Employee or contractor? Mistakes often costly

By Allen Smith Jan 5, 2007
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The misclassification of independent contractors isn’t a problem just during tax season, as state unemployment compensation and workers’ compensation offices increasingly are acting year-round as “the eyes and ears” of the Internal Revenue Service (IRS), according to Ronald E. Wainrib, president of Ronald E. Wainrib & Associates in Franklin, Mass.

In their zeal to cut costs, employers sometimes lay off employees and hire so-called “independent contractors” to do the same work but treat the replacements like employees.

If these “independent contractors” subsequently are laid off, they often seek unemployment compensation. When the agencies inform them that unemployment compensation will be denied because they aren’t employees, the workers usually respond “ ‘You’ve got to be kidding’ and start battling,” Wainrib remarked in a recent interview.

The same kind of scenario often plays out with workers’ compensation claims as well, he added, noting that employees, not independent contractors, typically are eligible for workers’ compensation benefits. But Wainrib said the disputes over classification as independent contractors happen more frequently with unemployment compensation.

Lisa B. Petkun, an attorney with the law office of Pepper Hamilton LLP in Philadelphia, agreed. Inquiry into a worker’s classification during unemployment compensation hearings can trigger an audit by the IRS, she told HR News.

Different tests

However, states and the IRS often do not use the same test to determine who is an independent contractor, observed GJ Stillson MacDonnell, an attorney with Littler Mendelson in its San Francisco office.

As reflected in Section Two of its Publication 15-A for the past 10 years, the IRS looks at 11 factors (rather than the old 20 factors) within three areas—behavioral control, financial control and the type of relationship of the parties. But “there is no universal test,” MacDonnell pointed out in an interview.

The IRS of today isn’t the IRS of old that went after independent contractor relationships aggressively, she reflected. This is partly because of Section 530 of the Revenue Act of 1978, which created a safe harbor provision for employers. That said, it still is important for employers to examine the status of employees to ensure proper classification at the federal and state level, MacDonnell noted.

Often, HR professionals are not involved in the classification of workers as independent contractors until HR is stuck with what happens when someone’s classification is challenged, she added. Organizations need to look at classification not just from an accounts payable perspective but from the employment relationship as well. Consequently, it is important for HR professionals “to be engaged in the process of whether someone should be an independent contractor vs. employee,” MacDonnell remarked.

Filing a Form SS-8, which the IRS revised in November 2006, can provide an employer with the federal tax status of whether someone is an independent contractor, but not their state tax status, explained MacDonnell, who worked with the IRS in developing the form.

Moonlighters

Layoffs and the replacement of employees with independent contractors aren’t the only situations in which employers need to be concerned about misclassifying workers as “1099 workers,” according to Christine V. Walters, J.D., SPHR, a member of the Society for Human Resource Management’s Employee Relations Special Expertise Panel. The phrase “1099 workers” is a shorthand reference to independent contractors, and refers to a federal tax form (Form 1099-MISC, rather than the W-2) used by employers to report payments to independent contractors.

Suppose an employer has an employee it really likes and that employee has a business on the side, Walters hypothesized. The employer hires the worker as an independent contractor to perform other work, such as cleaning after business hours, and the person continues to work as an employee during business hours.

That’s fine as long as the lines are kept distinct. But if the individual starts to do cleaning or other tasks originally envisioned as independent contractor work during business hours, the lines can blur between independent contractor and employee status, she cautioned.

Clarify distinction with former employees

Walters has found that the most common time for misclassifications is when an employee leaves a position on good terms and then fills in on a temporary basis as an independent contractor for a month or two while the employer searches for a replacement.

The worker often ends up doing exactly what the person did as an employee. One month turns into two, then four, and before long the employer is not working as hard to fill the position. The question then arises whether the person is classified properly.

HR professionals face such classification issues commonly, Walters noted. “How many of us have left to do consulting and then do consulting for the company we just left?”

Patterns can be difficult to change, but it is up to the employer to communicate and act clearly if it wants to make someone an independent contractor who in the past was an employee.

That person no longer should be attending team meetings, be going into an office regularly or be expected to work certain hours, Petkun noted. Also, the individual shouldn’t have company business cards or be referred to as an employee.

Employers frequently tell Petkun that they want certain workers to be independent contractors, but when she talks with them and digs deeper, she realizes they actually want the workers to be under supervision and in an employer-employee reporting relationship.

Allen Smith, J.D., is SHRM’s manager of workplace law content.

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