Whether engaging a construction worker, real estate sales agent, property manager, leasing consultant, or other worker, companies sometimes struggle with appropriately classifying a worker as an employee or independent contractor. The right classification has gained in significance as of late. This year, the IRS implemented a crackdown on employers whereby the IRS plans to audit the employment tax practices of 6,000 randomly-selected businesses over the next three years to include review of the independent contractor classifications maintained by these companies.
In April, Congress introduced legislation currently called the Employee Misclassification Prevention Act (EMPA), which would amend the Fair Labor Standards Act to require businesses to keep records of non-employee workers who perform services for pay and penalize businesses that misclassify those workers as independent contractors. Last year, Colorado passed the Employee Misclassification Law (C.R.S. § 8-72-114), which provides a complaint process for reporting the misclassification of employees as independent contractors and imposes significant fines per misclassified employee. How might a business best protect itself from liability for incorrectly classifying workers as independent contractors during this time of increased scrutiny?
First, businesses must understand that there is more to being an independent contractor than simply an agreement between the company and the worker that the worker will perform services as an independent contractor. Several federal and state agencies have different criteria for determining whether the relationship between a worker and business is an employer-employee relationship or an independent- contractor relationship. For example, the IRS, Colorado Department of Labor (unemployment and workers compensation divisions), U.S. Department of Labor, and Equal Employment Opportunity Commission, all have their own set of criteria, as does the common law.
Second, because the criteria used by these federal and state agencies (including the criteria under common law) tend to overlap and share common themes, businesses should take time to become familiar with at least one of these agency's criteria. For example, by any criteria, the level of direction and control exercised by the company over the worker is critical to the analysis— e.g., less direction and control over the worker is more consistent with an independent contractor relationship. While there are many factors, other important criteria include how the worker is paid (salaried, hourly, fixed rate), whether the worker and company combine business operations, and whether the worker works exclusively for the company.
Under the Colorado Employee Misclassification Law, a company will be fined up to $5,000 per misclassified employee for the first misclassification, up to $25,000 per misclassified employee for the second and subsequent misclassifications, and can be prohibited from contracting with, or receiving any funds from, the state for up to two years. As currently proposed, companies would face similar penalties and fines under the federal Employee Misclassification Prevention Act, in addition to increased audit activity.
There are some situations that present "red flags" to an employer indicating there might be a misclassification of a worker.
- Sometimes, an independent-contractor relationship is something employers enter into at the employee's request. For example, an employee will resign or retire from "full-time" employment and ask the employer if he or she can stay on as an independent contractor, doing essentially the same work the employee performed when he or she was an employee, but possibly on a reduced schedule. In this type of a situation, the employee almost never qualifies as a true independent contractor because the work performed is still under the direction and control of the employer.
- Other times, the employee requests an independent contractor status (sometimes referred to as "1099 status") to avoid applicable withholding from his or her paycheck for taxes. Although the worker may be fully intending to pay appropriate taxes at the end of the year, this is not a sufficient reason for changing to an independent contractor status and could subject the employer to certain penalties and fines.
- Another red flag is a situation in which the employer has two workers performing the same or similar duties, but one is an employee and the other is an independent contractor. This contradiction could be evidence of a misclassified worker. Generally, the existence of one worker doing certain duties who is considered an employee is an indicator that all workers performing those duties should be considered employees.
- Finally, some employers classify all of their workers as independent contractors because they are trying to avoid the administrative workload of preparing payroll, as well as the related costs associated with employee benefits. This is similar to the tendency by some employers to classify all employees as exempt from overtime because they are trying to avoid the administrative workload of tracking hours. Both are inappropriate and, in many cases, unlawful. Just as there is almost no situation in which all employees of a business may be considered to be exempt from overtime, there is almost no situation in which all workers would qualify as independent contractors.
Generally, most workers qualify as employees and not independent contractors. Therefore, understanding the various criteria used by federal and state agencies when auditing these relationships, and entering into and conducting independent contractor relationships consistent with those criteria, is key to placing the company in the best possible position for a successful audit. It is also the key to avoiding potentially costly liability.