July 9, 2015

Many companies are utilizing independent contractors over hiring new employees, due largely in part to increasing employment tax burdens and a recessed economy. From an initial cost perspective, this makes sense. However, businesses should be aware of the benefits and detriments that come with using independent contractors, especially in positions that have been traditionally filled by employees.

The benefits of independent contractors are fairly well-known. Independent contractors offer employers flexible staffing arrangements. They usually charge fixed costs that help with budgeting. By working independently from their client, they can even reduce “agency” issues that cause liability risks. Most notably, businesses hiring independent contractors can avoid state and federal unemployment insurance taxes, state income withholding taxes, Social Security and Medicare taxes, worker’s compensation coverage, employee benefits, and greatly reduce their need to comply with employment and immigration laws. By avoiding these areas, employers can greatly reduce regulatory and tax burdens (as well as corresponding financial costs.)

There is a downside. Misclassifying an employee as an independent contractor can lead to significant legal and financial risks. The likelihood of this occurring is increased by the number of tests utilized by the IRS, common law, and other federal and state agencies (the Darden, Economic Realities, and Hybrid tests to name a few). Many of these tests are specific to a particular area of law. For instance, the IRS adopts a holistic three factor test that adapts to the issue in question (i.e. exemptions from the FLSA). It also has its own statutory exemptions and classifications. The IRS may apply these tests when determining whether an employer is properly remitting taxes on its workers. Missouri courts, on the other hand, follow a “right to control” test coupled with specific tests that will be utilized for the particular laws in question. In any event, it is crucial that all federal and state tests are satisfied for each worker.

In addition to meeting the applicable tests, employers are now under heightened scrutiny by the US Department of Labor, the IRS, and some state departments of labor and revenue. In 2011, the US DOL and IRS signed a Memorandum of Understanding, agreeing to work together to share information that could help identify misclassified workers. Currently, Missouri is one of at least 22 states that have signed similar Memorandums of Understanding with the US DOL (Kansas has not). Under this movement, known as the “DOL Misclassification Initiative,” the US DOL, IRS, and member states are now actively working to share and collect information that may identify employers with unpaid overtime, unemployment insurance, workers compensation premiums, and taxes due to wrongfully classified independent contractors. Many Midwest states have joined the initiative with other states expected to follow.

The penalties for misclassification can be severe. Missouri’s Division of Employment Security requires employers who defraud the state through misclassification pay 25% of the amount owed (100% if there is a prior history) plus a fine between $50 and $1,000 per day, per worker misclassified. The employer will also be liable for any unpaid taxes on the worker’s earnings plus a 5% penalty. The company’s owners can even be held personally responsible for the taxes, interest, additions, and penalties if the amounts go unpaid. These penalties are in addition to the state’s worker’s compensation laws, IRS penalties, and civil claims that could be brought by the misclassified worker. However, companies can take steps to ensure that a worker is truly an independent contractor.

Step 1: Careful Contract Drafting. A properly drafted service contract (not an employment contract) is often the starting point of any IRS evaluation and, while it is not conclusive, is evidence of the worker being an independent contractor. This is especially true if both parties follow its terms during their working relationship. With assistance from counsel, companies can construct such an agreement to foster a relationship that satisfies most factors under the applicable tests. Independent contractor agreements often place taxes, insurance, business licensure, and other obligations on the worker and often require compliance with industry standards. Service agreements should also clearly outline the worker’s responsibilities and duties while limiting the length of the contract. Requiring indemnification procedures in the event of a breach is another factor that points to an independent contractor relationship.

Step 2: Procedural Steps. In addition to a proper agreement, the company has several options for securing its independent contractors classifications. Audits by third parties can provide an objective determination. Providing worker training can help independent contractors comply with most applicable laws. A company can even obtain a ruling from the IRS on Form SS-8, stating whether a particular worker’s classification is proper (this last step can take up to 6 months, but creates a strong presumption of compliance). Effectively filing a Form 1099-MISC and staying current on all tax returns will help as well. There is also a safe harbor under IRC 530 for employer-owed taxes if a company can show that it had a reasonable basis for misclassification, treated all similarly situated workers as independent contractors, and reported all federal tax returns necessary for independent contractors. Other methods can also be utilized for making a proper determination.

Utilizing independent contractors is not always a risky venture.   Many times the position served by the contractor may be appropriate and poses little risk to the employer. However, if there is a question about the accuracy of the classification or about the means used for making the determination, then seeking legal advice may be appropriate.


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