Independent Contractor Compliance Blog - by Collabrus™

Do you have two minutes? Take this short test to see if you are misclassifying your consultants.

My clients often ask me for the silver bullet, the quick and simple way to know for certain if a consultant is properly classified as an IC or not. 

The truth is there is no silver bullet. Common law is a complex area and it takes an expert to make the right decision, or to help you set up an IC relationship properly so that down the road a government auditor, or court, won’t reverse your decision.

There are, however, some universal Red Flags that shout out “Employee Misclassification.” I’m going to share them with you today.

The questions below will give you some insight about these Red Flags and if your company is at risk or not. You need to be brutally honest in answering the questions (just like an objective third party would) because this is how a government auditor will approach it!

Answer the following questions for any consultant you currently have classified as an IC.

Answer ‘Yes’ or ‘No’ to the following:

1. Have you renewed the consultant’s contract several times, with minor changes in the deliverables, which has had the practical effect of extending the initial engagement for an indefinite time period?
2. Do you provide the consultant with a work station at your facility?
3. Do you provide the equipment needed to do the job (a computer, software, office supplies, vehicle, or tools)?
4. Do you pay the consultant’s expenses?
5. Do you pay the consultant by the hour?
6. Do you pay the consultant even if a job needs reworking?
7. Do the day-to-day duties vary for the consultant depending on the needs of the company?
8. Does a manager in your company oversee the consultant’s work and have the authority to insist on reworking or changing the method of doing the job?
9. Has the consultant become exclusively dependent on the work you provide for his/her livelihood because he has either dropped his other clients, or never had other clients?
10. Is the consultant expected to attend regular meetings with your employees?
11. Was the consultant once your employee and now does substantially the same job, under similar working conditions, as an IC?
12. Can you decide what hours the consultant will work?

Scoring

If you answered ‘Yes’ to four or more questions for a consultant you classify as an IC, there is a possibility the consultant is misclassified.

If you answered ‘Yes’ to six or more questions the consultant has a high likelihood of being misclassified.

However, to be sure you need a full evaluation because this list is not complete and the weighting of each factor may vary depending on a number of other factors. 

One Last Thought

If you do not know the answers to these questions then your company could be at serious risk. You need to gain control now before it become a much bigger problem. This type of evaluation is one of the services Collabrus provides to clients throughout the United States.

A recent US Supreme Court ruling about text messaging provides some insight on how the Court sees a limited segment of employer-employee relationship.

The U.S. Supreme Court issued a ruling stating employers may conduct limited warrantless searches of electronic media. To read the decision you may go to:  http://www.supremecourt.gov/opinions/09pdf/08-1332.pdf

There were also some implied assumptions about the nature of employer-employee relationships.

The primary issue at stake in this decision was the employee’s (Fourth
Amendment) right of privacy and the need for employers to have clear and comprehensive electronic communications policies. However, there was also an underlying (unstated) principle recognized about the nature of an employer-employee relationship. For example:

Direction and Control

The Supreme Court off handily recognized that when employers provide equipment they have a right to control how it will be used and even how much it could be used. To exercise this right they must clearly communicate the policies for employer-owned/provided equipment, including establishing the nature of the communications that are made using, or that interface with, employer-provided equipment. This includes all electronic systems, such as email, voicemail, text messages, cell phones, and other (probably not yet invented) technology.

From an IC Compliance point of view I consider this requirement the smoking gun for direction and control. If you provide your consultant with pagers, cell phones, laptops, PCs, etc, and then have polices the consultant must adhere while using them to do the job, to you are directing and controlling how the consultant will work while using your equipment on the job. That’s evidence of direction and control.

Paying Expenses

The court also recognized that employees are paid for their expenses. The decision stated,”…the City and OPD (Ontario Police Department) had a legitimate interest in ensuring that employees were not being forced to pay out of their own pockets for work-related expenses…”

This statement implies paying the consultant’s expenses makes them look more like an employee…

I might be taking a little bit of creative license…

I might be guilty of stretching this a little further than the Supreme Court Justices intended for me to get out of their decision, but the principles I stretched to are still correct and I think they offer compliance professionals important clues on making defensible worker classification decisions.

Douglas H. Shulman, IRS Commissioner, recently spoke before the American Payroll Association & the American Accounts Payable Association. He said he’s excited about the new law I mentioned earlier this week giving the IRS more tools to close the Tax Gap…

Commissioner Shulman stated that the IRS is gearing up to implement new requirements recently passed into law to require Form 1099’s for payments “made from businesses to corporations, and on payments businesses make for goods.”

Shulman stated, “This new information reporting requirement applies if businesses pay a single entity $600 or more per year in aggregate for these types of transactions starting in 2012.” The Form 1099, reporting payments to corporations, must be filed in January of 2013.

This requirement will apply to payments you make for services by independent consultants who have formed a corporation.

The IRS has been lobbying Congress for several years to get this law.

In a written statement, dated February 16, 2007, Nina E. Olson, IRS Taxpayer Advocate, said:

“Under current law, an individual taxpayer can escape information reporting by incorporating.  This is true even if the taxpayer is performing the same services that would be subject to Form 1099-MISC (Miscellaneous Income) reporting if the taxpayer were conducting business as an unincorporated entity.

For Form 1099-MISC information reporting purposes, I believe there should be no distinction between taxpayers providing the same services for compensation merely because one taxpayer has incorporated and another has not.” 

Also in her 2008 report to Congress, she again recommended that Congress require service recipients to issue Forms 1099-MISC to incorporated service providers and increase the penalties for failure to comply with the information reporting requirements.

So now it’s law.

The IRS knows this will place a new burden on small business.

Shulman stated, “…those that represent small businesses…have raised concerns about the burden that this new provision may impose. I want to assure the business community that the IRS will look for opportunities to minimize burden and avoid duplicative reporting. 

He went on to state, “…We plan to…exempt from this new requirement business transactions conducted using payment cards such as credit and debit cards. These transactions will already be covered by reporting requirements on payment card processors…”

He closed the talk saying it was “very exciting…”

“In conclusion, let me thank you again for inviting me to share some thoughts with you today on the evolution of information reporting. We are entering a very exciting new phase of information reporting with great potential for improving compliance and the effectiveness and efficiency of our tax system…”

The laws and requirements change all the time.  Are you keeping up?

WASHINGTON DC-The Internal Revenue Service invited public comment on how to carry out “The Patient Protection and Affordable Care Act of 2010,” also known as the Heath Care Bill, that requires all corporations to receive a Form 1099 for their goods and services to other businesses.

What does Health Care have to do with 1009 reporting?

A lot since Congress quietly slipped in the requirement during the confusion surrounding the health care bill. The IRS had been asking Congress for years to require that corporations receive a Form 1099 for their goods and services to other businesses, just like sole proprietors and partnerships. The IRS got its wish and the requirement takes effect for all payments made after December 31, 2011.

The IRS believes one of the major sources of the $350 billion Tax Gap each year is underreporting of income by small businesses that do not receive a Form 1099.

The IRS argues that third party reporting of payments to small corporations will put these payments on the Tax Radar and significantly increase reporting of income (and generate more revenue).

Now the IRS is asking for input on how to implement the new law

The IRS is asking taxpayers, especially businesses, to provide input on how this new requirement may be efficiently implemented to, “…help the IRS issue guidance that implements this provision in a manner that minimizes burden and avoids duplicate reporting.”

The notice cites an example of how the IRS has already found one instance to prevent duplication by piggy-backing on another IRS requirement:

“…Under a proposed regulation, many business purchases made with credit or debit cards would be exempt from the new reporting requirement because they are already reported by banks and other payment processors…”

To me corporate 1099 reporting is clear since it basically puts corporations in the same category as individuals for 1099 reporting.

So I had to ask myself, “Why the input? Is the IRS trying to build “buy-in” on a potentially controversial law change by giving the impression businesses have some control over how it is implemented?”

I don’t know the answer to that question, but it will be interesting to see to what extent input is actually considered. In either case, it is clear the IRS is actively implementing this new requirement.

The IRS and state tax agencies are serious about IC Compliance-you should be too.

• Both federal and state enforcement agencies constantly lobby their legislatures for new laws to obtain stronger tools to make their job easier.
• They spend billions each year to collect every possible dollar from taxpayers.
• They employ accountants, CPAs, IT experts, criminal investigators, attorneys and others to close loopholes and to identify and prosecute violators.

Tax agencies utilize full-time experts focused only on one task-compliance. Shouldn’t you have the same for your business?

Recently, I completed an internal review for a company who wanted to prepare for an anticipated IRS employment tax audit.

Unfortunately, the company waited until they had already been contacted by the IRS before looking at their consultants’ status and proper documentation from a third-party’s objective perspective. It’s too late to lock the barn door after the animals have escaped and are running down the road.

This story is about two of the consultants I reviewed. I think it provides a great example of the complexity involved in making a proper worker classification. It also illustrates one of the principles I often talk about in my Collabrus training sessions: the ultimate determination decision is based on all of the evidence presented…any one factor will generally not make the decision between Independent Contractor or Employee status.

One looked like an IC (Joe) while the other looked like an employee (Jim). Both were doing almost identical work which typically is a red flag for auditors, who like to batch like consultants and make them all the same (their overwhelming bias of an auditor is to make everyone an employee. However, in this case I thought the company would be justified in distinguishing the status of these two individuals from each other.

Here’s a synopsis of the Tale of Two Consultants: Joe the IC and Jim the Employee.

So this was two consultants doing the same basic work but one looked like a legitimate Independent Contractor, while the other looked like a misclassified worker.

Last week Deputy Labor Secretary Seth Harris, speaking in Washington DC before the Center for American Progress (a pro labor research group) said his department intends to foster a stronger culture of IC compliance among employers to counter a practice he describes as follows: “They are playing a dangerous game of catch me if you can, and they are putting workers’ rights, even their lives, at risk…”

When stating employers are “putting…lives, at risk,” I assume he is referring to safety rules that apply to employees, but not to independent contractors, such as in the coal mining and construction industries.

As a side issue: The coal mining industry is specifically coming under close scrutiny by the Obama administration for environmental and safety issues.  To read more on this go to:  http://topics.nytimes.com/top/news/business/energy-environment/coal/index.html?inline=nyt-classifier

The Department of Labor wants companies to publish plans explaining why their consultants are IC’s.

This is just talk today-maybe a very soft “ping” to see what kind of reaction they get from private industry. But if the Department of Labor follows through it would require companies to prepare and adopt compliance plans aimed at ensuring they do not violate wage, job safety and equal employment laws. He indicated that the department’s proposed rules are still being drafted, and businesses will have a chance to respond before any final rules are issued.

What rules are being considered?

Deputy Secretary Harris said, “Employers will have to put together a plan that is designed to avoid violations of workplace laws…In safety and health, they will have to prepare a plan that will avoid safety hazard in the workplace. They will have to implement the plan, and they will have to make sure the plan, as implemented, is effective in avoiding violations for risks and hazards to workers.”

Or is it really about revenue?

During his speech, Mr. Harris also referred to Social Security taxes as an example of how companies avoid paying their fair share by misclassifying workers. This ties in to the recent partnership formed by the IRS and the Department of Labor to work together to investigate and prosecute employers who misclassify workers. Both agencies have received a significant increase in their budgets to fund this partnership.

If you wish to read more about the partnership go to:

 U.S. Department of Labor Plans to Crack Down on Employee Misclassification

This is just another squall contributing to the Perfect IC Compliance Storm. Have you prepared your company?

You get a letter from the state EDD or the IRS informing you that your company has been selected for an employment tax audit. Are you Ready?

Did you know that:

• Over 70% of all employment tax audits conducted result in a finding of misclassified workers?
• The EDD and the IRS win 90% of the cases that go to hearing or trial?
• The EDD and the IRS have been getting increased funding during this recession to enforce IC compliance?

Unfortunately it is too late to prepare for an audit challenge after you receive the letter, or a phone call from the auditor. The best time to prepare is now, before it happens.

Why?

Because audits review what was done in the past. Most statutes of limitations for an audit are three years. That means how you classified your consultants three years ago will be scrutinized today. Can you prove today what you did three years ago is right?

But you have a good attorney…

Many times upon receiving a notice of an audit companies will call an attorney. That’s not a bad choice, however, at that point it may be too late; the cow is already out of the barn!

A good attorney (one with experience in the area of employment tax and labor law) can help minimize the inconvenience and possibly some of the liability (except his fees of course); however:

• The audit will still happen.
• The assessment will still be issued.
• The audit results will be shared with other enforcement agencies.
• Misclassified workers may file civil suites.
• Word may get out to your customers and investors.

The best the attorney will do is minimize the damage-maybe-but it’s better if the audit never happened.

Your best defense is never to be selected for an audit

Enforcement agencies screen businesses to identify and select for audit only those that appear to be misclassifying workers. Agencies like California’s EDD have special units whose sole purpose is to identify businesses that appear to be misclassifying workers. Enforcement agencies like to know they will make a tax assessment before they contact you. They almost never perform survey, or random, audits.

So if you are doing it right, and there are no red flags, the odds are very low you will ever be selected for an audit. 

Even if you are selected for an audit the proper documentation can, and will, protect you.

It’s always possible something will cause your company to be selected for an audit. If this occurs just knowing you are right is not enough. However, the correct documentation can protect you.  An expert will know the information and level of detail required to protect you in the event of a challenge.

Don’t wait to react after you receive the letter.

You should call an expert like Collabrus now. We have the ability and experience to cost effectively help you attract the best talent and properly classify and document their status. But don’t’ wait until after an auditor or the investigator has called you.

Stay ahead of the curve.

Massachusetts-The State Supreme Judicial Court recently issued a ruling that increases the amount of damages a worker can receive if he or she has been misclassified as an independent contractor, even though he was paid at a higher rate than he would have gotten as an employee.  (Somers v. Converged Access, No. SJC-10347)

The company attempted to save money by making the engineer an IC, avoiding the costs of an employee.

A quality assurance engineer applied for work as an employee with a software company on two separate occasions. After turning him down a second time as an employee, the company offered him a position as an “independent contractor.” He accepted a 60-day term, because he needed the work, and then they extended his contract for another 90 days. 

They paid him at a higher rate than he would have been paid as an employee.  The client company believed paying at the higher rate protected them from future issues, such as  overtime, vacations, holidays or the other benefits offered to company employees.

Sour grapes set in.

In my seminars I tell of the literally thousands of incidents I have seen where the former IC decides he got a raw deal and files either a complaint with the local unemployment office for unemployment benefits, or finds an attorney and sues his former “client” for employee benefits, such as stock options, overtime, expenses, retirement benefits, etc. Either of these actions can lead to large unplanned liabilities for the company.

That’s what our engineer did. He brought a civil suit claiming, among other things, that he had been misclassified as an independent contractor. He sought to recover the value of the overtime, vacation pay, holiday pay and other benefits that he would have received had the company classified him properly as an employee.

What happened?

The company argued he was an IC. They also said even if he had been an employee he shouldn’t receive benefits at the higher pay rate he was paid as an IC, but should receive them at a lower rate an employee would be paid. They argued he would not have received as much pay as an employee. Paying him full benefits at the higher pay rate would be “unfair.”

The court disagreed. The final decision was the engineer was an employee entitled to all the benefits an employee should receive at his higher IC pay rate. 

The company gambled and lost.

It takes an Expert-not a Weekend Warrior

The company apparently did not consult an expert before venturing in to the worker misclassification jungle. They should have called Collabrus!

The Maryland Department of Labor, Licensing, and Regulation (DLLR) published its proposed regulations to implement the recently enacted Workplace Fraud Act of 2009 (the Act), which took effect on October 1, 2009. While the Act and regulations currently affect primarily those employers in the construction and landscape industries, all Maryland employers should pay close attention because all employers are covered under the law for unemployment insurance (UI) purposes. The state’s UI division investigates employee classification through both random and targeted audits and when a person claims UI benefits but is not listed as a covered employee. In addition, Governor Martin O’Malley has made it very clear that he hopes to target other industries as soon as possible.

This article provides a summary of the Act, highlights some of the DLLR’s proposed regulations and suggests how employers can take affirmative steps to ensure they are in compliance. In brief, the Act changes the standards by which employers in the construction and landscaping industries classify employees as independent contractors. The Act also awards back pay to employees who were misclassified and provides for substantial additional penalties for those employers that “knowingly” misclassify employees. Notably, even before the Act takes effect, employees in these (and other) industries already had protections against misclassification under the Fair Labor Standards Act (FLSA), the Maryland Wage & Hour Law, and the Maryland Wage Payment and Collection Law for these same purported violations. This new Act simply complicates employer compliance and will have the intended effect of increasing fines and penalties paid to the State of Maryland.

The Act creates a rebuttable presumption that all workers, including bona fide independent contractors, are employees. The existence of an independent contractor agreement between the employer and the independent contractor appears to be only a minor consideration. If challenged, the employer must demonstrate that:

• the individual is free from control and direction over the performance of the work both in fact and under the contract;
• the individual is customarily engaged in an independent business or occupation of the same nature as that involved in the work; and
• the work is outside of the usual course of business of the person for whom the work is performed.

This test appears to be more stringent than other similar tests, such as the “economic reality test” under FLSA, because there does not appear to be any flexibility in these requirements. If an employer fails to rebut the presumption of an employee/employer relationship, the DLLR can impose a penalty of up to $1,000 per misclassified employee and order restitution to any individual not properly classified. Under the Act, the DLLR is required to adopt regulations to provide further guidance on this section, which it has not yet done.

Significantly, if the DLLR can prove that there was a knowing violation of the Act, an employer can be subject to a penalty of up to:

• $5,000 per misclassified employee;
• $10,000 if the employer previously has been found in violation by a final order of a court or administrative unit; and
• $20,000 per misclassified employee for third time offenders.

In determining whether an employer “knowingly” violated the Act, the DLLR will consider, among other factors, the gravity of the violation, the size of the employer’s business, the employer’s good faith, and the employer’s history of similar violations.

Under these regulations, the DLLR also will consider previous violations of state or federal law that involve misclassification, the employer’s assistance in the investigation, and evidence of retaliation, among other factors. The proposed regulations also place affirmative duties on an employer when it contracts with an independent contractor. For example, a bona fide independent contractor agreement must now contain the following information:

• A statement by the employer that the independent contractor will perform the work according to the independent contractor’s own means and methods, free from control of the employer in all details connected with the performance of the work, except as to its product and result;
• Notification that the individual’s classification as an independent contractor means that they are not eligible for protection under protective laws, including, but not limited to, employment discrimination and anti-retaliation laws, occupational safety and health laws, living wage and prevailing wage laws, and wage and hour laws; and
• Notification that the independent contractor or exempt person is obligated to provide a “Notice to Independent Contractors and Exempt Persons” for independent contractors or exempt person with whom they contract.

Furthermore, employers in these affected industries must now create and maintain a recordkeeping system, which requires that employers track and maintain several different categories of information. Significantly, the Act mandates that each employer keep, for three years, a record of the hours that each independent contractor works each day and each workweek. This provision is particularly onerous because independent contractors are typically paid a flat fee, and the number of hours actually worked by an independent contractor is generally difficult, if not impossible, to monitor. Other recordkeeping requirements include a record of all licenses held by an individual classified as an independent contractor, as well as an acknowledgment form signed by the independent contractor that the employer provided all of the applicable notices required by the proposed regulations.

What Employers Should Do to Ensure Compliance

There are many other provisions in the Act that are of critical importance to employers in the landscaping and construction industries. To that end, every affected employer should review the Act and proposed regulations and monitor the DLLR’s website for other developments and additional proposed regulations. In addition, an employer may want to consider conducting an audit of their independent contractors using DLLR’s test as set forth in the Act to ensure their independent contractors are properly classified. This audit also should ensure that their recordkeeping systems and independent contractor agreements are in compliance with the final regulations.

If an employer is contacted by the DLLR, it is recommended that labor and employment counsel be contacted because a prompt and thorough response is required. Indeed, the DLLR may require an employer to identify and produce all records relevant to the classification of each alleged misclassified individual within 15 business days, may enter a place of business or work site without any prior notice, and may interview individuals at the work site or observe work being performed.

IRS Auditors Look at More Than Accounting Records When Auditing an IC’s Business

Collabrus works on behalf of client companies to help them safely and cost-effectively engage contingent workers in their business. As such, most of the articles I write are employer-centric. In today’s article I will look at the issue of IC Compliance from the perspective of the Independent Contractor. Specifically, an IC who is being audited by the IRS (not an uncommon occurance in today’s environment).

Of course, it depends on why the IRS auditor knocked on your door, but there are some general truths about an IRS audit you should know.

It’s not just income taxes…

If you are being audited for income tax issues the auditor may also examine employment taxes too, especially in today’s IC compliance environment. The auditor will first look at yours; did you pay your self employment taxes? But in addition, you may be defending any labor or contractor expenses you incurred by sub-contracting work out. You may be asked to prove they were really independent contractors and not your employees.

Be aware that:

1. The burden of proof is on you to prove their status-not the IC or the IRS.
2. The IRS will be looking at the past as much as the present so you may need to prove today what you did three years ago was correct.
3. Once the auditor starts looking at your consultants all of them are likely to be scrutinized.
4. The IRS shares information with the state agencies, so expect your state to follow up if you are out of compliance with the feds.

But there is more…the auditor is also looking at you personally-not just your books and records…

When conducting an income tax audit, the auditor wants to see how your lifestyle matches up with the income reported on your tax return. The IRS refers to this as “economic reality.” In other words, does the way you live match your reported income? The auditor will be observing:

• How you dress,
• If you have expensive jewelry,
• The type of car you drive,
• The home you live in,
• Do you take luxurious vacations to exotic places?

How does the money flow?

If your business handles a lot of cash, the auditor will look for skimming cash before reporting it as income.

If you are using a credit card or debit card for most of your purchases the auditor may track down the source of that card to see if you are hiding money off shore, in a secret account, and then drawing against it with the card.

Business expenses

If you use your personal car for business and deduct expense and depreciation expect it to be challenged. The IRS doesn’t believe personal autos are used 100% for business. It believes everyone uses them to run to the grocery store or the dentist and rarely allows 100% as a business expense. Be able to prove the mileage you claim for business with a detailed mileage log.

Business travel and entertainment expenses are another area where the IRS will challenge you. Be able to prove how they are business related.

There are others, but my best advice is not to get audited.

There are certain red flags that draw the IRS’ (and other enforcement agencies) attention. You need to be sure you aren’t waving those red flags, begging the IRS to audit you. How do you do that? Use an unbiased, third-party expert to do a risk assessment and advise you. It is too difficult to look at your own company objectively and see it the way the IRS will.