In order to assure that workers are being classified correctly, the Department of Labor and the IRS are working together to pay close attention to cases involving determination of work status and issuing the correct penalty to employers.
When it comes to doing work for money, employers can classify workers as either employees or independent contractors (IC). These classifications have a significant impact on the costs an employer must take on, as well as the control an employer has over its workers. The main reason employers would try to classify an employee as an IC is due to taxes. According to an IRS publication from 2008-2010, “Federal employment withholding taxes represent nearly 70% of all federal tax revenue to be paid to the IRS, which seeks back taxes and penalties from employers that wrongly treat workers as self-employed contractors.” That being said, there are many actions in place when it comes to identifying which of these someone should be labeled as, responding to false classifications, and issuing penalties. With the rise in freelance services, this distinction is becoming more essential for society.
When it comes to defining whether someone should hold IC status or not, the DOL and IRS have several overlapping tests that will allow them to determine misclassification. While some states may have a different jurisdiction for working status, these tests are very thorough and effective at defining a general baseline. While these tests are truly impressive, and the DOL and IRS federal and state regulators are doing everything in their power to improve them daily, many professionals believe the simple approach of labeling everyone as an employee when status is not unquestionably apparent is the best approach.
One way of determining IC status is the common law test. This was designed by the IRS and evaluates a worker using 20 factors. These factors include, but are not limited to, level of instruction, amount of training, method of pay, need for onsite services, and right of termination. In this test, the 20 factors will be carefully analyzed for each worker in order to see how they fit into their workplace.
While the common law test is effective, especially when it comes to the worker and employee relationship, it has evolved into the Three-Factor Test. This newer test, also by the IRS, takes those 20 factors from the common law test and places them conveniently into three categories for examination. These three categories have the main goal of determining specifically how much control an employer has over its workers. The first category is behavioral control which measures what the company’s say over a workers jobs and how those jobs are done. The second is financial control which determines how the employer controls the economic status of a worker with such things as being able to have additional jobs and providing tools. Finally, there is relationship control which measures how both employer and worker view each other through providing benefits, contracts between the two, and permanency of employment.
While the IRS test is detailed, an investigation by the DOL and its testing is more effective in discovering a worker’s true status than the 20-factor test. The DOL generally applies what can be considered an “economic realities test” under the Fair Labor Standards Act. This will take into account six major factors including the importance of the worker’s roles, permanency, worker’s tool investment, employer control over work, employer’s impact on profits of the worker or rejection of additional opportunity, and the skill level required for functioning in the worker’s position. Moving into July of 2015 the Wage and Hour Division of the DOL decided to add more clarifications to this analysis. These set more guidelines as to the importance of hours and location, specialized skills, and employee investment in business success.
On top of these three examinations, there are a few other ways to determine status that are less commonly used but borrow much of the same concepts. The Civil Rights Act, National Labor Relations Act, Americans with Disabilities Act, and Age Discrimination in Employment Act are all examples of this.
There are ways for those who want to file a complaint if they feel their workplace has been misclassifying workers as ICs. Individuals may receive help depending on the state, but the DOL handles large scale investigations that involve many workers being misclassified since those can cause a substantial loss when it comes to taxes. Anyone can choose to file a complaint with the DOL or the applicable state department of labor or unemployment agency.
Those who have been caught will have varying penalties for misclassification depending on whether it was intentional, unintentional, or fraudulent. If unintentional, this generally calls for a reclassification to ICs becoming employees and receiving their rightful payment as wages. If they are found to have done this intentionally, there will be additional fines and penalties, and if fraudulent there can be criminal penalties and even prison sentences. One can find a full list of penalty codes for the DOL and IRS online.
Employers should always consider finding a proactive certified public accountant to discuss employees regularly in order to assure there is never a need for further investigation. There are also a number of forms, acts, and settlement programs that will help employers find acceptable ways to move forward when placed in a case of misclassification when it comes to changing employment status and taxes. The IRS form SS-8, section 530 relief act, and voluntary classification settlement program are three main actions in place that any employer should look into and understand.
There are a number of recent examples of misclassification, many on a large scale. One such example was a cable TV installation company across 10 states who classified their technicians as ICs and denied fair overtime compensation. This became part of a nationwide FLSA action suit. This is only one of many over the years, and the attempts to misclassify is only growing as more people turn to jobs that require specialized skills or for employees to set their own hours.
Much of this information has been taken directly from the CPA journal article “Employee Versus Independent Contractor” by Frank Messina, DBA, CPA, Bruce P. Ely, JD, LLM, Lisa-Ann Polack, Ph.D., CP and Marena Messina, CPA.
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