Independent Contractor Compliance Blog

Common Misclassification Traps


At one time or another, almost every business has engaged a consultant who insists on being an independent contractor (IC) when s/he really doesn’t meet the qualification test. Often the consultant insists the only way s/he will work is as an IC. Everyone does what they believe is necessary to get the job done. In most cases, it turns out well.

However, sometimes companies come to regret this decision. The real danger can hit two or three years after the project is over. Here is a very common scenario:

-  The consultant, who once insisted on being an IC, is now applying for unemployment benefits; especially in the current economy where projects can be more difficult to secure. The consultant learns that only ex-employees (not ex-ICs) are entitled to unemployment benefits, and the consultant’s perception of the project begins to change.

-  The consultant contacts the unemployment office and a sympathetic caseworker wants to help the former consultant receive benefits.  The issue is referred to a state employment tax audit office to verify the status. In the meantime, the former consultant may be paid benefits on the assumption s/he was misclassified.

-  When the state tax auditor receives the assignment, an information gathering process begins:

  1. Verifying the correct IC status of the former consultant
  2. Arranging a tax audit to review all potential misclassified workers in the company — not simply the consultant who filed a claim

The result is that companies may need to prove that every IC engaged during the statutory period (normally three years) was properly classified. This common scenario accounts for tax audits on thousands of businesses each year.

Other facts to consider are:

  • The consultant applying for unemployment benefits is no longer loyal to the company, because he needs benefits and his perspective has most likely changed.
  • The manager may have moved on and is not available to provide details about the working relationship.
  • Even if there are still people who remember the details of the project, their memories have faded — details are lost about the day-to-day working relationship.
  • The auditor will give the former consultant’s version of the working relationship more weight than the company’s, unless the company has some very convincing evidence.
  • Companies’ primary evidence is typically a written contract predicting what was going to happen in the future, while the auditor is looking at what actually happened in the past. In addition, written contracts rarely provide the level of detail required to resolve a classification issue.
  • Statistically, more than 70% of employment tax audits result in a finding of misclassified workers. One reason for this high rate is that the burden of proof is on the business to prove it acted correctly, not on the government to prove its tax assessment is correct.

Misclassification challenges can also result from other incidents.  For example:

  • A consultant is injured on the job
  • A consultant alleges unjust treatment
  • The consultant claims entitlement to employee fringe benefits

In any of these cases, the consultant may be telling the tax auditor, attorney or the judge that the project was accepted as an IC because it was the only way to get work. Enforcement agencies refer to this as an adhesion contract and use it as evidence there was direction/control from the employer’s side. Usually, they find that the consultant was a misclassified employee.

The best way to prove the IC was properly classified is to have an expert qualify the consultant and then secure and maintain the proper documentation from the project’s inception.

Disclaimer: Given the general nature and context of this article, the material presented should not be relied upon or construed as either tax or legal advice. For specific information on recent developments, the effects of particular factual situations or of a particular law in regards to your business, or before making decisions based upon this presentation, you should obtain the opinion of a qualified expert.

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