Assessing Your Worker Misclassification Exposure
If you are a company that hires independent contractors, now is a good time to do a self-audit of your worker classification and assess your worker misclassification exposure.
A person is not an IC simply because the parties agree to that classification. The common law rules determine the status of each worker.
A number of courts have issued some interesting decisions in cases involving worker misclassification claims. As a result, a multitude of tests have evolved for determining whether a worker is an employee or an IC. Because federal and state agencies apply different tests to determine who is an employee versus an IC, it is possible for a worker to be an employee under one test and an IC under another.
What test does the IRS and Missouri use?
Historically, the IRS and Missouri used what has become known as the “Twenty Factor” test to determine whether a worker is an IC or an employee. However, under pressure from Congress and from labor and business representatives, the IRS has recently attempted to simplify and refine the test. It consolidated the 20 factors into 11 main tests, and organized them into three main groups:
· Behavioral control
· Financial control and
· The type of relationship between the two parties.
Behavior Control
Behavior control refers to the extent of your right to tell the worker exactly how to do the job. Giving instructions, providing training, and using evaluation systems are all strong evidence that you have the right to control a worker on the job, which makes the worker look like an employee.
1. Instructions the business gives the worker. The single most important factor in this test is giving instructions. All of the following are examples of types of instructions about how to do work:
a. When and where to do the work
b. What tools or equipment to use
c. Which other workers will help do the work
d. Where to purchase supplies or services
e. What work must be performed by a specified person
f. What routines or work patterns the worker must follow
g. What order or sequence to follow in doing the work
2. Training the business gives the worker.
Financial Control
The second area of this test looks for evidence of financial control – whether you have the right to control how the worker conducts business. The factors that the IRS usually looks at are whether the workers:
3. The extent to which the worker has unreimbursed business expenses. IC’s are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.
4. The extent of the worker's investment. An employee usually has no investment in the work other than his or her own time. An IC often has a significant investment in the facilities he or she uses in performing services for someone else. The IC doesn’t have to purchase the equipment, renting is sufficient. A significant investment is not necessary for IC status.
5. The extent to which the worker makes services available to the relevant market. An IC is generally free to seek out business opportunities. IC’s often advertise, maintain a visible business location, and are available to work in the relevant market.
6. How the business pays the worker. An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An IC is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay IC’s hourly.
7. The extent to which the worker can realize a profit or loss. Since an employer usually provides employees a workplace, tools, materials, equipment, and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss. An IC can make a profit or loss.
Type of Relationship
Type of relationship refers to facts that show how the worker and business perceive their relationship to each other.
8. Written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship, not what the parties choose to call it. However, in close cases, the written contract can make a difference.
9. Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay. The power to grant benefits carries with it the power to take them away, which is a power generally exercised by employers over employees. A true IC will finance his or her own benefits out of the overall profits of the enterprise.
10. The permanency of the relationship. If the company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
11. The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the company's regular business activity, it is more likely that the company will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
There is no magic or set number of factors that makes the worker an employee or IC and no one factor stands alone in making this determination. That’s what makes it so subjective.
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.
Create a file for each IC and go through this process on a regular basis. In some cases, the relationship between a worker and employer can change over time and an employer could find themselves unintentionally getting into a risky situation.
Keep IC files separate from employee files.
So what if my answers are 50/50 between IC and employee? What then?
Because the IRS test is considered subjective, a lot of states are using the A-B-C test or a modified version of it. This three prong test is much simpler and less subjective but more stringent. So you may not like the answer it gives you. Missouri does not use this test yet but it may help you make a determination in a grey situation.
For a worker to be considered an IC under the A-B-C test, all of the following must be satisfied:
A. The worker has been and will continue to be free from control or direction over the performance of his services, both under his contract of service and in fact;
B. The service is either outside the usual course of the business for which such service is performed or the service is performed outside of all the places of business of the enterprise for which such service is performed; and
C. The worker is customarily engaged in an independently established trade, occupation, profession, or business.
The A-B-C test places a greater focus on your control over the worker (A) and proof of an independently established business (C). The C prong is generally the one that is going to be a problem for a lot of you.
New Jersey uses the A-B-C test and a contractor must be shown to be in his own business, such as evidencing that the business is incorporated, having liability insurance, business cards, advertising and, most importantly, doing work for more than just one employer.
Best Practice: What can you do if you are worried about C?
A well-drafted IC agreement may be the answer. A carefully drafted document will contain all the provisions that demonstrate, on paper, that an individual is an IC not an employee. I have a sample one in my office you can use if you’re interested. Just email me.
Keep in mind though that even the best drafted document will not help if the actual circumstances vary from what is on the paper.
Can I just get the IRS to tell me what type of worker I have?
You can file Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding”, with the IRS and they will make the determination of whether the worker is your employee or not. You can view the revised form here.
Any worker or company can fill out and submit this form. And unlike most other rulings, this one is free. Most of these forms (85-90%) are submitted by workers who want to contest their treatment as an IC. Once the request has been submitted, the IRS often tries to contact the business or the worker to obtain a clearer understanding of the facts.
A company should think carefully before filing Form SS-8. Filing the form could cause the employer to be subjected to a worker classification audit.
The form has a natural bias toward an employee classification. Only 3% are generally ruled IC.
For this reason, many companies simply use the SS-8 as a self-audit to avoid a misclassification trap; they don't actually submit the form to the IRS.
Another downside to filing Form SS-8 is that your company could lose protection that comes from the Section 530 Relief safe harbor rules which prevents the IRS from reclassifying a worker as an employee if the business has a reasonable basis for it.
Check back in a couple of days and I will tell you what you need to know. J
If you have any tax questions or are interested in the IC sample agreement, you can call me. My contact information is on my website.
