In 2010, employers can expect an unprecedented increase in enforcement efforts targeting employees misclassified as Form 1099 independent contractors. Attention to this issue has been growing in recent years. However, with state and federal budget deficits now headlining the news, and cash-strapped governments aggressively searching for unrealized tax revenue, the time is right for this nagging issue to become a major headache for employers. The IRS recently announced that in February 2010, it would begin a national audit targeting up to 6,000 employers, with the goal of quantifying the revenue shortfalls created by misclassification of employees. Two-hundred auditors have already begun training to staff this new program. Furthermore, the Department of Labor’s Wage and Hour Division and twenty-nine states have signed up to collaborate with the IRS and share the results of their own misclassification-related audits.

In addition to increased tax revenue, state and federal agencies are also seeking significant penalties from employers who have misclassified their workers. On December 10, 2009, the Illinois Department of Labor (IDOL) announced that it had imposed a $328,500 civil penalty against a first-time offender. IDOL assessed penalties of $1,500 per day for 218 days of alleged misclassification and an additional fine of $1,500 for the company’s failure to maintain proper records on the misclassified employees. New York also reported recently that it had uncovered 12,300 instances of misclassification in 2009. The fines and penalties imposed on those employers totaled nearly $6 million. With even more enforcement efforts slated for 2010, more such penalties are likely to follow.

Could You Have a Problem?

The starting point for analysis of a worker’s classification is the IRS test. The familiar “20-factor test” has been reformulated into an analysis of three characteristics of the relationship between a business and its workers:

  • behavioral control
  • financial control
  • type of relationship

“Behavioral control” relates to the degree of employer control over how the worker performs the work. Factors suggesting employee status include: (1) significant employer instructions regarding how, when, and where to perform the work; (2) evaluation systems that measure how the work was performed rather than merely the end result; and (3) training in how to perform the work, including specific procedures and methods to follow. The “financial control” factors relate to the amount of employer control over the economic aspects of the worker’s job. Indicators of a lack of financial control, and thus independent contractor status, are the worker’s: (1) significant investment in tools and equipment; (2) unreimbursed expenses; (3) opportunity for profit or loss; (4) freedom to provide services to multiple employers; and (5) payment by flat fee or at a job rate rather than by salary or an hourly rate.

Finally, the IRS looks at how the worker and employer perceive their relationship. What does the contract say? Does the employer provide benefits? Is there permanency or a set duration of the relationship? Is the worker involved in key activities of the business? If the employer provides benefits and a long-term role in a core aspect of the business, the worker is more likely to be an employee. In contrast, independent contractor status is more likely where a written contract specifies such status, provides for no employment benefits, and calls for short-term services unrelated to the core aspects of the business.

Added Complexity From Conflicting Laws

Employers must bear in mind that the definition of “independent contractor” varies from statute to statute, agency to agency, and state to state. For example, federal courts and the U.S. Department of Labor use a more liberal “economic realities” test to determine worker status for purposes of federal employment laws such as the Fair Labor Standards Act, Title VII of the Civil Rights Act of 1964, the ADA, the FMLA, and the WARN Act. In addition, state unemployment and workers’ compensation statutes often use entirely different criteria for determining employee status, such as the nine-factor test set forth in the Colorado Employment Security Act.

This maze of conflicting requirements creates a minefield for employers. For example, a worker who satisfies all of the IRS’s three-part test for independent contractors may nevertheless be an employee under the Colorado unemployment statute if the paychecks are issued in the worker’s individual name, rather than the name of a business entity.

Where Do We Go From Here?

As seen in the recent IDOL case, the cost of misclassification can be severe. Improperly categorizing employees as independent contractors exposes employers to liability for federal and state taxes, wage and hour violations, unanticipated coverage by employment laws, and claims under state wage payment statutes. In addition, many states are also increasing their statutory penalties for misclassification. For example, Colorado raised its penalties in June 2009 to fines of $5,000 per misclassified employee for a first offense and up to $25,000 per misclassified employee for a second or subsequent offenses. Fortunately, employers can take specific steps to mitigate the risk and safely navigate the murky waters the many conflicting standards create. These include:

  • consultation with employment counsel regarding the applicable standards;
  • thorough review of all workers currently classified as independent contractors;
  • reclassification of those who are clearly employees; and
  • restructuring the remaining relationships to satisfy as many of the independent contractor factors as possible, including execution of an independent contractor agreement that closely tracks the various requirements of federal and state law.