the full committee during which a high-ranking member of the Obama administration and three other panelists spoke in favor of EMPA, and one panelist spoke in opposition to the bill.
Although no further hearings are yet scheduled for the labor bill, Congress appears likely to pass both EMPA and the Fair Playing Field Act this year.
Recent State Misclassification Legislation
In the absence of federal legislation addressing misclassification, in the past three years 16 states have passed their own laws seeking to curtail misclassification of employees as independent contractors, including five states so far in 2010: Connecticut, Nebraska, New York, Vermont, and Wisconsin. Some of these state laws address misclassification generally by employers in all industries, while others are limited to specific industries.
The most recent state law enacted focuses on one of the industries in which misclassification has been found to be most prevalent: the building and construction trade. The New York Construction Industry Fair Play Act, which was signed into law on August 27, 2010, virtually eliminates the permissible use of independent contractors in that industry by creating a presumption of employee status for any worker performing construction services in New York.
If, as expected, Congress passes EMPA and/or the Fair Playing Field Act of 2010, it is likely that few state legislatures will find it imperative to pass additional independent contractor legislation. The federal laws, if enacted, should provide ample regulation of misclassification while allowing businesses to continue to use legitimate independent contractors.
Three Options for Employers Using IC Diagnostics™
For businesses using independent contractors, and especially companies that are highly reliant on independent contractors, there are a number of alternative means to enhance compliance with the tests used to determine independent contractor status. While the proposed legislation in Congress is likely to cause many businesses to wonder if they should immediately reclassify some or all of their independent contractors, companies can take at least two other measures to minimize or avoid the risk of future liability: bona fide restructuring of the relationship between a company and its independent contractors, and use of an employee leasing or staffing firm to employ the workers directly.
Where bona fide restructuring is feasible, the business need not discard its independent contractor business model. Using IC Diagnostics, a business can determine the extent that restructuring of the independent contractors’ positions will minimize or avoid future misclassification liability. IC Diagnostics refers to a process starting with an examination of whether the position in question would pass the applicable independent contractor tests under governing state and federal laws, using each of more than 48 factors used by different decision-making bodies in determining independent contractor status.
With the exception of a few state laws, most tests used by the courts and administrative bodies are based in whole or part on whether the hiring party has the “right to control the manner and means” by which the worker accomplishes the end product of his or her work. For companies interested in maintaining their use of independent contractors but eager to minimize or avoid future misclassification liability, the first step in restructuring their independent contractor relationships is to consider what adjustments they are prepared to make to their present level of control over the manner and means by which their independent contractors accomplish their work.
At the end of the IC Diagnostics process, the company’s degree of compliance with each of the applicable laws can be measured on an IC Compliance Scale.™ This process can provide a company with an informed means by which to determine the extent that the restructuring alternative may minimize or eliminate future misclassification liability. If IC Diagnostics indicate that the bona fide restructuring option is a sound choice, the business can memorialize its bona fide restructuring in a modified independent contractor agreement. Businesses must ensure that the independent contractor agreement will actually be implemented in the field and is not merely an empty recital of policy, which the law disregards. Companies also may review and revise company operating manuals and procedures, document the implementation of certain of the provisions in the independent contractor agreement, and institute safeguards to ensure that actual business practices conform to the terms of the modified independent contractor agreement. If, however, IC Diagnostics suggest that, even with restructuring, the workers will not likely pass the governing tests for determining independent contractor status when measured on the IC Compliance Scale, the business has at least two other alternatives to avoid or minimize future risks of misclassification liability.
Employee leasing or other staffing alternatives can reduce the risk of misclassification liability. When an employee leasing or staffing organization hires some or all of a company’s independent contractors as their employees, the leasing company withholds income taxes, makes Medicare and Social Security contributions, pays workers’ compensation and unemployment insurance premiums, provides an array of benefits to the former independent contractors, including health insurance under a plan maintained by the leasing company, and handles the employee relations of the leased employees.
Although use of an employee leasing or staffing company can substantially lessen the risk of future misclassification liability if all legal documentation and procedures are carefully observed, it is by no means a panacea. For example, a business that contracts with an employee leasing or staffing organization may still need to account for the leased employees in the employer’s benefit plans’ language and perform “nondiscrimination” testing required under the Employee Retirement Income Security Act (ERISA).
If the Fair Playing Field Act and/or EMPA are enacted as expected, companies will be obligated to notify all independent contractors that they have the right to a governmental determination as to whether they have been properly classified as an independent contractor. Voluntary reclassification is likely to be far less painful and costly than being forced by a government agency or court to reclassify in connection with an order to make payment of back taxes, unpaid Social Security and Medicare contributions, and unpaid unemployment insurance and workers’ compensation premiums.
Reclassification requires businesses to consider relevant federal and state tax, employee-benefits and employment laws, and can be labor-intensive if done properly. Reclassification does not, however, require that all workers previously excluded from an employee benefit plan be included in the future. Exclusions are permissible if the governing documentation for the company’s plans is drafted properly and the exclusion does not violate applicable tax or ERISA rules.
If and when enacted, the Fair Playing Field Act and EMPA would constitute a two-pronged federal legislative scheme to curtail misclassification. Neither law prohibits the use of independent contractors. As noted above, businesses can choose from a number of alternatives to reduce or eliminate the risk of future misclassification liability. In view of the current legislative landscape, inaction may be the only unacceptable alternative.