On September 19, 2011, Secretary of Labor Hilda Solis and IRS Commissioner Doug Shulman signed a Memorandum of Understanding to coordinate both agencies’ law enforcement efforts aimed at businesses that misclassify employees as independent contractors.  At a ceremony held at the Labor Department headquarters in Washington, Secretary Solis said, “We’re standing united to end the practice of misclassifying employees.”  Commission Shulman likewise stated that “This agreement takes the partnership between the IRS and Department of Labor to a new level.”

The Memorandum of Understanding between the two federal agencies will enable the Labor Department and IRS to share information with each other and coordinate law enforcement efforts.  The agencies will also and outreach materials and guidance for businesses using independent contractors and for employees who may be misclassified.

Secretary Solis also announced that seven states have signed memoranda of understanding with the Wage and Hour Division of the U.S. Department of Labor to address and combat employee misclassification.  Those states are Connecticut, Maryland, Massachusetts, Minnesota, Missouri, Utah, and Washington.  Four other states have agreed to enter into similar memoranda of understanding with the Wage and Hour Division:  Hawaii, Illinois, Montana, and New York.

Takeaway 1. Use of independent contractors remains a legitimate business model. The Labor Secretary noted in her press release that the use of an independent contractor business model, even those that attempt to “change, obscure or eliminate the employment relationship,” are “not inherently illegal.”  Thus, businesses that lawfully pay some of its workers on a 1099 basis should not hesitate to continue with such business models – except in those states where the test for independent contractor status under applicable state wage, unemployment, workers compensation, or tax laws are more restrictive than the tests under the federal labor and tax statutes.

Presently, about half of the states have more restrictive tests for independent contractor status than the tests under federal law.  Nonetheless,  companies can often take bona fide actions to enhance their independent contractor compliance in almost all of those states.

Takeaway 2.  It is not too late to enhance independent contractor compliance. Companies that use a number of independent contractors are facing a more aggressive law enforcement effort at the federal and state levels than ever before.  Companies that are audited by the IRS now run an even greater risk that a finding of misclassification with that federal taxing agency will be shared with the state Tax Commissioner as well as federal and state labor departments.

Although government law enforcement efforts are increasing, most independent contractor disputes still derive from challenges by the workers paid on a 1099 basis.  While class action lawsuits get the most publicity, the most common type of legal challenge to an employee’s classification status involves unemployment benefits.  More and more workers being paid on a 1099 basis are applying for unemployment benefits.  In the course of determining whether the worker is entitled to unemployment benefits, state Labor Departments typically make an inquiry of the company about the worker’s status as an employee or independent contractor.  If the state Labor Department concludes the worker has been misclassified, it usually issues a determination that the company should have been paying unemployment taxes not only for the claimant but for all other similarly situated workers as well.  An assessment of unpaid unemployment taxes, plus interest and penalties, typically follows.