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Get proactive with employee classification to avoid IRS and DOL penalties

January 5, 2016


New guidance handed down from the U.S. Department of Labor (DOL) could drastically alter the landscape of how companies classify and hire employees. As a result of the new DOL guidance, more independent contractors may actually be defined as employees. The guidance appears to stem from the new business models created from share- and on-demand-based technologies (e.g., Uber) that exist outside the traditional workplace.

Naturally, this change will have a significant impact on employers. Independent contractors can be beneficial for companies: They don’t require employee benefits or payments for payroll taxes and workers’ compensation, and they aren’t eligible for many typical workplace protections, such as overtime and minimum wage.

However, the DOL argues that more independent contractors take away tax revenue from the government and create an unfair playing field for employers. As a result, the guidance reclassifies many independent contractors as employees.

Who is now an employee?
The difference between an employee and an independent contractor has historically been determined by the control test, a long-standing tool used by businesses to ascertain the amount of control the business has over the worker and how the worker does the job.

Instead of the control test, the DOL now suggests that employers categorize all workers based on the Fair Labor Standards Act (FLSA), which defines employment as the ability to “suffer or permit to work.” This definition is extremely broad, and can include many workers who were once considered independent contractors. In fact, the DOL is making a concerted effort to move away from the control test, and has provided a six-factor economic realities test:

  • Is the work done an integral part of the employer’s business?
    • For example, carpenters are integral to a framing business. Software developers are not.
  • Does the worker’s managerial skill affect the worker’s opportunity for profit or loss?
    • Workers that are not employees face the possibility to not only make a profit, but also a loss.
    • The ability to work more hours or do a better job does not differentiate a contractor from an employee.
  • How does the worker’s relative investment compare to the employer’s investment?
    • The worker should make some investment in order for there to be an indication that he or she is an independent business, and that investment should not be relatively minor in relation to that of his employer. Cost of tools may simply be a prerequisite for doing a job – not an indication of an independent business.
  • Does the work performed require special skill and initiative?
    • A worker’s business skills, judgment and initiative, not his or her technical skills, will aid in determining that the worker is economically independent of his or her employer.
  • Is the relationship between the worker and the employer permanent or indefinite?
    • When an industry is seasonal, the proper test for determining permanency of the relationship is not whether the alleged employees returned from season to season, but whether the alleged employees worked for the entire operative period of a particular season.
  • What is the nature and degree of the employer’s control?
    • The worker must control meaningful aspects of the work performed such that it is possible to view the worker as a person conducting his or her own business.
    • The worker’s control over the hours when they work is not by itself indicative of independent contractor status. Flexible work schedules are common to many businesses.
    • The assertion by employers that the control they exercise over workers is due to the nature of the business, regulatory requirements, or the desire to ensure customer satisfaction is not an effective argument that such workers are not employees.

Following this guidance, the new gauge is whether or not a worker is economically dependent on the employer, while falling under the “suffer or permit to work” definition, which can include control as a factor to consider. True independent contractors are separate businesses that are economically viable with or without the assistance of the employer. Employees, on the other hand, rely on that employer for economic sustainability.

What does this mean for companies with independent contractors?
With the new DOL guidance, many independent contractors may now technically be employees, even though they are still classified as the former.

This puts employers in a tough fiscal and legal bind. Employers caught misclassifying employees can be severely fined and penalized, and may be required to pay outstanding federal employment taxes and interest per employee. Misclassification is incredibly easy, especially given the new DOL guidance, so worker review is a must to ensure compliance.

Even though the DOL guidance is neither regulation nor legislation, it is not clear whether the IRS will be enforcing the new DOL guidance, or if they will continue to use the former guidance. However, the IRS has entered into a “Memorandum of Understanding” with the DOL on the new guidance. Lawmakers are having a difficult time getting their arms around the share- and on-demand-based technology, and have expressed interest in creating a third classification beyond employee and independent contractor. It should be noted that legislation on the topic is just discussion and is not imminent.

Although many states have signed on to support the FLSA-based classification initiative, there are some that have not — Ohio being one of those states. But the DOL has still been very aggressive in pursuing companies that have misclassified employees as independent contractors. As recent as October 2015 the U.S. Department of Labor’s Wage and Hour Division found that a Miami Valley company misclassified employees working as independent contractors, and the DOL has filed a lawsuit with the U.S. District Court for the Southern District of Ohio (Docket Number 3:15-cv-00350-TMR) on behalf of the employees misclassified as independent contractors. Per the lawsuit, the DOL has assessed the Company more than $14,000 in back wages and an additional amount of liquidated damages for several former employees. The Wage and Hour Division also charged the company civil penalties of more than $17,000 due to repeated and willful violations of the Fair Labor Standards Act.

If an employer needs assistance in determining the classification for a worker, the employer may file a Form SS-8 “Determination of Worker Status for Purposes of Federal Employment Tax and Income Tax Withholding” with the IRS.

If a business determines that it has misclassified employees, there is no reason to fear — the employer has an option to avoid penalties and mitigate the financial impact on the company.

IRS offers Voluntary Classification Settlement Program
Employers can avoid some penalties through the IRS’ Voluntary Classification Settlement Program (VCSP). As it sounds, the VCSP is a voluntary program for employers who have accidentally classified employees as independent contractors. Through this program, companies can change that classification for a partial relief from federal employment taxes.

By agreeing to the VCSP, employers will have to define the workers in question as employees for all future tax periods. In addition, the IRS also allows employers to:

  • Pay 10 percent of employment tax liability due on compensation from the most recent tax year
  • Avoid liability for interest and penalties
  • Not be subject to an employment tax audit related to the misclassified employees

To enter the VCSP program, employers must apply using Form 8952 at least 60 days before the desired change in classification date. The new DOL guidance, coupled with the already narrow line between independent contractor and employee, could mean that many firms have misclassified workers, and might be facing penalties from the IRS. Taking a proactive approach to come into compliance could save your company money in the long run.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.


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