With the increasing scrutiny from state and federal government agencies, worker misclassification has become quite the hot topic.

It all started in 2010, when the IRS launched its Employment Tax National Research Project. They hired additional staff to audit 6,000 random employers with a focus on identifying companies that are misclassifying workers (and therefore underpaying employment taxes). The Department of Labor has since gotten involved as part of an ongoing employee misclassification initiative, and in a September 2011 press release former Secretary of Labor Hilda Solis stated, “We’re here today to sign a series of agreements that together send a coordinated message: We’re standing united to end the practice of misclassifying employees.”

Their goal is to reduce the employment tax gap and improve compliance with federal labor laws. By 2014 the initiative will be fully in place and is expected to yield about $1.3 billion a year in additional tax revenue. That’s how often employers are misclassifying workers.

Worker misclassification is risky business. In addition to reducing the amount of funds contributed to unemployment, workers’ comp, and Social Security accounts, misclassifying your workers can deny them access to valuable benefits. If an employee is incorrectly classified as an independent contractor, your company may not only be held liable for back-taxes, but also IRS fines, interest, retroactive overtime claims, and litigation. A single IC filing a claim for unemployment benefits can trigger a tax audit to review all potential misclassified workers in the company.

The Dirty Dozen: Are They an Employee or Independent Contractor?
If you answer “yes” to any of the questions below, an individual classified as an independent contractor might actually be an employee. If you answered “no” to all of the questions, the worker is likely to be an IC.

1. Is the person integrated into the company’s staff? In other words, is he/she essential to the completion of daily operations?
2. Does the company provide instructions as to: Where the work is performed? What hours will be worked? How the work is performed?
3. Does the company provide the workstation for the person and most or all of the tools, materials and supplies needed to perform the work?
4. Does the company control (or have the right to control) not only the result of the work, but also the method of work?
5. Is the individual paid a set salary or wage for a workday, rather than a per-job or per-hour-of-work basis?
6. Can the company terminate the person without legal liability or risk of a breach-of-contract suit?
7. Does the company provide training or assistants for the work performed?
8. Is the working relationship long-term or ongoing, even if infrequent?
9. Does the company assume all risk of monetary loss on the project (no chance that service provider will lose money)?
10. Is the person performing the work only for this company (not for any other clients)?
11. Does the company expect to hire the person as an employee immediately following the termination of his or her services as an independent contractor?
12. During the 12 months prior to starting the service, was the person on the company payroll (regular or temporary)?

5 Red Flags to Watch For:

  • The relationship is long-term and open-ended
  • After an employee is terminated, the person is hired back on a 1099 basis to do work that resembles his/her former job
  • Providing the office space, equipment or supplies the worker will use
  • The worker submits expense reports, gets paid on a regular basis or receives benefits or perks
  • The worker replaces or supervises any of your employees

How to Lessen the Risk:

  • Become informed: Many times, employers simply don’t understand the risks and the rules, so be sure to educate yourself. The IRS website is an invaluable resource for employers, providing ample information on employer taxes and worker classification.
  • Be clear: Be sure your written IC agreements clearly define what the consultant is expected to accomplish, with clear, measureable milestones and deliverables. The agreement should also clearly define when the project will be completed and provide the metrics to determine if the project was completed successfully.
  • Enlist an expert: Many third party companies specialize in worker classification. By implementing a third party IC evaluation program, your company can remove the risk of misclassification and be protected in the event of an audit.

Tags: Advice, IRS, Allison Kent, Atrium Staffing, Department of Labor, Employment Tax National Research Project, Hilda Solis, Independent contractors, Misclassifying workers