worker classification – do it right or pay the …...2016/06/14 · 4 employee or contractor -...

Worker Classification – Do it Right or Pay the Penalties

Laurence C. Rubin, CPA and Michael L. Colavito, Jr., JD | 6/15/16

2© 2016 | www.aronsonllc.com | www.aronsonllc.com/blogs |

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Introduction

• Be able to identify whether your worker is an employee or an independent contractor (IC)

• Understand why proper worker classification is important

• Gain awareness of the regulatory consequences of worker misclassification

• How to ensure contractors really are contractors

• Considerations in growing a company that relies heavily on ICs

• Basic understanding of exempt vs. nonexempt employees










Employee or Contractor - Settlements• Landmark Microsoft case - $97 million

• 5 construction companies - $70,000 each and banned from bidding on public projects for 4 years. State’s attorney (IL) labels act as fraud

• XPO Logistics case – class action lawsuit brought by drivers settles for $2.8 million in Illinois

• FedEx case - $228 million settlement for misclassifying FedEx Ground drivers in California

• Lyft case – Lyft agrees to settle a worker misclassification class action suit for$12.25 million










Employee or Contractor?

• The more factors the employer meets, the more likely the worker is an employee

• No set number of factors or factors that weigh more than others –no “bright line” test

• IRS 20-factor test

• Common law tests

• Darden factors (Supreme Court decision 3/24/1992)











All of the following must be met for IC classification:

A. The worker is free of control and direction with respect to the means of how the work is performed

B. The worker has his own business providing the same services to others in the market

C. The work is: Outside the usual course of the company’s business OR Performed outside of the company’s place of business











Economic reality – U.S. vs. Silk (U.S. Sup. Court decision 6/16/1947)

• Degree of control exercised by the employer

• Extent of relative investments by worker and employer

• Worker’s opportunity for profit or loss

• Skill and initiative required in performing the job

• Permanency of the relationship

“IT IS THE TOTAL SITUATION”











Donald G. Cave, a Professional Law Corp vs. Commissioner (Tax Court Memo 2011-48, issued 2/28/2011)

1. Degree of control exercised by the principal over the worker2. Which party invests in work facilities used by the worker3. The worker’s opportunity for profit or loss4. Whether the principal has the right to discharge the worker5. Whether the work is a part of the principal’s regular business6. The permanency of the relationship7. The relationship the parties believed they were creating










Employee Perspective

Employees have certain expectations of their employer:

• Predictable pay schedule

• Payment for overtime

• Matching FICA/Medicare taxes

• Federal and state tax withholdings

• Participation in retirement and health plans

• Workers’ comp and unemployment insurance coverage










Contractor Perspective

Despite numerous benefits of being an employee, there are people who want to be in business for themselves

• Control your own hours

• No boss telling you what to do

• Profit is all yours

• Better tax planning opportunities










Employer Perspective – in favor of employees

Stable workforce – leads to efficiency and ability to plan

Employees can be trained to carry out the work the way the employer wants

Employer has control over what employees can and cannot do

IP protections: more control over the employee relationship

Less risk with client relationship










Employer Perspective – in favor of contractors

No HR headaches

No payroll tax compliance headaches

Avoids cost of employment taxes, worker’s comp*, health, retirement, etc.

Termination at will or at end of contract without fear of a discrimination lawsuit

Sounds great! What’s the problem?* Most state and private insurers require the employer to include independent

contractors on their policy absent proof of the IC’s own insurance










Government Perspective

Federal concerns Tax compliance and payment FICA and Medicare revenues DOL overtime entitlements

State concerns Income Tax – Nexus and Apportionment Sales tax Funding unemployment insurance pool Workers’ compensation Disability coverage

It’s all about collecting revenue and protecting workers










Common Red Flags

Worker completed an employment applicationControl

• Company tells the worker what, when, and how to do their job• Worker is given an employee handbook• Worker undergoes orientation program

Pay• Worker is paid through the company payroll system instead of accounts payable• Worker does not furnish an invoice

Hours• Worker has to punch a clock• Worker gets paid overtime

Benefits• Worker gets paid for company holidays, vacation, and sick leave• Worker gets a free parking space, meals, etc.










Penalties - Federal

• Pay taxes that should have been withheld

• Pay employment taxes that should have been remitted – FICA, Medicare, unemployment, etc.

• Pay back overtime

• Pay back pension contributions

• Since these payments are made late, applicable penalties and interest will apply










Non-Industry Specific Legislation - Selected States

Why are states targeting noncompliant employers?

• No wage withholding

• No unemployment taxes

• No workers’ compensation

• Pensions not funded

• Market competition is undermined










State Worker Misclassification Laws

Massachusetts Independent Contractor/Misclassification Law• Enhanced civil and criminal penalties for employers violating wage

and hours laws, payroll recordkeeping law, and/or withholding and unemployment tax law.

• Liability for both business entities as well as corporate officers and those with management authority over affected workers.

• Three-Prong Misclassification Test:1. Freedom of Control 2. Service Outside Employer’s Normal Business 3. Independent Trade, Occupation, Profession or Business










State Laws Enforcing Worker Misclassification

• California• $5,000 to $10,000 for first violations; up to $25,000 for repeat violations• Public notification of misclassification• Joint and several liability for consultants (excluding lawyers) who advise

employers on such independent contractor engagements.

• Illinois• Employee Classification Act• Construction industry specific• $1,000 fine for each violation

• Maryland• Workplace Fraud Act of 2009• $1,000 fine for each misclassified employee










Review of Employee Misclassification in Virginia

• Study by Virginia Joint Legislative Audit and Review Committee– A VEC audit of 1% of Virginia employers found 5,639 misclassified workers in

2010.– Estimated that Virginia could have 40,000 misclassifying employers and

214,000 misclassified workers.– Study concluded:

• The identified misclassified workers cost the state an est. $1M of revenue• Estimated $28 million on an overall basis

– Recommendations:• Legislation with clear definition of employee• Inter-agency information sharing procedures• Additional penalties for misclassification, including loss of the right to bid on state

and local contracts for period of time










Virginia Inter-agency Task Force

Gov. McAuliffe Executive Order 24 (8/14/2014) • Established inter-agency task force to investigate and report on the

issue of worker misclassification and payroll fraud • State Agencies Involved:

– Secretary of Commerce and Trade– Department of Labor and Industry– Virginia Employment Commission– Department of Professional and Occupational Regulation– State Corporation Commission’s Bureau of Insurance– Workers’ Compensation Commission– Department of Taxation










Virginia Inter-agency Task Force

Purpose of Task Force• Review statutes and regulations related to worker misclassification

and payroll fraud• Gather information on prevalence of misclassification in various

industries• Evaluate current enforcement practices of the agencies involved• Develop procedures for more effective inter-agency cooperation and

joint enforcement• Implement project for joint enforcement• Enhance technology for detection










Policy for Virginia Occupational Safety and Health (VOSH) Cases

• Virginia Dept. of Labor and Industry announced a new policy in June of 2015 to address worker misclassification in Virginia Occupational Safety and Health (VOSH) cases

• Policy Highlights– No reductions of penalties in any VOSH case where reasonable cause

exists that worker misclassification has occurred– Additional sanctions for employers that contract with unlicensed

subcontractors (construction industry)– Where contract value for a specific subcontractor's job is less than $1,000,

a written referral will be made to VEC for potential audit of the employer's employment practices










How Do You Get Caught?

• Random IRS audit of your business – field agents are now questioning why workers are not on the payroll

• Targeted audits

• You terminate the services of your IC and that person promptly files an unemployment insurance claim

• The IC gets hurt and files a workers’ comp claim

• The IC, shocked that he actually has to pay taxes, files form 8919 and/or SS-8 with the IRS to force employee classification










The Most Common Question

• All of my contractors sign IC agreements. Why is that not good enough?

• Because…– Many agreements are poorly written– The facts on the ground do not correlate with the terms of the

agreement

• Employers are not permitted to draft around their withholding and unemployment tax compliance requirements










Fixing Misclassifications – Current Year

• Place misclassified workers on payroll right away!

• All payments since the beginning of the year must be run through payroll – do NOT issue a W-2 and a 1099-MISC.

• Back withholding taxes are calculated at the regular rates. You will then need to seek any reimbursement from the employee for the taxes retroactively withheld.

• The taxes are reported on and remitted with form 941-X (amended quarterly federal payroll tax return).

• State unemployment tax returns will need to be corrected as well.

• Determine if 530 relief applies – this may give federal relief, but not state relief.










Fixing misclassifications – prior years

• Section 530 relief (may get repealed)– Prevents the IRS from retroactively reclassifying independent contractors as

employees– Available if all these requirements are met:

• Consistently treated subject workers and workers in similar job situations as independent contractors

• Issued a form 1099-MISC to each contractor in accordance with the form’s reporting requirements

• Had a reasonable basis for the treatment of the worker as an independent contractor

– Longstanding practice in your industry– Prior IRS audit with no assessment for employment taxes– Court case in your favor with similar fact pattern– Relied on professional advice










Fixing Misclassifications – Prior Years

• When Section 530 relief cannot be claimed– Recompute the worker’s pay as if he were an employee– Determine if 3509(a) or 3509(b) rates can be used– Amend all prior federal and state payroll and information reports

– generally for the three most recent years










Fixing Misclassifications – Applicable Federal Tax Rates

•Section 3509(a)–Available only for unintentional misclassifications a 1099-MISC was given to the worker in a timely manner–Cannot recover any tax from the employees–Tax rate is 10.68% of each employee’s wages up to the FICA wage limit ($118,500 in 2015 ), plus 3.24% of wages in excess of the FICA limit

•Section 3509(b)–Available only for unintentional misclassifications and a 1099-MISC was NOTgiven to the worker–Cannot recover any tax from the employees–Tax rate is 13.71% of each employee’s wages up to the FICA wage limit, plus 5.03% of wages in excess of the FICA limit










Fixing Misclassifications – Applicable Federal Tax Rates and Filings

• For either Section of 3509, the W-2 that is issued only shows the wages that was reported on the original 1099-MISC. Nothing is shown in the withholding boxes because the employee does not receive credit for those taxes.

• If neither part of Section 3509 applies:– Compute the FICA and Medicare taxes using the standard rates in effect for

that year.– No federal income tax withholding is computed– The W-2 reports the employee’s share of FICA and Medicare taxes– Employee must repay the employer the withholding taxes by end of the

current year. Otherwise, the tax itself is income to the employee.










Voluntary Classification Settlement Program

• Federal program introduced in 2011

• Tax cost is about 1% of the reclassified workers’ compensation

• Provides no clarity to existing laws – who is an employee remains just as murky as before

• Not binding in any states











Eligibility criteria:

• The employer has treated all workers consistently – the individual has never been classified as an employee, and workers who hold a substantially similar position have also never been classified employees.

• The employer has filed a form 1099 for each misclassified worker for each of the past three years.

• The employer cannot be presently under an employment tax audit.











If accepted into the program:• Prospectively treat the subject workers as employees;• Pay 10% of the employment tax liability that would have been

due for the previous year as computed under Code Section 3509;

• Not be liable for interest or penalties;• Not be subject to a federal employment tax audit for prior years

on the classification of these workers.










State Voluntary Disclosure Programs

Massachusetts• Mass. introduced voluntary compliance initiative relating specifically to employee

misclassification in 2009.• Criteria:

– Taxpayer must have had no previous contact with Department of Revenue regarding employee misclassification

• Benefits:– Taxpayers may come forward anonymously through a representative– Limits “look back” period to only 3 years – Penalties are generally waived– Only applies to employee wage withholding

Florida• Reemployment tax (i.e., unemployment tax) is covered in Dept. of Revenue’s

general voluntary disclosure program.










Now What?

• Realize that all of the expenses associated with having employees is a necessary cost of doing business

• Establish procedures to be implemented on all new IC arrangements

• Conduct due diligence on all of your current independent contractors

• Have your attorney draft a good IC agreement – this is not a do-it-yourself task

• Establish protections for your IP

• Put all misclassified workers on payroll ASAP

• Companies without a payroll or HR department should retain those services from third parties that are bonded and insured

• If you are under audit, consult a competent tax professional. Do not attempt to handle the matter yourself










State Tax Implications of Employee vs. IC Classification

Nexus Issues• When will employee or IC activity in a state cause your

company to be subject to a state’s income tax?

• From a Constitutional Standpoint

• From a Statutory Standpoint










Nexus

• From a Constitutional Standpoint– Characterization of workers as “employees” or “independent

contractors” is “a fine distinction without constitutional significance”

– Classification as an employee or IC is irrelevant– Scripto, Inc. v. Carson, 362 US 207, 80 S. Ct. 619 (1960)

• In-state activities that are significantly associated with the company’s ability to establish and maintain a market in the state for sales are nexus-creating

– Takeaway – using ICs instead of employees will not insulate you from state taxes










Nexus

• From a Statutory Perspective

– Public Law 86-272

• Federal statute that prohibits states from imposing an income tax on out-of-state sellers of tangible personal property whose onlyactivity in the taxing state is the "solicitation of orders" provided that the orders are sent outside the state for acceptance and, if accepted, the goods are delivered from outside the state.

• P.L. 86-272 does make a distinction between employee and independent contractor sales personnel.










Nexus

Public Law 86-272• Independent contractors may engage in the following limited

activities in the state without a company losing P.L. 86-272 protection:

1. Soliciting sales2. Make/finalize sales3. Maintain an office

• In-state employee sales personnel are permitted, but allowable office is limited to home office.

• Consigning property with an IC is not allowed under P.L. 86-272.• Sales reps. who represent a single principal are not considered to be ICs

under P.L. 86-272.










Apportionment

• Payroll Factor– Most states exclude independent contractors from the payroll

factor• Sales Factor

– Many states source receipts from services based on where the taxpayer’s income-producing activity occurs

– What’s an income-producing activity?• Most state include activities performed on behalf of the taxpayer by third

parties (e.g., ICs)– For services performed in more than on state, receipts are

apportioned based on “costs of performance” (COP)• Payments to ICs are considered a “direct cost” and taken into account in a

COP analysis• For certain taxpayers, the failure to account for these costs can drastically

change their sales factor percentage










Exempt vs. Nonexempt

• Nonexempt– Protected by FLSA (Federal Labor Standards Act) and state laws– Paid by the hour– Overtime premium (1.5 x hourly rate) is required to be paid for over 40

hours within the same week– Any employee that does not meet the narrow definition of Exempt is

therefore Nonexempt











• Exempt– Must be paid by salary of at least $47,476 per year ($913 per week)– Wages are not subject to reduction due to the amount or quality of work

done– No required overtime pay– Examples of exempt employees include professionals, executives,

administrators, outside sales– Job title does not matter – it’s facts on the ground










Exempt - Executive

• The employee must be compensated on a salary basis (as defined in the regulations) at a rate not less than $913 per week;

• The employee’s primary duty must be managing the enterprise, or managing a customarily recognized department or subdivision of the enterprise;

• The employee must customarily and regularly direct the work of at least two or more other full-time employees or their equivalent; and

• The employee must have the authority to hire or fire other employees, or the employee’s suggestions and recommendations on the hiring, firing, advancement, promotion or any other change of status of other employees must be given particular weight.










Exempt - Administrative

• The employee must be compensated on a salary or fee basis (as defined in the regulations) at a rate not less than $913 per week

• The employee’s primary duty must be the performance of office or non-manual work directly related to the management or general business operations of the employer or the employer’s customers

• The employee’s primary duty includes the exercise of discretion and independent judgment with respect to matters of significance










Exempt - Professional

• The employee must be compensated on a salary or fee basis (as defined in the regulations) at a rate not less than $913 per week

• The employee’s primary duty must be the performance of work requiring advanced knowledge, defined as work which is predominantly intellectual in character and which includes work requiring the consistent exercise of discretion and judgment

• The advanced knowledge must be in a field of science or learning

• The advanced knowledge must be customarily acquired by a prolonged course of specialized intellectual instruction.

• This designation does not apply to doctors, lawyers, or teachers










Exempt – Computer Employees

• The employee must be compensated on a salary or fee basis (as defined in the regulations) at a rate not less than $913 per week or on an hourly basis at not less than $27.63 per hour.

• The employee’s primary duty must be in one or more of the following areas:

– Application of systems analysis to determine hardware, software, or system functions specs

– Design, development, documentation, analysis, creation, testing, or modification of computer systems or programs










Exempt – Highly Compensated

• The employee earns total annual compensation of $134,404 or more AND is paid at least $913 per week on a salary basis

• The employee’s primary duty includes performing office or non-manual work

• The employee customarily and regularly performs at least one of the exempt duties or responsibilities of an exempt executive, administrative or professional employee

Example – a manager is paid $1,000 per week and receives periodic bonuses, pushing her salary over $140K for the year. She routinely directs the work of at least two full-time employees, which is one of the duties of an executive. She is an exempt employee.











• Evaluate each employee and document your conclusions

• Find more details from the Department of Labor online: https://www.dol.gov/whd/overtime/final2016/SmallBusinessGuide.pdf

• If you are not 100% certain, consult an HR specialist










Questions?










Laurence C Rubin, [email protected]

301.222.8212Linkedin: https://www.linkedin.com/in/larry-

rubin-cpa-82b20a6

Michael L. Colavito, Jr., [email protected]

301.231.6298Linkedin: www.linkedin.com/in/michael-colavito-

6a622040

Contact Info










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worker classification – do it right or pay the …...2016/06/14 · 4 employee or contractor -...

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