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Employee or Independent Contractor?

Costly Consequences for Worker Misclassification

When business is growing and companies are adding workers, classifying employment status of each one can be tricky. Accidental misclassification of workers carries penalties and payment of back wages. Intentional misclassification of workers can carry criminal penalties and back wages.

Since the Fair Labor Standards Act (FLSA) passed in 1938, employers and workers have faced the dilemma of determining the appropriate classification, such as exempt vs. non-exempt, employee vs. independent contractor, etc. While the answer may seem obvious in most circumstances, some situations leave both sides scratching their heads. What is not in question, however, is the fact that state and local governments around the country are stepping up investigation and enforcement. Misclassification of workers costs taxpayers millions, and companies found guilty of misclassifying their workers can pay millions in fines.

According to the Department of Labor (DOL): “Misclassification of employees as independent contractors presents a serious problem for affected employees, employers and the entire economy. Misclassified employees often are denied access to critical benefits and protections – such as family and medical leave, overtime, minimum wage and Unemployment Insurance – to which they are entitled. Employee misclassification generates substantial losses to the U.S. Treasury and the Social Security and Medicare funds, as well as to state Unemployment Insurance and workers’ compensation funds. Misclassification also creates a competitive disadvantage for employers who comply with the law.”

Says noted construction industry attorney Joe F. Canterbury, Jr. of the Dallas-based firm Canterbury, Gooch, Surratt, Shapiro, Stein & Gaswirth, P.C., who serves as general counsel for the American Fire Sprinkler Association (AFSA): “Contractors who operate on the up and up, paying their employees as employees and providing the applicable training and benefits, are often at a 30-percent disadvantage when bidding against unscrupulous or uneducated contractors that classify their installers as independent contractors.”

Why? Employers that classify workers as independent contractors instead of employees avoid paying the following expenses:

  • Employer’s share of Social Security and Medicare taxes
  • Overtime pay
  • Employee benefits, including vacation, holiday and sick pay
  • Unemployment compensation tax
  • Workers compensation insurance.

Canterbury notes that the practice has been around for years and occurs across many industries – from construction contractors, to health spas, hotels, nursing agencies, restaurants, grocery stores, day care facilities, and more. However, in recent years the government’s ability to investigate and prosecute the violators has improved considerably, and penalties for noncompliance can be severe. In fact, criminal penalties of up to $1,000 per misclassified worker and one year in prison can be imposed, and the person responsible for withholding taxes can be held personally liable for any uncollected taxes plus penalties under the Internal Revenue Code (IRC).

The DOL reports that its Misclassification Initiative is making great strides in combating the issue.

“In September 2011, former Secretary of Labor Hilda L. Solis announced a major step forward with the signing of a Memorandum of Understanding (MOU) between the Department and the Internal Revenue Service (IRS). Under this agreement, the agencies will work together and share information to reduce the incidence of misclassification of employees, to help reduce the tax gap, and to improve compliance with federal labor laws.

“Additionally, labor commissioners and other agency leaders representing 22 states have signed MOUs with the Department’s Wage and Hour Division, and in some cases, with its Employee Benefits Security Administration (EBSA), Occupational Safety and Health Administration (OSHA), Office of Federal Contract Compliance Programs (OFCCP), and the Office of the Solicitor. The Department is actively pursuing MOUs with additional states as well.

“These MOUs will enable the Department to share information and to coordinate enforcement efforts with participating states in order to level the playing field for law-abiding employers and to ensure that employees receive the protections to which they are entitled under federal and state law.”

In Fiscal Year 2013 alone, Department of Labor Wage and Hour Division investigations resulted in more than $83 million in back wages for more than 108,000 misclassified workers. Some examples of recent fines announced by DOL include:

  • January 29, 2015: “Specialty Painting & Wall Covering Inc. and M & S Enterprise have paid 22 painters and sheetrock installers $108,783 in overtime back wages after an investigation by the U.S. Department of Labor’s Wage and Hour Division. The investigation revealed violations of the Fair Labor Standards Act’s overtime and record-keeping provisions and found that workers at M & S Enterprise were misclassified as independent contractors.”
  • December 9, 2013: “Norwood Commercial Contractors Inc. has agreed to pay 96 workers $395,465 in back wages and liquidated damages following an investigation by the U.S. Department of Labor’s Wage and Hour Division. The investigation found that the commercial construction contractor misclassified 16 workers as independent contractors ….”
  • May 9, 2013: “The U.S. Department of Labor has obtained a consent judgment in federal court ordering Bowlin Group LLC and Bowlin Services LLC to pay 196 employees a total of $1,075,000 in back wages and liquidated damages. … defendants misclassified 77 employees as independent contractors and violated the Fair Labor Standards Act ….”

Enforcement Evens Competition Many AFSA members across the country welcome the increased enforcement with the hope that it will level the playing field in bidding jobs. For example, contractors in AFSA’s Carolinas Chapter have been working with the North Carolina State Board of Examiners of Plumbing, Heating & Fire Sprinkler Contractors to strengthen the language in the state’s laws for more effective enforcement.

North Carolina requires work in several trades – including plumbing, heating and fire sprinkler – to be performed by a state licensee, and it is a clear violation of the state licensing law to misclassify employees. Presently the statute requires that a person conducting the work be individually licensed or be a bona fide employee of a licensed company.

Dale L. Dawson, executive director of the North Carolina State Board of Examiners of Plumbing, Heating & Fire Sprinkler Contractors, says that in recent years the state received a large number of complaints where licensed contractors were subcontracting work that requires a license to persons who do not hold a license or are not on a licensed contractor’s payroll. However, Dawson notes that pursuing violators has been difficult because the Board does not have audit authority; therefore, they have to wait for a complaint to be filed before they can investigate, and at that point they must obtain W2 or 1099 documentation from the employees involved before they can investigate the company in question. If the individual has been working as a subcontractor to a licensed contractor – submitting a 1099 rather than W2 – it is a clear violation of the state licensing law. If the state licensing Board confirms a violation, the most it can do is revoke a license.

A series of articles that appeared in the Charlotte News & Observer, the Charlotte Observer and several other McClatchy Company newspapers last year called attention to the problem in North Carolina and six other states and awakened officials to the significant tax revenue loss – estimated $467 million per year in North Carolina alone – as a result of employee misclassification. The attention stirred by these articles prompted a number of administrative and enforcement changes by state officials and legislators.

Proposed legislation and/or amendments currently under consideration in the North Carolina State Legislature clearly define criteria used to determine employee or independent contractor status, state that misclassification is prohibited, and identify civil penalties. If adopted, the legislation will establish an Employee Misclassification Task force to investigate complaints and share information among applicable enforcement agencies. It also will provide audit authority to the state Board, allowing random audits of company records. Dawson says having the ability to audit company records would allow the Board to identify and investigate violations much earlier.

Determining the Relationship Joe Canterbury explains that on a national level federal courts have consistently applied a five-factor test, which examines:

(1) degree of control exercised by the alleged employer;

(2) extent of the relative investment of the worker and the alleged employer;

(3) degree to which the worker’s opportunity for profit or loss is determined by the alleged employer;

(4) skill and initiative required in performing the job; and

(5) permanency of the relationship.

However, according to the IRS: “There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making the determination. Also, factors that may be relevant in one situation may not be relevant in another. The keys are to look at the entire relationship, consider the degree or extent of the right to direct and control, and finally to document each of the factors used in coming up with the determination.”

An employee cannot waive employment status. Therefore, even if an individual signs an agreement self-identifying himself or herself as an independent contractor, that is not sufficient to remove the employee from the FLSA. If that individual is expected to report to work at a specified time, at a specified wage, and perform work under the supervision of the employer, he or she will almost certainly be classified as an employee. If, however, the individual has negotiated and signed an agreement to complete a certain project for a specified amount of money and by a specified deadline, and that individual can choose when and how that project will be completed and can also be eligible to work on other contract projects for other employers during the same time, then the relationship is more likely to meet the definition of independent contractor.

If after reviewing all the definitions a worker’s status is still unclear, a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding, can be filed with the IRS. The form may be filed by either the business or the worker, but it may take at least six months to receive an official determination.

Conclusion Increased scrutiny from the DOL, IRS, individual states and the media should prompt all businesses that hire independent contractors to review their practice for compliance with the laws. Businesses that have made mistakes in employee classification and want to correct the situation may take advantage of the IRS Voluntary Classification Settlement Program (VCSP). The VCSP “provides an opportunity for taxpayers to reclassify their workers as employees for employment tax purposes for future tax periods with partial relief from federal employment taxes. To participate in this voluntary program, the taxpayer must meet certain eligibility requirements and apply to participate in the VCSP by filing Form 8952, Application for Voluntary Classification Settlement Program, and enter into a closing agreement with the IRS. In 2013, the IRS expanded its VCSP. Under the revamped program, employers under IRS audit, other than an employment tax audit, can qualify for the VCSP.”

Employers that have questions about worker classification will find helpful information at the and websites, including answers to frequently asked questions and downloadable fact sheets. Links to additional information and references are provided below.

Helpful Resources

For employers that have questions about classification of workers, the DOL and IRS websites have information available, including downloadable fact sheets. Some helpful links are listed below:

EDITOR’S NOTE: Our thanks to Dale Dawson of the North Carolina State Board of Examiners of Plumbing, Heating & Fire Sprinkler Contractors and Joe F. Canterbury, Jr. of the Dallas-based firm Canterbury, Gooch, Surratt, Shapiro, Stein & Gaswirth, P.C., for their assistance in the preparation of this article.

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