United States: Got Independent Contractors? (Are You Sure?)

Last Updated: February 17 2012
Article by Bryan J. Lazarski

As we embark upon 2012, now is an excellent time to evaluate your company's practices with respect to its workforce. In particular, a common issue facing many employers in California, the misclassification of employees as "independent contractors," will be subject to increased penalties under a new California law in 2012, which may warrant action in the new year. Misclassification can have serious ramifications from both an employment and a tax perspective. For several reasons, now may be a good time to correct misclassifications and ring in the new year with a compliant start.

Independent Contractor or Employee? A Quick Self Examination

The difference between an independent contractor and an employee is a legal distinction that may not always be straightforward or easy to recognize. A dangerous but pervasive myth is that a company can simply agree with a worker that he or she shall be treated as an "independent contractor." This is entirely untrue. Whether a worker qualifies as an independent contractor or an employee is determined by the realities of the relationship between the parties, which cannot be overcome by agreement or contract.

Federal and state enforcement agencies apply a multi‐factor analysis to analyze classifications. Ultimately though, the main distinction boils down to whether the employer/principal only has the right to control the result of the work or if it also controls the manner and means of how the work will be done. If it's the latter, the worker is probably an employee.

A quick test to determine whether you may have a misclassified independent contractor in your organization is to take a look at anyone you currently treat as an independent contractor, which includes anyone whose pay you report by IRS Form 1099.

Ask yourself:

  • Are they working full‐time (or close to full‐time) for you?
  • Are they expected to work regular hours with you (i.e. a set shift like 9‐to‐5)?
  • Do they work exclusively or almost exclusively at your facilities?
  • Do they wear uniforms or use tools or equipment you provide?
  • Are they expected to continue their work for your company indefinitely (as opposed to a finite project)?

If you answered "yes" to any of these questions, you may have an employee that has been misclassified as an independent contractor.

Why Act Now?

Unfortunately, identifying misclassified independent contractors is only part of the battle. There are also several things to consider when reclassifying a worker to employee status. Among other things, and depending upon the situation, you may owe back taxes, have liability for unpaid overtime, and be subject to other fines and penalties. If done correctly though, a well‐timed, well‐executed voluntary reclassification can significantly reduce or eliminate your risk of a much costlier lawsuit (or a class action lawsuit if there are multiple misclassified contractors).

There are two new legal issues that may influence your decision to act now:

1. Increased Penalties in California—The Stakes Are Going Up: On October 6, 2011, Gov. Jerry Brown signed SB 459 into law, which provides for significantly increased penalties for misclassification, effective January 1, 2012. The new penalties range from $5,000 up to $25,000 in some instances per misclassified worker. There is also a "public shaming" provision of the new law, under which employers who are found to have misclassified workers must post a statement on their company website for a year stating that they violated the law.

In recent years, both federal and state authorities have devoted increased resources to finding and punishing employers who misclassify workers. Because of the penalties and back taxes that authorities can assess for misclassification, seeking out noncompliant employers is a major revenue generator for them, so this increased attention is not likely to go away any time soon. It is also a major revenue generator for the Plaintiff's bar, who frequently file lawsuits to recover on behalf of misclassified workers.

2. Tax relief: From a tax standpoint, generally you must:

(a) withhold income, Social Security and Medicare taxes, and

(b) pay payroll and unemployment taxes on employee wages, which is generally not true for independent contractors. For this reason, any misclassification could lead to years of noncompliance with various tax codes, resulting in back taxes, interest and penalties.

This past September, though, the IRS announced a safe‐harbor program for employers who voluntarily reclassify employees. This safe harbor program could significantly reduce federal tax liability for a misclassification, but it also provides the potential for other adverse legal consequences and should be undertaken with caution and in consultation with counsel. Among the potential downsides, applicants for the IRS program should be aware that their company may not be able to avoid penalties from other governmental agencies. For example, the California Employment Development Department is not presently providing any safe harbor for back taxes.

Secondly, applying for the IRS program could potentially be construed as an admission of prior wrongdoing in an action against the company to recover back wages/benefits for the misclassified worker(s). Nevertheless, the federal safe harbor may provide a significant tax incentive to reclassify now while the program lasts, and it warrants analysis if your company is considering reclassifying any of its workers. More information on the IRS program is available here: http://www.irs.gov/newsroom/article/0,,id=246203,00.html.

If you believe you may have a misclassified independent contractor working for you, you should consult with counsel to discuss a suitable plan of action.

Bryan J. Lazarski is an Associate in the firm's Labor & Employment Practice Group in the Los Angeles office.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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