Proper Classification is Crucial

As the economy begins to recover, some businesses may find they need additional help, but aren’t in a position to hire permanent employees. These organizations may look to temps or contractors to help bridge the gap.

Other businesses customarily deal with seasonal variations by staffing up with temporary workers during busy times. Many use temps to cover staff shortages due illness, vacation, military service or other issues.

No matter your reason for employing contract workers, it’s important you understand the associated wage-and-hour issues. The classification of these workers as employees or as independent contractors promises to become an increasingly expensive and troublesome headache for businesses going forward.

The changing enforcement landscape

Enforcement efforts related to employee classification have been ramping up for some years now. However, 2010 looks to be the year this becomes a major issue — one that will continue to impact businesses for years to come.

Beginning in February, 2010, the IRS began a national audit, involving 200 auditors and targeting up to 6,000 employers, specifically looking for misclassification of employees. The Wage and Hour Division of the U.S. Department of Labor, along with 29 states, have agreed to collaborate with the IRS and share results of their own audits.

For 2011, the Obama administration’s budget for the Department of Labor includes an additional $25 million to target the misclassification of employees as contractors. The money will fund an additional 100 inspectors as well as providing grants to states to support their enforcement actions.

At the state level, Maryland, Colorado, Illinois, Massachusetts, New Jersey and New Mexico have passed laws targeting misclassification in designated industries, while Iowa, Michigan, New York and Wisconsin have created task forces charged with uncovering employee misclassification.

What makes this issue so important for employers?

In addition to the business disruption and expenses involved in a labor audit or defending yourself against a wage and hour lawsuit, the penalties for misclassification can be crippling. For instance:

  • In 2009, Colorado increased the penalties to $5,000 per misclassified employee for the first offense and $25,000 per misclassified employee for each subsequent offense.
  • New York State reported in 2009 it uncovered 12,300 instances of misclassification and imposed penalties of nearly $6 million on the affected employers.
  • Illinois recently imposed a fine of over $328,000 on a first-time offender, including penalties for misclassification and for failing to maintain proper records for the misclassified employees.

The issues

Business and tax incentives encourage employers to classify workers as contractors whenever possible. For instance, employers are generally required to withhold payroll taxes and pay FUTA and the employer’s portion of FICA taxes for employees, but not for independent contractors. Many temporary workers may also prefer to be classified as independent contractors.

However, simply because you plan to employ someone for only a limited period of time or to work only on a specific project, this doesn’t automatically make that worker an independent contractor under the law.

For example, under Colorado state law, a worker may meet all the other criteria to be considered an independent contractor, yet their employer would be required to classify the worker as an employee if checks are issued in the worker’s individual name rather than in the name of a business.

The IRS analyzes the worker / employer relationship using three main criteria:

  • Behavioral control: Does the employer specify when, where and how the worker performs his or her job? Does the employer base performance evaluations on how the worker does his or her job, or simply look at the result of the work performed? Does the employer train the worker on specific procedures to follow in doing the job?
  • Financial control: Does the worker provide his or her own tools and equipment? Does the worker have the opportunity to either profit or lose from performing the work? Does the worker have the freedom to provide services to multiple employers? Is the worker paid a flat fee or job rate rather than a salary or an hourly rate?
  • Type of relationship: Does the employer provide the worker with benefits? Is there a contract, and if so, what are its provisions? Is the position of fixed duration, and if so, for how long? Is the worker involved in key aspects of the business?

Further complicating the landscape, other federal agencies and the states often use different criteria than the IRS. The federal courts and the U.S. Department of Labor use a more liberal test than the IRS to determine worker status under the Fair Labor Standards Act, Title VII of the Civil Rights Act of 1964, the Americans with Disabilities Act, the Family Medical Leave Act and other laws. Various states have their own differing standards for employee classification.

What can you do to reduce the risk for your organization?

Some employers may decide to hire temporary help through a staffing agency, rather than contracting directly with the workers. This would appear to shift the risk of potential classification issues from the hiring business to the agency.

What many businesses do not realize, though, is the law recognizes a concept called “joint employment.” If the temporary employees are under your direct supervision — that is, you control when they start and stop work and what they do while they’re on the job — while they technically are employees of the agency, you may be considered a “joint employer” along with the agency. If this is the case, you can still find yourself partially liable for wage and hour violations that might occur — even if it was the agency that actually committed the error.

If you decide to work with an agency, you will want to accurately track the workers’ hours and ensure the agency classifies and pays them properly. For instance, you may do well to set these workers up in your time and attendance system and track their time yourself so you can have your own independent record of many hours they’re working each week.

Whether you contract directly with workers or hire temps through an agency, your first line of defense should be a consultation with your employment law advisor. Your labor attorney can help you:

  • Determine which federal and state statutes and regulations apply to your situation.
  • Clarify what you need to do to stay on the right side of the law.
  • Help you conduct a self-audit to determine if you have any points of exposure.
  • Advise you what to do to solve them.

The bottom line: hiring contract workers is a viable means of staffing up to meet increases in business volume without increasing your permanent headcount. To avoid substantial back taxes, fines and penalties, however, it’s important to be aware of the criteria for these workers to be considered independent contractors under the law, and to properly classify all your workers according to those criteria.

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