CLASSIFICATION OVERVIEW

Worker misclassification issues are now drawing more attention from the Internal Revenue Service (IRS) and various states. This is in part due to the widening tax gap and the need for additional revenues to close budget deficits at the Federal and state levels. Additionally, states continue to be dissatisfied with the actions at the Federal level and are taking action on their own. This activity has increased substantially over the last year.

Under the common law, an employer/employee relationship exists if the person contracting for the services has a right to control and direct both the results of the services and the means by which those results are achieved. It is not necessary that the employer actually direct or control the manner in which the services are performed, it is sufficient that the employer merely have the right to do so. Conversely, if a worker is subject to the control or direction of another person only as to the result to be accomplished by the worker and not as to the means and the methods, he or she is an independent contractor.

The IRS and Social Security Administration have developed a 20-factor test to assess the degree of control held by the person contracting for the services. These factors were compiled and published in Rev. Rul. 87-41, and were distilled from cases and rulings that considered the issue of worker classification. Another guideline interpreting the twenty factors is found in IRS Publication 937, which lists the twenty factors and their respective relevance to the classification of a worker. In fact, these factors are merely guidelines or analytical tools and the relative importance of each factor varies with the occupation at issue and the surrounding factual context. Finally, the IRS issued a detailed training manual in order to aid auditors in the classification of independent contractors. The manual breaks down the control analysis into three component parts: behavioral control, financial control, and relationship of the parties.

Behavioral control is shown by facts that illustrate whether there is a right to control how the worker performs the specific task for which he or she is hired. Financial control is shown by facts that illustrate whether there is a right to direct or control how the business aspects of the worker's activities are conducted. Finally, the relationship of the parties is shown by facts that illustrate how the parties perceive their relationship.

FEDERAL INITIATIVE

The IRS will be utilizing a new National Research Project (NRP) audit program to cover employment taxes. It will encompass 6,000 U.S. companies over a three-year period. Commencing in February 2010, 2,000 companies will be audited each year and if selected they will be notified via an IRS Letter 3850-B. The initial audits will be based on Federal Form 941s and then be analyzed into other areas. The companies will be chosen at random and will include both small and large companies, for-profit and non-profit companies, and public and private companies. Any employment tax issue that presents itself during the course of these NRP audits will be examined.

The IRS has indicated that its goal in performing this NRP audit program is to collect data that will be used to form a basis of new audit selection formulas and over the long-term improve results of employment audits. The compilation of trending data will primarily focus on four categories: worker classification, fringe benefits, non-filers, and executive compensation. In addition to the NRP audits, the IRS will be conducting regular employment tax audits of about 60,000 employers annually.

STATE INITIATIVES

New Jersey: Senate Bill 2773 was signed into law on January 14, 2010. This legislation is broad based covering all types of employers and provides that the New Jersey Department of Labor and Work Force Development can audit any employer that fails to maintain or report for one or more employees every wage, benefit and tax record required under state law, or fails to pay wages, benefits, taxes or other required assessments. In addition to fines imposed for misclassification, the new law provides that if the Commissioner of Labor and Work Force Development determines that an employer knowingly violated the law, the Commissioner is allowed to suspend any business licenses held by the employer. The length of this suspension will depend on a number of factors including the number of employees for which the employer failed to maintain the required records or pay the required wages; the total amount of wages, benefits and taxes involved; and whether the employer made a good faith effort to comply with any applicable requirements. If upon a second audit conducted within 12 months of the first, the violations have not been corrected, the legislation affords the Commissioner the ability to permanently suspend or revoke the employer's business licenses.

Maryland: Effective October 1, 2009, Maryland enacted the Workplace Fraud Act of 2009, Senate Bill 909, covering all employers in the construction and landscaping industries. This legislation granted specific authority to the State Commissioner of Labor and Industry to investigate misclassification of workers. Moreover, the legislation makes distinctions between employers that "improperly" classify workers from those that "knowingly" misclassify such workers. In the event an employer has improperly classified workers as independent contractors, that employer will be given a 45-day period to pay restitution to the affected workers and come into compliance with all applicable labor requirements in Maryland. Failing to fully comply and make the corrections may result in a civil penalty of up to $1,000 for each employee improperly classified.

Delaware: Effective October 29, 2009, Delaware also enacted legislation entitled the Workplace Fraud Act, House Bill 230, covering construction service employers. Under this legislation, each construction company must keep records of all employees for 3 years and this legislation provides penalties up to $5,000 per misclassification of a worker. In addition, employers who fail to produce requested records can be issued a stop-work order by the Delaware Department of Labor and fined up to $500 per day for each day the records are not produced. This legislation provides that an employer-employee relationship is presumed to exist when work is performed for remuneration, and places the burden on the employer to demonstrate to the Department of Labor that the individual is an independent contractor. Finally, any employer who violates the act twice in a two-year period will be assessed a $20,000 penalty for each employee misclassified and may be debarred for a fiveyear period from obtaining any public construction contract.

Pennsylvania: House Bill 400 (Construction Workplace Fraud Act) has passed the Pennsylvania House and is being considered by the Pennsylvania Senate. As with Maryland and Delaware, this proposed legislation specifically attacks worker misclassification in the construction industry. The bill provides a specific set of criteria to be met by a worker in order to be classified as an independent contractor. Additionally, the bill provides a rebuttable presumption as an independent contractor if certain criteria are met. Although criminal penalties were eliminated from the latest version of the bill, there are still substantial civil penalties as well as debarment for a period of up to three years.

Based upon this expanded and seemingly extensive effort by the IRS and various states, every company that engages independent contractors should be reviewing these relationships and taking proactive measures to minimize potential exposure that may arise.

Cozen O'Connor's tax attorneys work regularly with clients in reviewing their relationships with independent contractors and assessing worker classification issues. For more information, please contact Dan A. Schulder (Harrisburg, 717.703.5905, dschulder@cozen.com).

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