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Misclassification mistakes: Know risks and prevention strategies

It’s almost an understatement to call misclassification of employees as independent contractors a hot topic. It’s certainly the subject of a growing list of court cases, government agency investigations, and legislative initiatives.

Various agencies at both the state and federal level have been in crackdown mode for a few years now, and it’s no wonder: Misclassification is blamed for putting worker rights in jeopardy and for being the source of billions in lost tax revenue.

So what should employers do? They should start by being on guard.

Susan Fentin, a partner with Skoler, Abbott & Presser, P.C. in Springfield, Massachusetts, spoke on the issue at the Advanced Employment Issues Symposium (AEIS) on October 4 in Nashville, Tennessee. She pointed out that the IRS has estimated 15 percent of all employers misclassify workers as contractors — about 3.4 million workers. That amounts to an ongoing and growing loss of revenue owed to the government.

In addition to lost tax revenue, workers classified as contractors aren’t eligible for employer-provided benefits, workers’ compensation, and unemployment benefits. They’re also not covered under wage and hour laws and antidiscrimination laws meant to protect employees.

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Determining the problem
When someone working as a contractor looks too much like a worker who would properly be classified an employee, antennas go up at no less than three federal agencies. But just what a properly classified contractor looks like can be unclear.

How can an employer tell the difference? “It depends,” Fentin says. Employers have to consider state statutes, court decisions, and rules and tests from federal agencies. The IRS has a 20-factor test; the Equal Employment Opportunity Commission (EEOC) has a 16-factor test, and the U.S. Department of Labor (DOL) applies an “economic reality test” based on the Fair Labor Standards Act (FLSA).

The various tests consider how much control and independence the worker has, among other things. For example under the IRS test, factors showing the extent of the worker’s control and independence are placed in three categories explained on the IRS website:

  • Behavioral control: Does the company control or have the right to control what the worker does and how the worker does the job? If so, the worker may not be properly classified as an independent contractor.
  • Financial control: Are the business aspects of the worker’s job controlled by the payer? (These include things like how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, etc.) If the business exercises too much control, the worker is likely an employee, not a contractor.
  • Type of relationship: Are there written contracts or employee-type benefits (i.e., pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business? A “yes” answer to those questions may indicate employee status.

The DOL test considers factors such as how integral the worker’s services are to the business; the permanence of the relationship; the worker’s investment in facilities and equipment; how much control the business exercises in the worker’s work; whether the worker has the opportunity for profit and loss; how much initiative, judgment, or foresight is required of the worker; and the extent to which the worker’s business organization is independent.

Fentin points out that the EEOC test parallels the other tests but also looks at whether the work is highly skilled or requires expertise. Generally the lower the skill and expertise, the greater the chance that the worker is an employee.

Classification mistakes can be costly. Fentin points out that failure to pay minimum wage or overtime can result in liability for business entities as well as for individuals. Plus, the employer can be on the hook for attorney fees, damages, unpaid wages, and taxes, plus other remedies under state law.

The federal government offers the Voluntary Classification Settlement Program (VCSP) that allows companies “to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes,” according to the IRS. Businesses must meet eligibility requirements to qualify for the program.

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Recommendations
Although proper classification can be tricky, Fentin has some suggestions for employers wondering if they’re in compliance. She suggests:

  • Know the laws in your state and how they affect the general employment relationship and who is eligible for unemployment and workers’ compensation.
  • Schedule a classification audit with labor and employment counsel.
  • Audit companies or agencies providing contract workers to determine any joint employment status.
  • Keep in mind that the existence of a contract doesn’t ensure someone is a contractor. Likewise, the worker’s preference to be considered a contractor doesn’t make a difference.
  • Be aware that employees cannot waive rights under wage and hour law.
  • If misclassification is suspected, check if any “safe harbor” applies, such as a court case or IRS ruling or audit. Also consider applying for the VCSP.
  • Make sure any independent contractor agreement shows evidence that the worker is truly independent.