Independent contractor misclassification: A major headache likely to get worse under PPACA

Article courtesy of SBAM Approved Partner ASE

By Anthony Kaylin

Misclassification of employees has been a long-term major issue in the workplace.  In 2001 Microsoft settled a misclassification suit over “long-term temp/contractors” who should have received Microsoft benefits for the years they were contractors. Microsoft’s bill was $97 million. These “permatemps” had signed an agreement saying that they were contractors and not employees. It did not stand up in federal court.  Since Microsoft exercised substantial control over how these workers performed their jobs, the court deemed them employees, not contractors.

Since that time there have been a number of high-profile lawsuits, from FedEx Drivers cases (one of which cost the company $27 million) to a more recent suit involving a group of exotic dancers who won $12.9 when they alleged that the strip club chain they worked for wrongly classified them as independent contractors and failed to pay them proper minimum wages and benefits.

And how does this misclassification impact a company?  Misclassified workers are entitled to significant benefit restoration, especially in three categories of benefit plans: tax-qualified pension plans (401k plans, defined contribution plans, defined benefits plans); welfare benefit plans (Section 125 plans, group health insurance plans, group term life insurance plans); and incentive stock option plans.  Furthermore, a misclassified worker can also jeopardize the tax-qualified status of a plan.

But misclassification is already a trend, and it is expected to grow. According to SurePayroll, a Chicago-based payroll firm, in December 2012 6.7 percent of payroll checks written by small employers went to 1099 workers (i.e., those not considered employees of a company).  In December 2007 the number was 3.5 percent of payroll checks.

Curbing misclassification has become a priority for the Obama Administration. Since 2011 the Department of Labor and IRS have worked together to tackle this issue. They signed a Memorandum of Understanding (MOU) to reduce the incidence of misclassification of employees.

The IRS has also established a Voluntary Classification Settlement Program (“VCSP”). The VCSP enables some employers to resolve past worker classification issues at a minimal tax cost.  Employers that voluntarily reclassify some or all of their independent contractors (IC) as employees for federal tax purposes, and pay a fee covering a portion of their past payroll obligations, can escape certain tax liability for improper misclassification.

Now comes the next whammy with misclassification:  Obamacare. It will fall like a heavy weight on small businesses who are grappling with how to grow the business while staying under the 50-FTE headcount that triggers healthcare obligations. It is a powerful incentive for employers to misclassify workers as ICs, and no doubt many employers will try to beat the system that way. They will likely regret it in time if not right away.

If they improperly exclude misclassified workers, they could run afoul of the Affordable Care Act. Moreover, the IRS being allied with the DOL may even cause more heartache for employers.  “If anything, [audits] will increase more” in light of the health-care law, says Monique Warren, partner at workplace law firm Jackson Lewis LLP in White Plains, N.Y. “Employers have to be real careful about calling someone an independent contractor.”

So what can an employer do to determine whether a worker is an IC or not?  According to the IRS, three major areas need to be reviewed:

Behavioral: Does the company control or have the right to control what the worker does and how the worker does it?

Financial: Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)

Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue? Is the work performed a key aspect of the business?

The IRS has a 20 point test for determination that covers these three areas.

The long and short of it is that Obamacare is likely to have a number of unintended consequences, one being slowing companies from growing. And the vigilance of the Obama administration in this area is likely to cause greater anxiety for employers in the future.