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New Crackdowns on Independent Contractor Relationships

[NOTE: Information and guidance in this article is intended to provide accurate and helpful information on the subjects covered. It is not intended to provide a legal service for readers' individual needs. For legal guidance in your specific situation, always consult with an attorney who is familiar with employment law and labor issues. This article was brought to you by Bell and Company and was reprinted with permission.]

Employers using independent contractors are facing increasing risks. That's because the U.S. Labor Department, the IRS and many states have implemented new initiatives to search for employers who misclassify employees as independent contractors. The latest example: President Obama's fiscal 2011 budget calls for hiring new federal investigators to help uncover improper classification cases. Here is a rundown of the new programs, as well as the steps employers can take to help protect themselves when engaging in independent contractor relationships.

Uncle Sam and States Look for Revenue in Worker Classification

Businesses that treat workers as independent contractors face an increasing risk that state and federal agencies will contest the classification of some of these individuals. Although independent contractor relationships have long been an audit target, governments experiencing deep financial pressures are scrutinizing them with new fervor.

Latest example: In his fiscal 2011 budget, President Obama proposes to focus more on employers using independent contractors. For the next fiscal year, the budget allocates $25 million to the Department of Labor for a joint effort with the IRS that includes hiring investigators to find workers who can be re-categorized as employees.

The result for Uncle Sam will be increased revenue. The Obama budget states the initiative will bring in an additional $7 billion over 10 years.

The budget initiative is the latest government effort to reclassify workers (see right-hand box for more examples).

When employees are misclassified as independent contractors, it often results in failure of the workers and employers to correctly pay income taxes, Social Security, Medicare and unemployment insurance taxes. That means substantial lost revenue to the federal and state governments.

What's a Business to Do?

There are several steps a business can take to increase the chance that workers are properly classified as independent contractors.

1. Have written, signed contracts with workers classified as independent contractors, spelling out the terms and conditions of the relationship. Consult with your attorney in the preparation of contracts.

2. Once contracts are in place, give outside workers leeway over how they perform their duties. Resist the urge to supervise them the way you oversee employees.

3. Send each contractor a Form 1099 showing non-employee income if you pay $600 or more in a calendar year. The annual deadline for sending these forms is January 31.

4. Consistently treat workers performing similar tasks as either independent contractors or employees. Don't supply outside workers with services you give employees. Some companies run into trouble after they provide office space, computers, cars and other perks.

5. Maintain good records. Obviously, you need to keep an independent contractor's taxpayer ID number and other information required by the IRS, but you should also keep items that help prove the person is self-employed. For example, business cards, a letterhead, invoices and advertisements placed in newspapers. Keep copies of business licenses and print out a contractors' Web site pages showing that services are offered to the public. A simple listing in the yellow pages of the phone book is sometimes enough to convince an IRS auditor that an independent contractor is in business for him or herself.

6. Do a self-audit of each worker's or each class of workers' status before a federal or state agency conducts one.

7. Have your tax adviser, attorney or HR professional familiar with employment law in your state conduct an audit of each worker's status.

What Does the IRS Look For?

Unfortunately, no single factor determines a worker's status by the IRS, other government agencies or the courts. Each situation is determined by the facts and circumstances involved.

Here are some of the factors the IRS considers to determine if a worker is an employee:

* Behavioral Control - An employee generally is told when, where, and how to work, as well as what order or sequence to follow.

* Tools - An employer usually gives tools, equipment and workspace to employees. In contrast, subcontractors often provide and invest their own money in equipment, tools and facilities.

* Assistants - Employees don't hire and pay others to help them do their jobs (although they may be told to hire assistants for the company). In contrast, contractors often hire, supervise, and pay their own assistants.

* Training - Employees are more likely to receive training from an organization than independent contractors.

* Other Customers - Independent contractors generally make services available to the public and are able to work for two or more businesses.

* Integral Role - An employer-employee relationship is supported when workers perform a service essential to the success of a business operation.

* Financial Control and Risk - An employer has the right to control the financial aspects of a job, such as the business expenses the employee incurs and how staff members are paid. On the other hand, a worker's opportunity to personally earn a profit and assume risk of loss may indicate a non-employee status.

An IRS determination that worker's status is an independent contractor status doesn't necessarily bind other agencies (such as the National Labor Relations Board) in making their decisions. However, the IRS tests for making its determination can help an employer avoid misclassifying a worker.

Conclusion: During recent tough economic times, many businesses increased their use of independent contractors to cut labor costs. However, employers that misclassify workers as independent contractors can end up with substantial tax bills as well as penalties for failing to pay employment taxes. They may also face employee benefit liability. In some cases, workers sue for benefits they claim they were eligible for, including overtime, health insurance and retirement plan contributions.

With the increased scrutiny coming from the federal and state governments, it's a good time to examine your organization's use of independent contractors to ensure you are in compliance with all applicable laws.

How Governments Are Targeting Organizations Using Contractors

In addition to the new budget program targeting independent contractors, here are some other examples of initiatives at the federal and state level:

Random Audits - Beginning in February 2010, the IRS launched a three-year program to randomly audit 6,000 employers. These examinations will delve into compliance with employment tax issues, including the misclassification of independent contractors, fringe benefits, reimbursed expenses and the compensation of owner-employees.

Information Sharing - The IRS signed information-sharing agreements in 2008 with labor and workforce agencies in 29 states, to assist them in uncovering employment tax avoidance schemes" and ensure proper worker classification."

Questionnaires Sent - In 2009, California sent employment relationship questionnaires to workers identified as independent contractors. The purpose was to determine if the workers should be classified as employees. The state's attorney general is taking action against a construction company, seeking more than $4 million. Last year, California won a $13 million court judgment from two firms that misclassified janitors.

Construction Focus - A 2008 Illinois law targets the construction industry and sets out heavy fines for misclassification. In one case, the state's Department of Labor levied penalties of more than $325,000 against a home improvement company for categorizing employees as independent contractors.

Increased Policing - An Iowa task force issued a 2009 report stating that about 15 percent of employers wrongly classified workers. The task force called for increased policing of classification in the state.

Exemptions Required - Last year, Minnesota started requiring certain individuals who want to work as independent contractors in the construction industry to obtain an exemption certificate from the state Department of Labor and Industry.

Multi-Industry Effort - New York continues a crackdown that began in 2008 targeting the construction industry, restaurants, car washes, janitorial firms, and trucking companies. Nearly 2,500 investigations were conducted with teams converging on some employers' premises to audit records. The effort reportedly found more than 31,000 misclassification cases and assessed $11 million in unpaid unemployment taxes and $14.5 million in unpaid wages.

Independent Contractors Can Tip
The IRS Off About Relationships

Be aware that the IRS has a couple ways for independent contractors to contact the agency about their employment status. In 2009, the IRS came out with new Form 8919 that allows workers who believe they have been misclassified as independent contractors to report half of the uncollected Social Security and Medicare taxes due. Once the IRS has the information, it may contact the businesses involved for the other half.

In addition, IRS Form SS-8 allows workers or businesses to give the IRS information about a relationship and ask the agency to determine if an individual is an employee or independent contractor.

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