Danger of Misclassification
“So what?” you say, “This is good business practice since we’re saving money on benefits.” Not so. It is not a good practice to misclassify workers. Each and every worker who is a bona fide non-exempt employee misclassified and paid as an independent contractor is a claim against you waiting to happen. You are on the hook for past under payment of over time going back for two years.
If found willful, that is that your organization misclassified intentionally or really should have known, then those two years grow 50 percent to three years. Plus, the likelihood of you having detailed hours of a 1099 worker is small, so the court will accept the workers’ recollection of time worked. Also, if one worker steps forward with allegations of underpayment due to misclassifications, the odds of you being subject to a full audit have just increased substantially. Lastly, there are civil penalties under FLSA for not paying over time. For willful violations, they may include fines up to $10,000 and/or six months imprisonment.
Those of you have put energy into these determinations may have used the “Twenty-Factor Test” in the past. The Internal Review Service has retired that tool and replaced it with the “11 Main Test”. This new instrument is the focus of this article.
Introducing the “11 Main Test”
The “11 Main Test” is a list of eleven questions to assess what level of control the employer has over a worker. That level of control is the key for determining if someone should be paid via a W-2 or 1099. The questions are in three key areas of behavioral control, financial control, and type of relationship.
Let’s review each of these IRS questions.
Behavioral Control: If the organization has the right to control how work is done the person doing that work is an employee. Independent contractors must commit to what is produced, but hold onto the right to decide how to do it.
1. Instructions that the business gives to the worker.
The degree and extent instructions are imparted to how that work gets done. This includes when, where, with which tools, and in what sequence.
2. Training that the business gives to the worker.
The amount of training given to the worker on how to do tasks may indicate employee status. Independent consultants get to choose their own methods.
Financial Control: Assesses the extent and nature of the business aspects of the worker via five questions. These are looking at facts about the degree of financial control.
3. The extent to which the worker has unreimbursed business expenses.
Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.
4. The extent of the worker's investment.
An employee usually has no investment in the work other than his or her own time. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.
5. The extent to which the worker makes services available to the relevant market.
An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.
6. How the business pays the worker.
An employee is generally guaranteed a regular hourly rate or salary. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
7. The extent to which the worker can realize a profit or loss.
Since an employer usually provides employees a workplace, tools, materials, equipment, and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss. An independent contractor can make a profit or loss.
Type of relationship: Four questions are posed to discern the facts regarding the nature of the working relationship.
8. Written contracts describing the relationship the parties intended to create.
This adds to what we already know, which is although verbal contracts remain legal, written contracts are still the best to clarify intent and expectations.
9. Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
An independent contractor financing his or her own benefits may try to negotiate on to your benefit plans, but for audit purposes, it is more prudent to say no.
10. The permanency of the relationship.
If the company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship. So, if you want an on-going relationship with an independent contractor, it is more prudent to do so only at a fixed finite interval at a time, such as one financial year.
11. The extent to which services performed by the worker are a key aspect of the regular business of the company.
If a worker provides services that are a key aspect of the company's regular business activity, it is more likely that the company will have the right to direct and control his or her activities.
There is a "safe harbor" rule in Section 530(a) of the Revenue Act of 1978 that sometimes allows companies to classify workers in close cases as independent contractors if it is an industry practice. Consult your employment lawyer before assuming that safe harbor rule is one that is valid for your circumstances.
Need more information? Go to IRS Publication 15-A, 2010 Edition, page 6; available for downloading from http://www.irs.gov/pub/irs-pdf/p15a.pdf (PDF). This article is based upon that publication. For understanding the independent contractor tests another source is http://www.irs.gov/businesses/small/article/0,,id=99921,00.html.
By Beverly N. Dance, MBA, SPHR-CA, CCP, CEBS
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