Saving your company from ruins due to worker misclassification
Executive Summary
Over the years, full-time employees in the United States have enjoyed the fruits of long-term employment benefits where a good majority of the baby-boomers practically worked for a single employer until retirement. However, business circumstances have lead to a new trend in the industry over the last 2 decades where companies have adopted a contingent workforce comprising of independent contractors in almost every industry, including IT or Information Technology.
From the business perspective, this was welcomed and embraced by employers who saw opportunities to enhance their bottomline due to perceived or realized cost savings from this new industry practice. The use of these contingent workforce enabled high scalability for companies to wind-up or wind-down resourcing depending on business demands. Add to that the realized benefits due to decrease in amount of employment taxes and costs of employee benefits, and exempting the companies from responsibilities under the traditional labor laws.
However, as years pass by, the concept of contingent workforce was so over-used which can lead to significant risk exposure for companies who misclassify independent contractors. This was obviously attributed to their lack of understanding on the underlying differences between an independent contractor and an employee. The grey area had since grown much wider and complicated as interested parties took notice of it and started asking the right questions.
While most companies understood that such worker misclassification have penalties such as increased tax liabilities, this is just the icing and not the cake. Some employers have not yet considered the full devastating impact of other problems it can bring to them such as unpaid benefits, attorneys and court fees, etc. To sum it all up, the total business impact of worker misclassification can actually cost these companies their whole business.
However, proactive initiatives by companies to conduct third-party audits bring in good value to their organizations. This is especially so in order to understand better and mitigate risks involved in employing these independent contractors. In the recent years, we can take a look at actual cases related to workers misclassification and gain a deeper insight on the complexity of the issues, and how your company can avoid the pitfalls of erring companies in the business.
FedEx: A Case of Independent Contractor Misclassification
The company received a bad news from the Internal Revenue Service (IRS) on December 22, 2007 with regards to independent contractor misclassification issue. The IRS has assessed approximately $319 million in back taxes by FedEx for tax year 2002 due to misclassifying a great number of FedEx Ground/Home Delivery drivers as “independent contractors” instead of as employees. FedEx has disclosed this decision of the IRS in its recent filing with the US Securities and Exchange Commission. The $319 million assessed liability was only for 1 tax year, you must understand, and it can still increase when the IRS start looking at their other tax years for similar infractions. Class action lawsuits against FedEx have also increased in number around the country, and over 50 lawsuits were consolidated at a federal court in South Bend, IN. The class action involving around 14,000 current FedEx Ground/Home Delivery drivers nationwide may still grow with inclusion of additional 10,000 former drivers. In California, FedEx’s position was further challenged as the California Supreme Court released its decision on the case Estrada vs. FedEx which affirmed an Appeals Court ruling that FedEx Ground/Home Delivery drivers were indeed misclassified as independent contractors instead of as employees of the company.
While FedEx has been largely considered as the common example for worker misclassification, it used to be Microsoft Corporation who carried that bill for a while back then. Sometime in the late 1980s, the company employed around 1,000 workers under the category of independent contractors. As part of their processes and procedures, those workers signed an agreement that affirms their being independent contractors, and that they were not entitled to the company’s Benefits Program for employees. The IRS conducted an audit on the company during the 1989 to1990 tax year, and found that those workers classified by the company as independent contractors should actually be employees. The IRS findings were based on Microsoft’s inherent ability to “exercise direction and control” over the services performed by those workers. Thus, Microsoft decided to comply and paid employment (back) taxes for the workers and even hired some of those workers as employees. However, Microsoft’s woes did not end there when a group of those former “independent contractors”, now employees, demanded for benefits that they could have enjoyed during the specific period they were classified as independent contractors. While the company disputed the claims, around 8 of those employees sued Microsoft (Vizcaino vs. Microsoft) for the right to participate in the Benefits Plans. Microsoft settled the suit in December 2007 in the amount of $97 million.
Looking at the two examples above, the issues resulting to worker misclassification infractions were not new at all. And they illustrate the continuing legal trend in the industry with regards to worker misclassification. Problems continue to hound the conflicting interpretations of the legislation and the ambiguous guidelines followed by federal and state agencies to enforce the law on worker misclassification. In September 12, 2007, then Sen. Barack Obama introduced Senate Bill 2044 known as the Independent Contractor Proper Classification Act of 2007. The bill is still pending in the senate, and related bills were also introduced such as HR 6111 and S.3648. With the proponent of the bill now sitting as President of the United States, it may not be long before S.2044 becomes a landmark legislation that will affect all industries using and benefiting from contingent workforce.
So, who are the Independent Contractors? Who are the Employees?
In distinguishing between an independent contractor against an employee, the degree of “control and direction” over the worker plays a key part. This particularly with regards to the degree of control exercised by the employer over the manner and means that service is to be performed by the worker. A real independent contractor is a master craftsman, they are qualified experts in their trade, with verifiable professional credentials and do not need any degree of “control” over their manner and means to perform their services.
Employees, however, would usually require basic to advanced training or instructions on how to perform their work assignment. This also includes instructions on designated hours of work, production rate, and the work area assignment among others. Potential risks happen when the employer’s degree of control over the work output (per independent contractor relationship) crosses the line over the manner and means of performance of the work output (showing an employee relationship). Not all members of employer’s supervising team are appreciative of those salient nuances which can really be ambiguous especially during times of tight deadlines to meet.
It is when these dividing lines merge or the distinction blurs, such can easily fall prey to scrutinizing eyes of the independent contractors themselves, the employees, or other interested parties such as federal or state agencies, union organizers, labor lawyers, etc. which may lead to further scrutiny. And when these parties identify that a company may be misclassifying workers, they will make allegations of an employee relationship violation resulting to aggravated risks on the part of the employer.
Among the things often looked at in this case are the degree of control exerted by the company over the worker’s time and work hours, the degree of assistance given by the company’s employees to the independent contractors to perform their services, and the company’s control over the means or methods used to perform the work. That is, the way to complete a work assignment versus concern only for the final output. This is further aggravated where the so-called “independent contractors” are provided training by the company. Depending on pending circumstances and contributing factors, the company will be liable for violation of the law concerning employment of independent contractors.
Impending Liability: Sword of Damocles?
Numerous studies showed that the US government was losing hundreds of millions of dollars in taxes annually due to this worker misclassification practices in various industries. This lead to intense deliberations in the legislative bodies and new bills introduced to remedy the problem. While deliberations are still going on, let us revisit what can be the potential risks carried by non-compliant companies:
- Back taxes, with both employee and employer contributions.
- Cost of settlement for benefits that should have been enjoyed by affected workers had they been considered employees.
- Pension contributions or profit shares that should have been enjoyed by affected workers.
- Penalties from federal and state agencies plus accrued interests over the years covered in the violations.
- Intentional misclassification of independent contractors which can lead to punitive or triple damages.
- Encouragement of potential union organization efforts by affected workers.
While we cannot guarantee that nobody will challenge any company’s efforts to comply with proper worker classification legislations, what happened to FedEx and Microsoft were just sneak peeks of a potential upsurge on these cases that may come in view of the expected $1.58 trillion dollars budget deficit of the US government for the year 2009.
How can you protect your business?
It is true that, no matter how much you comply, it is still possible that someone or somebody will challenge you for a variety of reasons – trivial or otherwise. Even the experts believe that the issues on worker misclassification will continue to exist not necessarily due to employers’ misgivings but also because of the changing legislations concerning the matter which opens new avenues for debates. Be that as it may, the sure thing is that there will continue to be a need for careful and factual interpretations of these laws and their impact to the business.
Today, a lot of employers have limited appreciation of what processes do they have in place for properly classifying their workers, or how their current independent contractors are providing services to their company. The first thing they needed to do to review their existing policies for worker classification. While their staff may be able to follow what is already written on the policy manuals, interpreting the ambiguities of various legislations for worker classification is usually not these companies’ core competencies which open the door for potentials risks to happen.
The IRS has Section 530 Relief Requirements for those employers who engage independent contractors’ services. Obviously, the burden of proof rests on the employers to support their qualifications to avail of the relief under Section 530. Taking into consideration the broad interpretations on each of the three (3) requirement areas, even an employer who complied having “Reasonable Basis” can still fail under Substantive Consistency or Reporting Consistency. The margin of error is too narrow to allow for uninformed decisions on the part of the employers. There can be so much at stake for too little to make as benefits for taking the risks. You must always refer back to the courts’ notion about the “duck.”
We can lay down a few steps for companies like yours to consider in regards to employing independent contractors in your organization:
- Be sure to apply appropriate government guidelines. Many federal and state agencies provide basic tests that are applied during a tax audit. Follow the guidelines as completely as you can when engaging independent contractors in your organizations. A lot of these audit guidelines are public information and may be found on the agency’s website. But be careful about the making ambiguous interpretations, and be sure to ask or qualify your interpretations as necessary.
- Only use independent contractors with an established business already. Select independent contractors who have a good list of multiple clients serviced over the years, and which can be verified or validated. Require your prospective independent contractors to present supporting documents such as client references, professional licenses, marketing materials, and proof of insurance before signing them up for services you require.
- As possible, only use independent contractors who provide services which are not integral to your core business. Never engage independent contractors for services that are similarly performed by your regular employees. Doing so will be indicative of staff augmentation instead of a defined project allowed for contracting.
- Be sure to create and execute proper contracts with each independent contractor for each engagement. Make sure that the contractual agreement you sign with an independent contractor clearly defines the relationship of both parties to each other. Engage the services of an expert to review your contracts to ensure that you are compliant to federal and state government guidelines. Remember that each state may have varying guidelines that you need to comply with. It must be that your contract presents a business-to-business transaction and veer away from any employer-employee language that hints about supervision or management of the worker. The contract must include a Statement of Work that details the contractor’s actual deliverables (work output) and subject to acceptance by your company. You should also include Non-Disclosure Agreements in contracting, and the standard provisions about Intellectual Property Protection on the contract itself.
- So as not to lose track of compliance, be sure to address worker classification for all projects that you do. Be mindful that even while you deal with a real independent contractor, your compliance can be diminished due to the ambiguity of your project scope and definitions. To remedy this, having an expert eye to review your documents can save you all the trouble in the near future. Problems may not happen now, but it does not mean they will not happen at all if you miss out on current compliance requirements.
- Always maintain audit files / records as references to support your worker classification decisions. In classifying workers as independent contractors, be sure to support this with as much documentation that you can have – from evaluation of competencies, customer references, proof of concept, etc. With the process in place, you can be well prepared to support your worker classification decisions in case of an audit. The more supporting documentation and processes you have, the more credibility you have in the eyes of the auditors.
- Make it a rule never to engage a former W2 employee of your company as a 1099 independent contractor. This is the most common mistake committed by a lot of companies today. This is highly risky because more often than not, these workers are re-engaged to perform similar work that they used to do as W2 employees. It will for your best interest to instead engage a real independent contractor with excellent track record of delivering your required services. The difference can save you the trouble supporting your worker classification decisions during an audit later on.
- Explore about outsourcing your compliance assistance. Ensuring defensible compliance to 1099 independent contractor legislations require resources and strong expertise. The ever changing legislations both on federal and state levels continue to pose challenges for companies to ensure a worry-free path to compliance. Engaging the help of experts improves your confidence on compliance and weed out potential risks. Further, where an independent contractor engagement is not feasible, there may still be other means to acquire the talents you require for your projects minus the compliance risks.
- Be a good citizen of the country, and make no compromise about it. This country has offered your company great opportunities to do business and improve the lives of those who work with you. Be a model citizen and pay your taxes honestly. Cutting corners to save thousands or millions may actually cost you three-folds or more in the near future. And being a good American is your best contribution to our industry and our society at large.
Source by Lito Reyed
