I.
Introduction
Adam, a hard working entrepreneur, invests his life savings into a small business.
Artistic and handy, he decides to start his own carpentry business. Adam decides to hire workers to take on additional orders that Adam would otherwise be unable to fulfill. Like many small business owners, Adam wishes to minimize his costs. He classifies the workers as independent contractors, paying them slightly higher wages rather than providing them with medical benefits.
Are Adam’s workers in fact independent contractors or are they employees?
Beth, an accountant, forms an S-corporation, and renders professional services to an existing accounting firm. While Beth has not yet purchased any interest in the accounting firm’s practice, purchase of interest in the future is possible. Is Beth an independent contractor or an employee?
Lastly, Charles, a physician, forms an S-corporation which purchases half an existing medical practice. The former owner, sole shareholder of an existing C-corporation, and Charles, decide to form a limited liability company (“LLC”) through which both owners render medical services. Both Charles’s S-corporation and the former owner’s C-corporation are members of the
LLC. Can the LLC classify Charles and the former owner as independent contractors or are they considered employees?
As highlighted by the above examples, worker classification issues can arise in various forms. Yet, each employer must determine whether a worker is an employee or an independent contractor. There are certain economic advantages to classifying a worker as an independent contractor. For example, independent contractors are not eligible for expensive employee benefits and use of independent contractors can lessen a company’s exposure to tort liability.
Furthermore, because independent contractors are responsible for their own taxes, employers do not need to withhold taxes from payments to independent contractors or make payroll contributions on behalf of them. However, while there may be some economic advantages to classifying a worker as an independent contractor, misclassification can be costly. In 2009, the
IRS sought to assess tax and penalties of $ 14 million for the 2002 tax year against employers that misclassified workers as independent contractors.
1
According to a May 2007 report by the Government Accountability Office (“GAO”), the
Internal Revenue Service (the “Service” or “IRS”) estimated that 15 percent of employers misclassified workers as independent contractors in 1984, resulting in an estimated tax loss of $
1.6 billion, a number likely much higher today.
2
However, because of the difficulty of
1 Kevin E. Packman, United States: Act Now to Prepare for IRS Employment Tax Audit Initiative , http://www.mondaq.com/unitedstates/article.asp?articleid=94648 (last visited Oct. 18, 2010).
2 U.S. Gov’t Accountability Office, GAO 07-859T, Employee Misclassification: Improved Outreach Could Help
Ensure Proper Worker Classification.
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ascertaining which factors establish independent contractor status, misclassification sometimes is unintentional.
3
Courts, government agencies, and states use various standards to determine the classification of workers. For example, the Service utilizes a 20-factor test while the United
States Tax Court utilizes a 7-factor test. The California Employment Development Department utilizes an 11-factor test while the Federal Fair Labor Standards Act outlines a 6-factor test.
II.
Federal Tax Law
The Internal Revenue Code (the “Code” or “IRC”) does not define an employee or an independent contractor. Instead, IRC Section 3121(d)(2) provides that an employee is an individual who, under the common law rules, has a status of an employee. The two relevant common law tests focus on the amount of control the employer has over the worker.
4
Both the
United States Tax Court and the Service have come up with their own tests in determining whether a worker is an employee or independent contractor.
A.
The United States Tax Court’s Test
In determining whether a worker is an employee or an independent contractor, the United
States Tax Court focuses on whether the employer has the right to control and direct the worker as to the details of his work and the result to be accomplished.
5
In making its determination, the
Tax Court considers several relevant factors:
6
(1) The amount of control exercised by the principal over the details of the work performed by the worker,
(2) Whether the principal or worker invests in the facilities used in the work,
(3) Whether the worker receives profit from his work or assumes risk of loss or suffers a loss,
(4) Whether or not the principal has the right to terminate the services of the worker,
(5) Whether the work being done is part of the principal’s regular business,
(6) The permanency of the relationship, and
3 Jenna Amato Moran, Independent Contractor or Employee? Misclassification of Workers and its Effect on the
State , 28 Buff. Pub. Interest L.J. 105, 105 (2009-2010).
4 Robert R. Martinelli and Robb A. Longman, Preparing for Changes in Determining Whether Your Worker is an
Independent Contractor or Employee , The Practical Tax Lawyer, Winter 2009.
5 Weber v. Comm’r
, 103 T.C. 378, 387 (1994).
6 Id.
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(7) The subjective intent of the parties – whether the parties believe they are creating an employer-employee relationship or a principal-independent contractor relationship.
The Tax Court has noted that the degree of control is significant, but it is not exclusive.
7
Rather, the Tax Court examines both the control exercised by the principal and the degree to which the principal may intervene to impose control.
8 The Tax Court has also noted a distinction between professional services and nonprofessional services – the threshold level of control necessary to find employee status is generally lower if the worker is providing professional services.
9
B.
The Internal Revenue Service’s Test
In 1987, the IRS published a list of 20 factors to be considered and weighed when determining whether a worker was an employee or an independent contractor. These 20 factors, known as the common law factors, have been developed by the courts over the years.
10
The 20 factors are: 11
(1) Instructions . The amount of control the principal has over the worker.
(2) Training . The amount of training the worker receives from the employer (e.g., training conducted by experienced employees, mandatory meetings, interaction between the principal and the worker).
(3) Integration . Whether the worker’s services are integrated into the principal’s regular business operations. This tends to show whether there is control over the worker by the principal.
(4) Services Rendered . Whether the services rendered must be rendered by the worker himself.
(5) Supervision . Whether the principal directly hires, supervises, and pays any of the worker’s assistants.
(6) Continuing Relationship . Whether there is a continuing relationship between the principal and the worker.
(7) Set Hours of Work . Whether the principal controls the number of hours worked by the worker.
7 Id.
8 Id.
9 Id.
10 United States v. Total Employment Co., Inc.
, 305 B.R. 333, 337 (M.D. Fla. 2004).
11 IRS Rev. Rul. 87-41, 1987-1 C.B. 296 (1987); Moran, supra , note 3 at 110-12.
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(8) Full Time Required . Whether the worker is required to work full time or whether the worker has control to work when and for whom he chooses.
(9)
Work to be Performed on Principal’s Premises
. Whether the work or services are performed on the principal’s premises or whether the worker can choose the location of his office.
(10) Sequence Set . Whether a worker must perform services in a certain order or schedule or whether the worker is free to follow his own pattern of work.
(11) Reports . Whether the worker is required to submit regular reports to the principal.
(12) Payment Schedule . Whether wages are paid by the hour, week, or month or whether payment to the worker is based on the job task or by commission.
(13) Expenses . Whether expenses incurred by the worker are reimbursed or paid for by the principal (e.g., traveling or business expenses).
(14) Furnishing of Materials . Whether the principal furnishes the tools, materials, and equipment for the worker or whether the worker must furnish his own equipment.
(15) Investment . Whether the worker invests in the facilities that are used by him in performing services and are not typically maintained by employees.
(16) Realization of Profit or Loss . Whether the worker realizes a profit or suffers a loss as a result of his services (i.e., whether there is a risk of economic loss due to investment)
(17) Working Multiple Jobs at One Time . Whether the worker performs more than de minimis services for multiple principals at the same time.
(18) Service Available to Public . Whether the worker makes his services available to the general public on a regular basis.
(19) Right to Discharge . Whether the principal has a right to discharge the worker (e.g., whether a principal can exercise control through threat of dismissal, causing the worker to obey the principal’s instructions).
(20) Right to Terminate . Whether the worker has a right to end his relationship with the principal at any time without incurring liability.
When the IRS applied this now outdated test, the IRS focused mostly on the behavioral and financial control exercised by the principal.
12
Today, the IRS uses a simplified test of three
12 Martinelli and Longman, supra , note 4.
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factors: behavioral control, financial control, and relationship between the two parties.
13
Behavioral control focuses on whether there is a right to direct or control how the worker does work.
14 The worker likely will be classified as an employee if the principal has the right to direct and control the worker.
15
However, the principal does not have to actually direct or control the way the work is done—the important factor is whether the principal has the right to direct and control the work.
16 Financial control focuses on whether there is a right to direct or control the business part of the work (e.g., whether a worker has significant investment in his work).
17
Lastly, the relationship between the parties focuses on the subjective intent of the principal and the worker and how they perceive their relationship.
18
For example, a worker who receives medical or vacation benefits is likely an employee.
the principal and the worker’s intent.
20
19
Sometimes, a written contract formalizes
Both the Tax Court and the Service apply a totality of the circumstances approach—that is, all facts are considered, and no single fact or factor is dispositive. Therefore, it is important that a principal or employer still consider the original 20 factors published by the IRS in 1987.
III.
California Law
If having to know different tests for both the United States Tax Court and the IRS isn’t demanding enough, employers and principals should also be familiar with relevant California standards.
A.
The Employment Development Department Test
Under the test utilized by the California Employment Development Department (the
“EDD”), one main factor and 11 secondary factors are considered. The main test is whether the employer has the right to exercise control over the manner and means by which the worker performs his services.
21
An indicium of the right to control is whether the principal retains the
13 Moran, supra , note 3 at 113; IRS Pub. Ltr. Rul. 200323022 (Feb. 24, 2003). See IRS Pub. 1779 (2008).
14 IRS Pub. 1779 (2008).
15 Id.
; Treas. Reg. § 31.3121(d)-1.
16 Id.
17 Id. While there is no precise dollar test, the investment must be significant, but a significant investment is not necessary to be an independent contractor. See id.
18 Id.
19 IRS Pub. 1779 (2008).
20 Id.
21 California Employment Development http://www.edd.ca.gov/payroll_taxes/FAQs.htm.
Department, FAQs – Payroll Taxes,
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right to discharge a worker at will and without cause.
22
If an employer has the right to exercise control over the manner and means by which the individual performs his services, an employeremployee relationship exists.
23 If the employer does not have the right of control, the worker will generally be an independent contractor.
24
Sometimes, it is not clear whether a principal has the right to control the manner and means by which a worker performs his services. In this instance, other factors should be taken into consideration:
25
(1) Whether the worker is engaged in a separately established occupation or business,
(2) Whether, by industry standards, the services performed by the worker is the type of work that is usually done under the direction of a principal without supervision,
(3) The requisite skills to accomplish the desired result,
(4) Whether the principal provides the tools, equipment, and place of work for the worker or whether the work must supply them himself,
(5) Length of time and continuity of the services to be performed by the worker,
(6) Whether payment to the worker is made periodically, by task, or in one lump sum,
(7) Whether the work performed is part of the principal’s regular business,
(8) The subjective intent of the principal and the worker and their perceptions of their relationship,
(9) The degree of control exercised by the principal over the worker,
(10) Whether the principal is engaged in a business enterprise or whether the services being performed are for the benefit or convenience of the principal as an individual, and
(11) Whether the worker is able to realize a profit or suffer a loss.
B.
Statutory employees
22 Id.
23 Id.
24 Cal. EDD Information Sheet DE 38 Rev. 2 (4-09).
25 California Employment Development http://www.edd.ca.gov/payroll_taxes/FAQs.htm.
Department, FAQs – Payroll Taxes,
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The EDD has published a list of types of workers that, by law, are considered employees, even though at first glance that appear to be independent contractors. Statutory employees include: 26
(1) An agent-driver or commission-driver who distributes meat, vegetable, fruit or bakery products, beverages other than milk, or laundry or dry-cleaning services for his principal,
(2) A traveling salesperson, other than an agent- or commission-driver, who works full time on behalf of his principal, and takes orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar establishments for merchandise for resale or supplies to be used for their own business operations, and
(3) A homeworker performing work (according to a principal’s instructions) on materials or goods furnished by that person which are required to be returned to that person or a person designated by him.
However, these workers will be classified as independent contractors if a substantial amount of the work is personally performed, the worker does not have a substantial investment in the facilities used in the performance of those services (other than the transportation facilities and equipment), and the services are not in the nature of a single transaction.
27
The EDD also classifies the following workers as statutory employees:
(4) An unlicensed contractor who is performing services for a licensed or unlicensed contractor is considered an employee of the hiring contractor.
28
(5) An artist or author in the motion picture, radio or television industry if the worker’s work is done under a collective bargaining agreement defining the worker as an employee, and the employer retains the right to control the work to be performed by the worker.
29
(6) An author of commissioned or specifically ordered work if the written agreement between the worker and commissioning party specifies that the work is made for hire and retains ownership of the work.
30
C.
State case law
26 Cal. EDD Information Sheet DE 231 SE Rev. 5 (1-07).
27 Id.
28 Id.
29 Id.
30 Id.
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California state courts analyze a worker’s relationship with an employer much like the
EDD. The Second Appellate District in Garrison v. California has noted that a material and generally conclusive factor is the right of the employer to exercise complete and authoritative control of the manner in which the work is done.
31
The California Supreme Court in S.A.
Gerrard Co. v. Industrial Accident Commission noted that the existence of a mere right of control constitutes the relationship that of employer-employee.
32
The California Supreme Court in Press Publishing Co. v. Industrial Accident Commission has noted that the most conclusive factor in determining classification is whether the principal or employer retains the right to terminate the worker’s service at any time.
33
IV.
Audits, enforcements, and relief
A.
Audits by the IRS
According to the IRS, one of the most common types of employment tax noncompliance is misclassification of worker status. The IRS often receives referrals on cases of misclassification of workers.
34
In an abundance of caution, businesses often seek determinations from the IRS on whether a worker is an employee or an independent contractor.
35
By 2008, it was expected that Congress would increase the IRS’s budget, especially for enforcement activities such as audits and investigations.
36
Congress pressured the IRS to increase the taxcompliance rate to 90 percent by 2010.
37
In response, the IRS started the Questionable
Employment Tax Practices (“QTEP”) initiative. The QETP initiative is a collaborative, nationwide program between the IRS and certain States to increase compliance with employment tax rules and regulations by allowing the IRS and certain States to exchange audit reports and audit plans.
38
Furthermore, as a part of the QETP initiative, a memorandum of understanding (“MOU”) was entered into by the IRS, the Department of Labor, and several state agencies allowing them to share employment tax examinations and information regarding potential employment tax
31 Garrison v. California , 64 Cal. App. 2d 820, 824 (2d App. Dist. 1994).
32 S.A. Gerrard Co. v. Indus. Accident Comm’n , 17 Cal. 411, 413 (1941).
33 Press Publ’g Co. v. Indus. Accident Comm’n , 190 Cal. 114, 120 (1922).
34 See Kathryn Keneally and Charles P. Rettig, Worker Classification: IRS Launches Questionable Employment Tax
Practice Initiative , J. Tax Prac. & Proc. 19 (Feb.-March 2008).
35 See id.
(since 2004, there have been more than 19,000 requests for determination).
36 Id.
37 Id.
38 IRS FS-2007-25 (Nov. 2007).; Keneally and Rettig, supra , note 36 at 20 (as of 2007, 29 states have entered into individual information-sharing agreements with the IRS, including California).
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noncompliance.
39
Pursuant to the MOU, the IRS and the participating State agencies exchange employment tax information and examination results, or work collectively on examinations, for civil cases in which employers attempt to evade or inappropriately reduce employment tax liabilities.
40
In September 2009, the IRS announced its plan to audit 2,000 U.S. companies each year beginning in February 2010 as part of the Employment Tax Audit Initiative. One of the primary goals of the Initiative is to reduce the number of “misclassified” independent contractors.
41
If a business is examined, a couple of relief provisions may exist.
1.
Section 530 relief
If a business has been selected for an employment tax examination, the business may have some relief under the IRC. That is, the business may avoid paying employment taxes for misclassified workers if certain requirements are met. Under Section 530 of the Revenue Act of
1978, to receive relief, the business must meet all of the following requirements: 42
(1) The employer must have a reasonable basis for not treating the workers as employees.
To establish that an employer had a reasonable basis for not treating a worker as an employee, it can show:
(a) It reasonably relied on a court’s opinion or and IRS ruling about Federal taxes,
(b) Its business was previously audited by the IRS at a time when the employer treated similar workers as independent contractors and the IRS did not reclassify those workers as employees. However, if the employer relies on an audit beginning in 1997 or later, the audit must have included an examination for employment tax purposes of whether the worker involved (or a worker holding a substantially similar position) should be treated as its employee,
(c) It knew that was how a significant segment of its industry treated similar workers, or
(d) It relied on some other reasonable basis.
(2) The employer (and any predecessor business) must have treated the workers, and any similar workers, as independent contractors.
A substantially similar position exists if the job functions, duties and responsibilities are substantially similar and the control and supervision of those duties and responsibilities are
39 Id.
40 Id.
41 Morgan, Lewis & Bockius LLP, http://www.morganlewis.com/pubs/EB_PayrollTaxAuditInitiative_LF_26oct09.pdf (last visited Oct. 21, 2010).
42 IRS Pub. 1976.
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substantially similar.
43
This requirement however only applies to Federal tax treatment, and does not apply to differences in treatment for state unemployment tax purposes and federal tax purposes.
44
(3) The employer must have filed all required Federal tax returns (including information returns) consistent with its treatment of each worker as independent contractors.
Generally, the IRS requires an employer to timely file
Form 1099 with respect to a worker for the tax period at issue. However, Section
530 is silent as to the time of such filing for purposes of relief. The IRS has taken the position that Form 1099 must be timely filed before Section 530 relief is available.
45
However, this position has been rejected by the courts. In Medical
Emergency Care Associates v. Commissioner , the Tax Court held that untimely filing of information returns does not necessarily preclude a business from qualifying for Section 530 relief.
46
2.
The Classification Settlement Program
For employers unable to satisfy the requirements for relief under Section 530, such employers may benefit from a program launched by the IRS more than a decade ago called the
Classification Settlement Program (the “CSP”). The CSP establishes procedures under an optional classification settlement program that allows employers and tax examiners to resolve worker classification cases as early in the administrative process as possible, thereby reducing taxpayer burden.
47 Under the CSP, if an employer agrees to begin treating the misclassified workers as employees prospectively, a tax assessment is made for only one year, rather than for all years of the examination.
48
The examiner analyzes the extent to which a business meets the requirements for Section
530 relief, which is critical to determining whether the business can continue current classification practices and the appropriate nature of the offer the business will receive under the
CSP.
49 The examiner will then send the business with Forms 1099.
50 Then, full examinations
43 William Hays Weissman, Section 530: Its History and Application in Light of the Federal Definition of the
Employer-Employee Relationship for Federal Tax Purposes 6 (National Association of Tax Reporting and
Professional Management, 2009); IRS Training Guidelines, Course 3320-102 (10-96) at 1-9.
44 Weissman, supra , note 32 at 6; IRS Training Guidelines, Course 3320-102 (1096) at 1-11.
45 See Medical Emergency Care Assocs. v. Comm’r , 120 T.C. 436 (2003); see also Weissman, supra , note 32 at 7.
46 Medical Emergency Care Assocs.
, 120 T.C. at 445.
47 Internal Revenue Service, http://www.irs.gov/irm/part4/irm_04-023-006.html (last visited Oct. 21, 2010).
48 Weissman, supra , note 32 at 10.
49 Internal Revenue Service, http://www.irs.gov/irm/part4/irm_04-023-006.html (last visited Oct. 21, 2010).
50 Id.
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and detailed review is conducted to ensure that all businesses are provided appropriate settlement offers under the CSP.
51
Under the CSP, a series of graduated settlement offers is available. If the business meets the section 530 reporting consistency requirement but either clearly does not meet the Section
530 substantive consistency requirement or clearly cannot meet the Section 530 reasonable basis test, the offer will be a full employment tax assessment for the one taxable year under examination using IRC Section 3509, if applicable.
52
However, if the business meets the reporting consistency requirement and has a valid argument that it meets the substantive consistency requirement and the reasonable basis test, the offer will be an assessment of 25 percent of the employment tax liability for the audit year, computed using IRC Section 3509, if applicable.
53
Regardless, the business must agree to properly classify its workers prospectively, thus ensuring future compliance.
54 A business may qualify for more than one CSP offer if several classes of workers are at issue.
55
B.
Penalties and criminal investigations
1.
Unintentional misclassification
A business which hires an unincorporated independent contractor generally must file a
Form 1099-MISC. If a business does in fact file the required 1099 forms, but unintentionally misclassifies an employee as an independent contractor, generally, the business will be required to pay certain taxes: 56
(1) 20% of the FICA taxes the employee should have had withheld from their pay,
(2)
100% of the FICA taxes the business should have paid on the worker’s behalf as the worker’s employer,
(3) 1.5% of all wages that were paid to the misclassified worker, which is a penalty for the business’s failure to withhold federal income taxes from the worker’s paychecks, and
(4) All FUTA taxes that should have been paid.
51 Id.
52 Id.
53 Id.
54 Id.
55 Internal Revenue Service, http://www.irs.gov/irm/part4/irm_04-023-006.html (last visited Oct. 21, 2010).
56 See Stephen Fisherman, Working with Independent Contractors, 82 (Marguerita Fa-Kaji ed., 6th ed. 2008). See also IRC § 3509.
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However, if a business fails to file the required 1099 forms, the employee FICA and income tax assessments are doubled, and the business must pay:
57
(1) 40% of FICA taxes the employee should have had withheld,
(2)
100% of the FICA taxes the business should have paid on the misclassified worker’s behalf as the worker’s employer,
(3) 3% of all the wages that were paid to the misclassified worker, which is a penalty for the business’s failure to withhold federal income taxes from the worker’s paychecks, and
(4) All FUTA taxes that should have been paid.
2.
Intentional misclassification
If a business intentionally misclassifies an employee as an independent contractor, the business’s tax assessments are higher, with the business paying: 58
(1) 100% of FICA taxes the employee should have had withheld,
(2)
100% of the FICA taxes the business should have paid on the misclassified worker’s behalf as the worker’s employer,
(3) 20% of all the wages that were paid to the misclassified worker, which is a penalty for the business’s failure to withhold federal income taxes from the worker’s paychecks, and
(4) All FUTA taxes that should have been paid.
If the business can prove that the misclassified worker paid his income taxes for the years in question, then the business can offset or abate the income tax portion.
59
Furthermore, if the misclassified worker paid its own FICA tax, the business may also be entitled to an offset of the employee FICA portion of the assessment.
60
However, in practice, this offset may difficult to obtain because a misclassified worker has a right to claim a refund for all self-employment taxes that he paid for the tax years in question.
61
In addition to these assessments, the IRS may impose other penalties on businesses. For example, Code Section 6663 allows the IRS to impose a penalty for fraudulent underpayment.
Also, the IRS may conduct a criminal investigation and have the United States Department of
57 See Stephen Fisherman, Working with Independent Contractors, 83 (Marguerita Fa-Kaji ed., 6th ed. 2008). See also IRC § 3509.
58 Stephen Fisherman, Working with Independent Contractors, 83-84 (Marguerita Fa-Kaji ed., 6th ed. 2008).
59 Id. at 84.
60 Id.
61 Id.
at 85.
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Justice prosecute employers for tax evasion. Businesses convicted of tax evasion can be fined or sentenced to imprisonment.
62
C.
Audits by the EDD
The EDD, pursuant to its authority under the California Unemployment Insurance Code and the Government Code, conducts random payroll tax audits of businesses operating in
California. Generally, EDD employment tax audits cover a 3-year period, comprising the 12 most recently completed calendar quarters.
63
But in some situations, the audit period may be longer.
64
The EDD has a settlement program under which the EDD may settle certain civil employment tax disputes. Under the Settlements Program, the EDD generally only considers a settlement offer when the assessment or denial of a claim for refund is under petition with the
California Unemployment Insurance Appeals Board.
65
However, if the case is still in process or involves fraud, intent to evade, or a criminal violation, the case is generally not eligible for settlement.
66
When reviewing an offer, the EDD considers the risk of loss for the State and the cost of litigation balanced against the benefits of reaching a settlement agreement.
67
Issues of fairness, financial hardship, and the survival of the business may be considered to establish a settlement amount, but cannot be used as the sole reason for entering into a settlement agreement.
68
To apply for a settlement, the business must submit a settlement offer to the EDD.
69 If the workers’ status is the subject of any part of the litigation, the business may be required to agree to start reporting the workers as employees and start withholding and paying the payroll taxes on those workers’ wages.
70
V.
Payroll Fraud Prevent Act
In April 2011, a bill was introduced in the United States Senate that would impose new reporting requirements on employers, increase penalties for classification violations, and
62 See id.
at 87. See also IRC § 7201.
63 California Employment Development Department (“EDD”) DE231TA Rev. 7 (2-09).
64 Id.
65 California EDD DE 231SP Rev. 4 (8-10).
66 Id.
67 Id.
68 Id.
69 Id.
70 Id.
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establish new protections for workers who believe they have been misclassified. This bill, known as the Payroll Fraud Prevent Act (S. 770), would amend the Fair Labor Standards Act of
1938 (“FLSA”) to require employers to accurately classify all covered individuals 71 as employees or non-employees, and inform each covered individual by written notice of that individual’s classification and include in the written notice a statement directing the individual to the Department of Labor website established under the Payroll Fraud Prevention Act for the purpose of providing further information about the rights of employees under the law. The bill also would amend the FLSA to provide protections to workers who are fired or otherwise discriminated against as a result of their efforts to be reclassified as employees.
Moreover, the bill would increase penalties imposed on employers who misclassify their employees as independent contractors and are found to have violated employees’ overtime or minimum wage rights. Under the Payroll Fraud Prevent Act, a violation will result in a civil penalty for each employee or other individual who was the subject of such a violation in the amount not to exceed $1,100, or if the employer has repeatedly or willfully committed such a violation, the penalty shall not exceed $5,000. Furthermore, under the bill, the Social Security
Act would be amended to provide for administrative penalties for misclassifying employees or paying unreported wages to employees without proper recordkeeping.
VI.
Treasury Department’s Revenue Proposals
In 2011, the Treasury Department release its 2011 “Green Book,” which outlines and explains the Obama Administration’s Fiscal Year 2012 revenue proposals. One of the proposals addresses the misclassification of employees as independent contractors. The proposal is designed to reduce uncertainty about worker classification, eliminate potential competitive advantages and incentives to misclassifying workers associated with worker misclassifications by competitors, reduce opportunities for noncompliance by workers classified as self-employed, and maintain the benefits and worker protections associated with an administrative and social policy system based on employee status.
72
This proposal would permit the IRS to require prospective reclassification of workers who are currently misclassified and whose reclassification has been prohibited under current law.
Under the proposal, reduced penalties for misclassification provided under current law would be retained, except that lower penalties would apply only if the service recipient voluntarily reclassifies its workers before being contacted by the IRS or another enforcement agency and if the service recipient had filed all required information returns reporting the payments to the
71 The Payroll Fraud Prevent Act defines “covered individual” as an employee of the employer, or a non-employee of the person (including a person who is an employer), (A) whom the person has engaged in the course of the person’s trade or business for the performance of labor or services, and (B)(i) with respect to whom the person is required to file an information return under I.R.C. § 6041A(a) or (ii) who is providing labor or services to the person through an entity that is a trust, estate, partnership, association, company, or corporation if (I) such individual has an ownership interest in the entity, (II) creation or maintenance of such entity is a condition for the provision of such labor or services to the person, and (III) the person would be required to file an information return for the entity under I.R.C. § 6041A(a) if the entity were an individual.
72 See MgGuireWoods, Legal Updates , http://www.mcguirewoods.com/news-resources/item.asp?item=5539 (May
10, 2011).
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independent contractors.
73
Moreover, under the proposal, the Treasury Department and the IRS would be permitted to issue generally applicable guidance on the proper classification of workers under common law standards, which would enable service recipients to properly classify workers with much less concern about future IRS examinations.
74
The Treasury Department and the IRS would be directed to issue guidance interpreting common law in a neutral manner recognizing that many workers are not employees.
75 The Treasury Department and the IRS would develop guidance that would provide safe harbors and/or rebuttal presumptions, both narrowly defined.
76
The IRS would be permitted to disclose to the Department of Labor information about service recipients whose workers are reclassified.
77
Under the proposal, service recipients would be required to give notice to independent contractors, when they first begin performing services, that explains how they will be classified and the consequences thereof.
78 Independent contractors receiving payments totaling $600 or more in a calendar year from a service recipient would be permitted to require the service recipient to withhold for Federal tax purposes a flat rate percentage of their gross payments, with the flat rate percentage being selected by the contractor.
VII.
Conclusion
If understanding the different classification tests isn’t difficult enough, Congress has been contemplating making significant changes to curb perceived abuses relating to misclassification.
In 2007, the Senate introduced the Independent Contractor Proper Classification Act of 2007, which, if passed into law, would reform the Section 530 safe harbor provisions. In early 2008, the House of Representatives introduced the Taxpayer Responsibility, Accountability, and
Consistency Act of 2008, which, if passed, would repeal the safe harbor provisions of Section
530, but would provide a new, more stringent safe harbor provision with harsher penalties for misclassifications. A month later, the House introduced the Employee Misclassification Prevent
Act, which, if passed, would amend the Fair Labor Standards Act and require employers to keep records of non-employees who perform labor and services on behalf the employer. And in 2011, the Payroll Fraud Prevent Act was introduced in the United States Senate.
The IRS is clearly concerned about misclassification of workers, and its plan to audit businesses is evidence of its concern. Furthermore, Congress has been concerned due to the tax gap created by misclassification of workers. Businesses should therefore take preventive
73 Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals
(February 2011) at p. 107.
74 Id.
75 Id.
76 Id.
To make the guidance clearer and more useful, it would generally be industry or job specific.
77 Id.
78 Department of the Treasury, General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals
(February 2011) at p. 107.
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© David L. Rice - 2010

measures, such as record maintenance, understanding the tests outlined in this article, and reviewing materials published by the IRS and the EDD.
Furthermore, employers may need to consult a labor or employment law attorney to discuss the effects and ramifications of misclassifying an employee as an independent contractor.
Under the FLSA, employers are required to pay non-exempt employees overtime wages.
California law provides more protection than the FLSA. Employees who have been misclassified may file a claim with the Division of Fair Labor Standards Enforcement or can file a lawsuit against his employer. Therefore, it is imperative that employers consult with a labor or employment law attorney.
© David L. Rice - 2010
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