Employee or Independent Contractor?

Understand the difference and save yourself from an ugly government audit.

Construction firm owners continue to misclassify employees as independent contractors, and in the process, fail to pony up their share of taxes for unemployment and payroll, among others, to federal and state governments. So says the Internal Revenue Service (IRS) and state Departments of Labor, organizations that are investing millions of dollars in audits and investigations to find out. Based on the research- they have a point.

According to a study performed by the United States Accountability Office titled “Employee Missclassification,” (gao.gov/products/GAO-09-717) as many as 3.4 million “employees” are passed off as contractors nationally, while the U.S. Department of Labor claims that 30 percent of companies misclassify employees. The issue of how workers are classified- as employees or independent contractors- is not new for the construction industry, but it has regained vigor as the recession has cut into everyone’s cash flow, even the dollars of the federal government and state governments. The IRS and state labor departments are cracking down on companies in order to recoup the funds owed to them when employees are misclassified as “independent contractors.”

Here’s a sampling of governmental efforts:

• In August, the “Construction Industry Fair Play Act” was passed in New York to curtail worker misclassifications in the construction industry.
• About 25 states have increased their enforcement and are levying stricter penalties for misclassifying workers.
• The Obama administration is expanding investigations by hiring 100 more enforcement personnel. Earlier this year, the IRS earlier this year began auditing 6,000 companies for compliance.
• The federal “Employee Misclassification Prevention Act” was introduced earlier this year in the Senate, which amends the Fair Labor Standards Act by requiring every company to keep records of non-employee workers and to inform all new employees and non-employees of their classification and rights.

Based on my experience at an accounting firm, not all construction companies are trying to skirt labor laws to save money. Many are unaware of the guidelines for determining the classification of a worker. Others have an understanding, but fail to interpret IRS and Department of Labor guidelines correctly. Some firms fail to keep the proper documentation or fail at setting up procedures that help workers maintain their “independent contractor” status.

What Is at Stake?

What is the possible ramification of noncompliance? For construction firms, it is the cost (or savings) of 10 to 15 percent of an employee’s salary, which includes taxes on Social Security, Medicare, unemployment insurance, disability insurance and workers’ compensation insurance. For the government, it could mean the addition of hundreds of millions of dollars in revenues annually in unpaid taxes and fines. One California construction firm is facing a $4.3 million fine for misclassifying employees. In Illinois, a home improvement company was fined more than $325,000 by the state Department of Labor for misclassifying 18 workers, alleging that it had pressured them to form separate “incorporated” business entities.

What Can You Do?

What should a construction firm to do? Companies can take several steps to ensure that workers are classified properly-and that they can prove it.

• Know the rules and document the firm’s relationship with an independent contractor.
• Keep all documentation and review it annually to ensure that it is up-to-date.
• Conduct an internal audit of all employees and independent contractors with the help of qualified accounting and/or law firms.
• Make sure independent contractors have their own insurance, business location and a customer list that indicates you are not the only employer, as well as a business license registered with the state.
• Pay independent contractors through accounts payable, not out of payroll.

When determining whether to classify someone as an employee or independent contractor, it is usually an issue of control. Ask yourself, “Does the business have the right to control how the work is performed?” “Is the independent contractor allowed to take on other work?” Typically, employees are given desks, phone lines and regular assignments. Workers are generally considered employees when someone else controls how and when they perform their work. In contrast, independent contractors are generally in business for themselves, obtain customers on their own and control how they perform services. Independent contractors do not get paid time off from their client, nor vacations or benefits.

Red Flags for the IRS and Department of Labor

There is no indication that this renewed push by the IRS and state labor departments will let up any time soon. Both the federal government and state government are facing revenue shortfalls and pursuing those who they believe have failed to pay their tax burdens. While the government is collecting less in corporate and sales taxes because of lower profits, they are also paying out more money in unemployment benefits. Ironically, in many cases laid-off workers “red flag” a construction firm for the IRS and Department of Labor when he or she applies for the benefits. If a construction firm classified this worker as an independent contractor, the laid-off worker will be denied benefits-setting up a possible appeal in which the former worker claims employment status.

In some cases, the independent contractors may have been willing participants in the misclassification and asked their construction firm employer to pay them as an outside firm. Contractors, as opposed to employees, can establish their own business entity, and more effectively deduct expenses like tools and equipment, and lower their payroll taxes. In some instances, workers do not fully understand disadvantages, such as not being able to file for unemployment benefits if laid off. At the accounting firm where I work, numerous construction firm clients have received audit notices from the N.J. Department of Labor, which announced plans to conduct unemployment tax audits. Instead of a full audit, all the Labor Department wanted to see was the 1099s issued to independent contractors. These 1099 Forms were reviewed against independent contractors’ personal income taxes, to see if they were truly independent contractors. These clients were able to offer other documentation that proved status as an independent contractor to the Labor Department.

As states and the federal government continue to pursue construction firms, it is imperative that firms devote the time of a human resource professional or office manager to ensure compliance. Outside professionals, such as accounting firms and law firms, can also be helpful in determining classifications and in setting up systems to ensure independent contractors status do not lapse into “employee status” over time.

Construction Business Owner, December 2010