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Employers beware: federal and state agencies increase efforts to reduce independent contractor misclassification
March 19, 2010
Employment Law Alert
Author(s): Gary J. Oberstein

In light of a recently launched IRS enforcement program, as well as increased enforcement actions by the United States Department of Labor and state agencies, employers should carefully review their current payroll practices regarding independent contractors or face stiff penalties for incorrect classification.

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Misclassification of workers as independent contractors has apparently become so prevalent that the United States Department of Labor believes up to 30% of employers misclassify their workers. Citing the denial of basic rights to workers and accrual of less revenue to the Treasury, the federal government is increasingly cracking down on employers who incorrectly classify workers as independent contractors. The IRS recently launched a widespread audit of thousands of employers across the nation. In addition, Congress is considering a new bill which will strengthen protection for employee rights. Accordingly, it is very important for employers to take extra care when designating workers as independent contractors.
Correctly classifying workers as independent contractors has proven troublesome for many employers. Under federal law, the standards for independent contractor classification generally center on the level of control the employer exercises over the worker, but are often constructed in a manner that is too vague and difficult for employers to interpret with confidence. In addition, the laws in several states provide for a presumption that workers are employees, and place the burden of proving workers are independent contractors squarely on the employers. Then there is the law in Massachusetts, which not only presumes workers are employees but also requires employers to satisfy an exceptionally difficult three-prong test or face severe penalties for incorrect classification. (See discussion below on Massachusetts law.) It comes as no surprise that many employers mistakenly, but in good faith, classify workers as independent contractors.

IRS Enforcement Program

In February 2010, the IRS began conducting audits of randomly selected employers throughout the country. Over the next three years, the IRS plans to review the tax returns of 6,000 employers across various industries primarily to analyze five employment tax issues: worker classification, officer compensation, reimbursed expenses, fringe benefits, and non-filers. These National Research Program (NRP) audits will likely focus only on these five issues and be very detailed in nature. While the IRS will focus its audits on employment tax returns for 2007 and 2008, it may expand its investigation into other employment tax years or other tax categories. The IRS intends to have 200 to 300 of its most experienced agents conduct both face-to-face interviews and line-by-line reviews of selected companies’ income tax and employment tax returns, along with W-2s, 1099s and other forms issued to workers. It is safe to assume that returns will be closely scrutinized.

In addition, the Obama administration intends to re-write a long-standing IRS rule that permits employers to classify their employees indefinitely as independent contractors based on a once held reasonable belief that the workers were employees. If the rule is changed, employers will need to demonstrate on an ongoing basis why they have classified a particular worker as an independent contractor.

Increased action by other employment agencies

Employers should also be aware of other current governmental trends in favor of employees in line with the Obama administration’s pro-worker agenda. In February 2010, the President proposed an allocation of $25 million to the Department of Labor (DOL) strictly for the purpose of combating employee misclassification. Under this “Misclassification Initiative,” the DOL will add 100 enforcement personnel to their current staff and incentivize states with competitive grants to address the issue of misclassification. Other departments also may receive substantial boosts in their funds under the proposed budget to address employee issues, such as paid leave programs and increasing employment of individuals with disabilities.

Legislative support

In December 2009, Senator John Kerry (D-Mass.) introduced a bill to prevent employers from further taking advantage of a loophole found in the Internal Revenue Code. Section 530 of the Revenue Act of 1978 currently provides employers with a “safe harbor” for classifying workers as independent contractors for employment tax purposes regardless of their status under a common law test. The bill, known as the Taxpayer Responsibility, Accountability and Consistency Act of 2009, intends to revise Section 530 by requiring employers to possess a reasonable basis for designating certain workers as independent contractors. The bill also seeks to ensure workers are provided with workplace protections, including workers’ compensation, Medicare, Social Security, minimum wage, overtime, and unemployment compensation.

What to expect from the IRS

The IRS plans to audit employers of differing size and legal form, so there is not much that employers can do to avoid an audit. However, in anticipation of an audit, employers should review their current payroll practices, making sure to address and remedy any weakness or discrepancy in records with regard to the five employment tax issues stated above. Employers should also review their employment tax returns for the preceding three years.

Employers selected to be audited by the IRS should make sure they are following good IRS examination management practices. At a minimum, employers should:

  1. Appoint a clear “chain of command” to respond to audit notices, as well as other IRS communications;
  2. Involve expert outside advisors from the outset of the process; and
  3. In an attempt to maintain control over the audit, request additional time to respond appropriately to information document requests, or, where appropriate, narrow the scope of the information requested.

Massachusetts law

As noted above, Massachusetts is one of a number of jurisdictions where the law presumes a worker is an employee and sets forth specific requirements that employers must satisfy before classifying a particular worker as an independent contractor. Incorrect classification, even if done in good faith, may result in stiff mandatory penalties including treble damages and attorneys fees. Specifically, M.G.L. c.149, s.148B provides that all workers are employees until the company can show that all three of the following requirements are satisfied:

  1. The individual is “free from control and direction in connection with the performance of the service.”
  2. The service that the individual performs is “outside the usual course of business of the employer.” Unfortunately, neither the law defines “usual course of business” nor have Massachusetts courts set forth a clear definition.
  3. The individual “is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed.”

Although an employer may attempt to rebut this presumption by satisfying these three prongs, it will be an uphill battle, as the requirements are demanding, and Massachusetts courts and agencies usually find in favor of the employee.

Therefore, it is especially critical for Massachusetts employers to be careful in their classification of workers and have reasonable documentation to defend itself in any enforcement action. 

What to take away

In light of increased enforcement on the federal and state levels, all employers, regardless of their size, are at risk of an audit by the IRS or a charge by a state agency with regard to worker misclassification. Penalties can be severe. Therefore, it is in the best interest of all employers to review their current practices of classifying workers to ensure the classifications are defensible.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.