Misclassification of Independent Contractors Can Be Remedied

Employers that know many of their independent contractors really should be classified as employees can participate in one of three Internal Revenue Service (IRS) programs to remedy the situation.

One program is available only if an employer is not under audit, another is for an employer that is under audit, and the third is for an employer that has not been under audit for the past three years. Companies with numerous misclassification problems can benefit greatly from participating in these programs, according to Jason Sheffield, an attorney with Willis Human Capital Practice in San Francisco and a June 22 presenter at the Society for Human Resource Management 2016 Annual Conference & Exposition in Washington, D.C.

Growing Interest in Misclassification

Federal agencies' concerns about misclassification spiked following enactment of the Affordable Care Act (ACA), according to Sheffield, who said the agencies feared employers would try to classify workers as independent contractors to escape the ACA employer mandate.

From the IRS's perspective, independent contractor misclassification results in lost tax revenue and can lead to increased Medicare and Social Security costs if independent contractors become sick, because many of them don't have health insurance, Sheffield remarked.

The Department of Labor is concerned about unpaid overtime and wages, as well as independent contractors' ineligibility to take time off under the Family and Medical Leave Act.

State agencies also have a stake in misclassification. They're concerned about their own income tax revenue, as well as less money feeding into state workers' compensation funds.

Failure to classify correctly can lead to millions in owed back taxes and to doubled damages following a wage and hour audit.

Company morale can take a hit, too. Sheffield noted that if "independent contractors" are onsite doing the same work as employees, the contractors can collectively grumble about their lack of benefits.

Indicators of a Potential Problem

There are several indicators of potential misclassification. Questions to consider include the following:

• Are independent contractors paid the same way as employees and at the same time? Payment in the same manner (for example, if the checks look identical) and at the same time is a no-no.

• Do independent contractors go through progressive discipline if there are performance problems, or are their contracts terminated? Progressive discipline shouldn't be used for independent contractors, Sheffield said.

• Do independent contractors have company credit cards or expense accounts? If they do, they are employees, he commented.

• Do independent contractors use the same equipment as everyone else? That can get an employer into trouble, as independent contractors are supposed to use their own equipment, he cautioned.

• Are the independent contractors reporting to company supervisors? This is another potential trouble spot, as reporting to supervisors would undermine contractors' control over their own work. The more control a company exercises over individuals' work, the less likely they are independent contractors.

• Has the independent contractor been required to sign a noncompete agreement? That's a problem, according to Sheffield. Nondisclosure agreements are fine, though.

It's best for independent contractors to work under contracts that are up for renewal annually. Project-based work for independent contractors shouldn't last more than five years, he said. Take Action

So what do you do if you suspect misclassification of independent contractors is widespread in your organization?

The first of the three IRS options to remedy the situation involves using the "Advance Determination of Worker Status—Form SS-8." This form can be used only if the employer is not under audit. Tax liability under the program can be reduced to one year.

The second option is the Classification Settlement Program; this is for an employer that is under audit. If an employer can show that it always treated a position consistently as an independent contractor or had a reasonable basis for classifying the position in the way it did, the full employment tax assessment will be for only one tax year under examination in the audit. If the employer asks, the penalties may be reduced, Sheffield noted—but the employer has to ask for the reduction.

The third option, the Voluntary Classification Settlement Program, can be the most advantageous for eligible employers. To be eligible to participate, the employer must not have been under audit for the past three years, Sheffield noted. The penalty under this program is 10 percent of the employment tax liability due on compensation paid to workers in the most recent tax year. There is audit forgiveness with respect to the worker classification of the employees for prior years. 

The main downside to the third option is that the penalties can be steep if there is subsequent misclassification. So, if using the third option, employers must be tenacious about preventing future worker misclassification, Sheffield said. "It can't happen again."​