Employers watch out. President Obama's $3.8 trillion federal budget for 2011 has several new initiatives within the Department of Labor (DOL). One of them includes an additional "$25 million to target employee misclassification with a hundred additional enforcement personnel and competitive grants to boost states' incentives and capacity to address this problem." In addition, the Departments of Labor and Treasury are pursuing a plan to cut incentives for employers to misclassify workers, according to a budget summary.
The Obama administration's effort to target employee misclassification is the latest in a series of federal initiatives and state laws. At the beginning of 2010, President Obama signed an IRS directive that will increase the agency's scrutiny of federal contractors' classification of employees. States have begun to follow suit by passing legislation making it a violation of law to misclassify employees and imposing penalties on those who knowingly do so. For instance, the Illinois Employee Classification Act prohibits the misclassification of employees as independent contractors and provides stiff fines for non-compliance.
By definition, independent contractors are self-employed. Because they are not employees, they are not covered by employment, labor, and various tax withholding laws. In some instances, businesses reclassify employees as independent contractors in order to avoid paying and withholding taxes, paying for overtime and benefits, and workers' compensation liability. The determination of whether a worker is covered by a particular employment, labor, or tax law hinges on the definition of an "employee." Inadvertent misclassification is a genuine concern for many companies because state and federal agencies have different standards for classification.
The DOL, for instance, often relies on the "Economic Realities Test" to determine whether a worker is an independent contractor or employee. These tests take into account the degree to which workers are economically dependent on the business, in addition to considering the degree of control an employer exercises.
The IRS, on the other hand, uses a three-factor test for determining whether someone is an employee or an independent contractor. The factors focus on behavioral control, financial control and relationship of the parties. Given the nuances involved, employers need to be careful. There are severe consequences.
Along with payments of back taxes and potential interest come heavy penalties, personal liability of corporate owners, possible criminal sanctions and the possibility of losing government contracts for federal contractors. Moreover, although agencies apply different standards for classification, the DOL has coordinated its efforts with the IRS, the National Association of State Workforce Agencies, the Federation of Tax Advisors, and agencies that administer state employment and unemployment taxes.
Businesses should err on the side of caution and vet their contractors in-house only if they have the required expertise. There are third party companies that provide this service.