The Government Is Watching

In 2009, the Internal Revenue Service launched its National Research Program, which will have randomly selected and audited 6,000 employers before 2012 comes to a close. The IRS is looking at employers' compliance regarding worker classifications and various other "grey" areas.

In its new strategic plan, the United States Department of Labor (DOL) says it intends to continue its focus on employee misclassification as part of enforcement and outreach efforts under the federal Fair Labor Standards Act (FLSA). To that end, DOL has stepped up its FLSA enforcement efforts considerably, having hired approximately 250 new investigators. One of its main goals is to detect and deter employers that misclassify employees as independent contractors, thereby depriving them of wage and hour protections. DOL reports that it is now developing proposed regulations for release in 2011 to strengthen FLSA recordkeeping requirements and impose even more obligations on employers.

In this era of continued unemployment, the Illinois Department of Employment Security (IDES) is reacting harshly to employers who protest unemployment claims on the grounds that terminated workers were "independent contractors." These protests are being rejected, and employers are being subjected to seemingly random audits to assess whether employees have been misclassified as independent contractors.

What all of this means is that the government is watching, and it is now more critical than ever that businesses pay careful attention to the distinction between employees and independent contractors.

Tax and Wage Implications

Worker classifications may have tax and/or wage implications. For employees, a business generally must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages. On the other hand, a business generally does not need to withhold or pay any taxes on payments to independent contractors. Likewise, employees generally must be paid at least minimum wage, and non-exempt employees must be paid overtime compensation. Minimum wage and overtime requirements, however, do not apply to independent contractors.

Before determining how to treat payments you make to workers for their services, you must first know the business relationship that exists between you and the individual performing the services.

IRS View

In determining whether a worker is an employee or an independent contractor, the IRS considers all information that provides evidence of the degree of control or independence. These fall into three categories:

• Behavioral Control: Does the business control or have the right to control not only what the worker does, but also how the worker does his or her job? Factors include the nature and extent of instruction given, the nature of evaluation systems used, and the nature and extent of training provided.
• Financial Control: Does the business control or have the right to control the economic aspects of the worker's job. Factors include whether the worker has made a significant investment, has an opportunity for profit and loss, and/or makes his or her services available in the marketplace; whether expenses are reimbursed by the business; and how the worker is paid.
• Type of Relationship: How do the worker and the business perceive their relationship to each other? Factors include how the relationship is described in written agreements, whether the worker is granted employee-type benefits, the permanency of the relationship, and whether the work performed is a key aspect of the business.

There is no magic number of factors that tips the scales regarding whether a worker is an employee or an independent contractor, and no one factor is determinative. The key is to look at the relationship as a whole and consider the degree to which you have the right to direct and control the worker.

DOL View

To determine whether an individual is an employee, DOL looks to the "economic reality" of the parties' business relationship as a whole. The focus is on whether the worker is economically dependent on the company for which he or she is working, or the worker is in business for himself or herself. The focus is on the following six factors (many of which are similar to those considered by the IRS):

• The extent to which the worker's services are an integral part of the employer's business
• The permanency of the relationship
• The amount of the worker's investment in facilities and equipment
• The nature and degree of control by the business
• The worker's opportunities for profit and loss
• The level of skill required in performing the job and the amount of initiative, judgment or foresight in open-market competition with others required for the success of the worker

IDES View

Under the Illinois Unemployment Insurance Act, an individual who performs work for a business is generally presumed to be an employee. The act, however, carves out an exemption for services performed by independent contractors. In order to meet the exemption, the worker must satisfy all three prongs of the so-called "ABC Test":

A.  The worker must be free from control or direction over the performance of the services; 

B.  The services must be either outside the company's usual course of business or performed outside its place of business; and

C.  The worker must be engaged in an independently established trade, occupation, profession or business.

A strict burden of proof is placed upon any business seeking exemption from unemployment contributions under the Illinois Unemployment Insurance Act, and all three conditions must be established before an exemption is allowed. When interpreting the term "independent contractor" under the act, the actual relationship of the parties must be considered. Designations and terminology used in any agreements are not controlling, nor are the mechanics of compensation.

The third prong of the ABC Test is the most difficult to satisfy. "Engaged in an independently established trade, occupation or business" is interpreted by IDES to mean that the individual has a proprietary interest in the business that he or she can sell, give away or operate without hindrance from any other party. In other words, the individual truly must be operating his or her own business.

Protect Your Business

It is critically important that an employer has a valid basis for classifying a worker as an independent contractor. The following steps, while by no means a guarantee, should help the independent contractor classification withstand government scrutiny:

• Draft a written agreement that references the worker's independent contractor status to establish the intent of the parties and lists pertinent factors describing the nature of the relationship.
• Require the worker to form an entity so that you are contracting with another business, rather than an individual (i.e., "John Smith Painting, LLC" vs. "John Smith").
• Establish policies that require individuals who are deemed "independent contractors" to be treated differently than employees.
• Prepare documentation of all factors considered in classifying a worker as an independent contractor and require the individual to provide documentation to establish that status. Examples include insurance certificates, a business license, property and equipment leases, a business card, a website, promotional brochures or other advertising materials, listings in trade publications, contracts with other businesses and an IDES account number.
• Keep in mind that reclassification of a worker mid-year (so that the individual receives both a Form W2 and a Form 1099 in the same tax year) may be a red flag to the IRS.
• When challenging unemployment benefits on the grounds that a terminated worker was an independent contractor, be aware that such protests may lead to an audit.
• For any worker whom you are considering characterizing as an independent contractor, analyze the factors considered by the IRS, DOL and IDES. If there are not enough indications that the worker is an independent contractor, consider whether the classification is proper.
• Ensure that your actual practices conform to the factors considered by the IRS, DOL and IDES.

Proper classification of workers is one of many compliance issues employers face.