Are Your Employees Misclassified?
Worker classification has become a major concern for employers, as governmental agencies have stepped up their efforts to investigate allegations that individuals who are properly considered employees have been misclassified as independent contractors. Recently, the IRS announced a program under which employers may be eligible to reclassify workers as employees at a reduced cost and without the threat of major IRS penalties. This article examines the potential benefits – and pitfalls – associated with the new program and provides an overview of the worker misclassification conundrum.
The September announcement of a safe-harbor program by the Internal Revenue Service (IRS) for employers with misclassified employees -- the Voluntary Classification Settlement Program (VCSP) -- added new emphasis to one of this year's most discussed employment issues: the misclassification of employees as independent contractors.
Employment lawyers have been sounding the alarm about an uptick in enforcement efforts over misclassified employees in the past two years. These efforts have been coupled with more recent cooperation between state and federal agencies to crack down on misclassification of employees as independent contractors and to recoup unpaid wages and taxes. Long considered an easy "alternative” by employers looking to reduce staff and costs, the concept of using independent contractors to provide necessary services has come front and center as employers cope with a need to reduce expenses and state and federal governments look for more sources of revenue.
The question of employee misclassification is as relevant to nonprofit organizations as it is to traditional business operations, if not more so. Nonprofit organizations are more likely to experience nontraditional employment arrangements, such as telecommuting, or to have a short-term, part-time, or episodic need for services such as event coordination, publishing, or member accreditation. The limited nature of the services provided or the distance of the employee make it easy to internally justify treating the individual as a contractor, particularly if the employee agrees in writing. Properly answering the question is not so simple.
Traditionally, an independent contractor provides a business organization with a service or a product that is outside of the scope of the organization's main business purpose or which is not usually required for day-to-day operations. A contractor is someone who holds herself out to the public as providing these services. But defining the line is often complex.
There are multiple tests employed by the Department of Labor (DOL), the IRS, and the Equal Employment Opportunity Commission (EEOC), as well as various state agencies such as, in Maryland, the Comptroller of the Treasury and the Department of Labor Licensing and Regulation (DLLR), among others. Within these agencies, the issues range from wage and hour violations, unemployment compensation, withholding taxes, workers' compensation coverage, and pension and benefit issues. The classification question becomes even more complicated in states like Maryland, where the unemployment law has a very narrow definition of an independent contractor.
The closer you look at the issue of misclassification, the more apparent it becomes that the IRS program -- while offering a deal to avoid more severe penalties in the face of an audit -- does not address concerns that may exist under other federal and state laws such as the Fair Labor Standards Act (FLSA) and state unemployment insurance.
For example, an independent contractor is usually paid a set fee or an hourly rate for the service he provides. If the individual was treated as an employee, he might be eligible for overtime pay for all work tours in excess of 40 in any given week. Independent contractors, however, would not be paid overtime. Thus, entering into an agreement with the IRS to reclassify employees, no matter how confidential the "closing agreement" may be, will open the door to potential liability for unpaid overtime wages and perhaps claims for benefits for these misclassified employees.
The liability will grow with the more employees who are misclassified. If you add the possibility that employees will seek back wages through private action, you may need to consider an award of attorneys' fees to their lawyers, which in many cases can far exceed the dollar recovery for the employees. In one recent case, the settlement allocated more than 80 percent of the total recovery to attorneys' fees. While the court decided to take a closer look at the allocation when the agreement was submitted for approval, the fact that there may be a large disparity is not surprising. You don't need to look too hard to see that other legal risks could be much greater than unpaid taxes.
Some of these concerns prompted the IRS to announce recently that it would not share any data or information of those employers participating in the program within various states. Still open, however, is whether the information may be shared with other federal agencies such as the DOL, with which the IRS entered into a memorandum of understanding (MOU) addressing the agencies' coordination on employee-misclassification compliance and education. How the VCSP fits into this cooperation is not entirely clear, though it would seem counterproductive to expose a repentant employer to additional liability if the program was to succeed.
Does this necessarily mean that an employer should ignore the IRS offer? No. There are certain benefits to the program, particularly if there are a large number of misclassified employees. The savings on penalties could be substantial. What it does mean, however, is that any decision to pursue the VCSP should only be taken with caution.
There may be legal grounds to defend a classification of an independent contractor to recommend against accepting the terms of the VCSP, which include extending the limitations period for tax collection. There may also be significant risks of unpaid overtime claims for the employees in question and potential savings from a tax standpoint may not be large. An employer who has always treated the contractor as a contractor may have far less to be concerned about than the employer whose contractor was classified as an employee a year ago, particularly if the services of the former are intermittent and sporadic and the latter is doing much of the same work as she did while employed and still works a regular work week.
Reclassifying employees may also raise the number of employees to the point that the employer becomes subject to other laws, such as.
- Title VII of the Civil Rights Act of 1962, as amended
- The Age Discrimination in Employment Act
- Federal COBRA
- Family and Medical Leave Act of 1992
Each of these laws has a different employee threshold for coverage, and the implications of coverage should be understood before entering the program.
Whether an association decides to take the IRS up on its offer, all employers should be aware that the question of misclassification does not end there. The DOL has aggressively stepped up enforcement efforts to address employee misclassification, a topic they broadly define as 'Wage theft."
Recently, the DOL signed MOUs to share information and coordinate law-enforcement efforts related to reducing misclassification of employees with 11 states, including Maryland, Connecticut, New York, Massachusetts, and Minnesota, among others. Maryland, like New Jersey and other states, has enacted a law to increase cooperative efforts among various state agencies. In Maryland, these include unemployment, workers' compensation, the Comptroller of the Treasury, and the wage unit of the DLLR to share information and coordinate enforcement actions regarding misclassified employees. The same law established target industries, such as construction and landscaping, where fines would be levied on employers who misclassify employees.
The issue remains active in Congress as well. Representative Lynn Woolsey (D-CA) has reintroduced legislation to address misclassification in the form of the Employee Misclassification Prevention Act (EMPA). Similar to the 2010 bill that was stalled in committee, the 2011 version of the bill, which has also been introduced in the Senate, would impose strict recordkeeping and notice requirements on businesses and organizations with respect to workers treated as independent contractors and establish potential fines from $1,000 up to $5,000 per worker for each violation. The bill would also allow targeted audits in industries that are known to misclassify employees and permit information sharing absent an interagency MOU. The bill would also add administrative penalties under the Social Security Act for misclassification.
Even if the EMPA does not pass Congress, the DOL may well take action to establish similar mandatory recordkeeping and notification requirements on businesses and organizations covered by the FLSA. Such regulations may require that every employee treated as an independent contractor be provided a detailed explanation as to the basis for the classification and require that the information be kept on file.
There is a lot at stake for this issue to consume the interest of governmental agencies for years to come. Estimates in some industries are that up to 20 percent of the workforce is misclassified. That reflects a substantial amount of revenue for agencies looking to make up shortfalls in budgets and to justify their performance.
Likewise, as employees feel the pressure of the current financial downturn, they may pursue their own remedies to address misclassification issues that have denied them healthcare coverage, pensions, and the benefit of social security, unemployment, and workers compensation coverage.
The incentives are very real and should serve as a warning shot to employers to do a close review of those they call independent contractors. Maybe the VCSP is for them, or perhaps some other approach is the best remedy. But getting ahead of the ball now is far preferable than waiting for a summons, subpoena, or an audit tomorrow.
This article was originally published in the December 2011 issue of Association Law and Policy and is reprinted by permission of ASAE.