Navigating The 1099 Independent Contractor Compliance Landscape

Written by admin on May 16th, 2011

Saving your company from ruins due to worker misclassification

Executive Summary

Over the years, full-time employees in the United States have enjoyed the fruits of long-term employment benefits where a good majority of the baby-boomers practically worked for a single employer until retirement.  However, business circumstances have lead to a new trend in the industry over the last 2 decades where companies have adopted a contingent workforce comprising of independent contractors in almost every industry, including IT or Information Technology.

From the business perspective, this was welcomed and embraced by employers who saw opportunities to enhance their bottomline due to perceived or realized cost savings from this new industry practice.  The use of these contingent workforce enabled high scalability for companies to wind-up or wind-down resourcing depending on business demands.  Add to that the realized benefits due to decrease in amount of employment taxes and costs of employee benefits, and exempting the companies from responsibilities under the traditional labor laws.

However, as years pass by, the concept of contingent workforce was so over-used which can lead to significant risk exposure for companies who misclassify independent contractors.  This was obviously attributed to their lack of understanding on the underlying differences between an independent contractor and an employee.  The grey area had since grown much wider and complicated as interested parties took notice of it and started asking the right questions.

While most companies understood that such worker misclassification have penalties such as increased tax liabilities, this is just the icing and not the cake.  Some employers have not yet considered the full devastating impact of other problems it can bring to them such as unpaid benefits, attorneys and court fees, etc.  To sum it all up, the total business impact of worker misclassification can actually cost these companies their whole business.

However, proactive initiatives by companies to conduct third-party audits bring in good value to their organizations.  This is especially so in order to understand better and mitigate risks involved in employing these independent contractors.  In the recent years, we can take a look at actual cases related to workers misclassification and gain a deeper insight on the complexity of the issues, and how your company can avoid the pitfalls of erring companies in the business.

FedEx: A Case of Independent Contractor Misclassification

The company received a bad news from the Internal Revenue Service (IRS) on December 22, 2007 with regards to independent contractor misclassification issue.  The IRS has assessed approximately 9 million in back taxes by FedEx for tax year 2002 due to misclassifying a great number of FedEx Ground/Home Delivery drivers as “independent contractors” instead of as employees.  FedEx has disclosed this decision of the IRS in its recent filing with the US Securities and Exchange Commission.  The 9 million assessed liability was only for 1 tax year, you must understand, and it can still increase when the IRS start looking at their other tax years for similar infractions.  Class action lawsuits against FedEx have also increased in number around the country, and over 50 lawsuits were consolidated at a federal court in South Bend, IN.  The class action involving around 14,000 current FedEx Ground/Home Delivery drivers nationwide may still grow with inclusion of additional 10,000 former drivers.  In California, FedEx’s position was further challenged as the California Supreme Court released its decision on the case Estrada vs. FedEx which affirmed an Appeals Court ruling that FedEx Ground/Home Delivery drivers were indeed misclassified as independent contractors instead of as employees of the company.

While FedEx has been largely considered as the common example for worker misclassification, it used to be Microsoft Corporation who carried that bill for a while back then.  Sometime in the late 1980s, the company employed around 1,000 workers under the category of independent contractors.  As part of their processes and procedures, those workers signed an agreement that affirms their being independent contractors, and that they were not entitled to the company’s Benefits Program for employees.  The IRS conducted an audit on the company during the 1989 to1990 tax year, and found that those workers classified by the company as independent contractors should actually be employees.  The IRS findings were based on Microsoft’s inherent ability to “exercise direction and control” over the services performed by those workers.  Thus, Microsoft decided to comply and paid employment (back) taxes for the workers and even hired some of those workers as employees.  However, Microsoft’s woes did not end there when a group of those former “independent contractors”, now employees, demanded for benefits that they could have enjoyed during the specific period they were classified as independent contractors.  While the company disputed the claims, around 8 of those employees sued Microsoft (Vizcaino vs. Microsoft) for the right to participate in the Benefits Plans.  Microsoft settled the suit in December 2007 in the amount of million.

Looking at the two examples above, the issues resulting to worker misclassification infractions were not new at all.  And they illustrate the continuing legal trend in the industry with regards to worker misclassification.  Problems continue to hound the conflicting interpretations of the legislation and the ambiguous guidelines followed by federal and state agencies to enforce the law on worker misclassification.  In September 12, 2007, then Sen. Barack Obama introduced Senate Bill 2044 known as the Independent Contractor Proper Classification Act of 2007.  The bill is still pending in the senate, and related bills were also introduced such as HR 6111 and S.3648.  With the proponent of the bill now sitting as President of the United States, it may not be long before S.2044 becomes a landmark legislation that will affect all industries using and benefiting from contingent workforce.

So, who are the Independent Contractors?  Who are the Employees?

In distinguishing between an independent contractor against an employee, the degree of “control and direction” over the worker plays a key part.  This particularly with regards to the degree of control exercised by the employer over the manner and means that service is to be performed by the worker.  A real independent contractor is a master craftsman, they are qualified experts in their trade, with verifiable professional credentials and do not need any degree of “control” over their manner and means to perform their services.

Employees, however, would usually require basic to advanced training or instructions on how to perform their work assignment.  This also includes instructions on designated hours of work, production rate, and the work area assignment among others.  Potential risks happen when the employer’s degree of control over the work output (per independent contractor relationship) crosses the line over the manner and means of performance of the work output (showing an employee relationship).  Not all members of employer’s supervising team are appreciative of those salient nuances which can really be ambiguous especially during times of tight deadlines to meet.

It is when these dividing lines merge or the distinction blurs, such can easily fall prey to scrutinizing eyes of the independent contractors themselves, the employees, or other interested parties such as federal or state agencies, union organizers, labor lawyers, etc. which may lead to further scrutiny.  And when these parties identify that a company may be misclassifying workers, they will make allegations of an employee relationship violation resulting to aggravated risks on the part of the employer.

Among the things often looked at in this case are the degree of control exerted by the company over the worker’s time and work hours, the degree of assistance given by the company’s employees to the independent contractors to perform their services, and the company’s control over the means or methods used to perform the work.  That is, the way to complete a work assignment versus concern only for the final output.  This is further aggravated where the so-called “independent contractors” are provided training by the company.  Depending on pending circumstances and contributing factors, the company will be liable for violation of the law concerning employment of independent contractors.

Impending Liability: Sword of Damocles?

Numerous studies showed that the US government was losing hundreds of millions of dollars in taxes annually due to this worker misclassification practices in various industries.  This lead to intense deliberations in the legislative bodies and new bills introduced to remedy the problem.  While deliberations are still going on, let us revisit what can be the potential risks carried by non-compliant companies:

Back taxes, with both employee and employer contributions.
Cost of settlement for benefits that should have been enjoyed by affected workers had they been considered employees.
Pension contributions or profit shares that should have been enjoyed by affected workers.
Penalties from federal and state agencies plus accrued interests over the years covered in the violations.
Intentional misclassification of independent contractors which can lead to punitive or triple damages.
Encouragement of potential union organization efforts by affected workers.

While we cannot guarantee that nobody

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