Blurred lines between employees, contractors can complicate taxes

KANSAS CITY, Mo. -- The guy who came to fix your cable box: Employee or independent contractor?

The package delivery agent running up your sidewalk: Employee or independent contractor?

The beautician at your salon: Employee or independent contractor?

It can be hard to tell.

The distinction is important because employers' labor costs are substantially lower for contract employees, giving employers a powerful incentive to misclassify employees.

Now the Obama administration intends to crack down on that practice.

With the goal of claiming an estimated $2.72 billion a year in unpaid Social Security, unemployment insurance and income taxes from both employers and workers -- as well as protecting workers' rights -- enforcers are charging out of the gate.

And hitting a stumbling block: Just who are the estimated one in five U.S. workers who are independent contractors?

Donald Main didn't think he was.

The Kansas City-area resident, who temporarily drove his car for the 7/A Luxury Transportation service, thought he was an employee. So when he wasn't paid as he expected, he called the Labor Department's Wage and Hour Division, the Internal Revenue Service and Legal Aid.

He said all told him that he was an independent contractor. If he wanted to get paid, he'd have to sue the employer in small-claims court.

"I was surprised I didn't have an employee's rights," said Main, who subsequently got paid without filing suit.

Main's confusion is shared by many.

The Fair Labor Standards Act, the basis of American wage and hour law, along with years of judicial opinions, regulatory opinions and IRS rules, has yet to produce a clear distinction between who is an employee and who is an independent contractor.

"It is a tricky area," acknowledged James Koren, district director of the Wage and Hour Division in Kansas City, Kan.

The Labor Department has estimated that up to one-third of U.S. employers are incorrectly classifying as least one employee -- some by intent, others in error.

Part of the problem is that the distinction is complicated, and the government knows it.

To that end, the Internal Revenue Service has added 200 employment tax auditors and may strengthen its employer guidelines.

The U.S. Department of Labor's 2010 budget calls for 250 more Wage and Hour investigators. And the department's new top enforcement official has a history of payroll investigations that unearth misclassifications.

The administration's intent to ferret out wrongdoing and clarify the employee/independent contractor distinction is important to an ever-increasing percentage of workers.

In part because of payroll cuts during the recession, one in four U.S. workers is likely to soon fall into the independent employment ranks. Some authorities forecast that it's only a matter of years before it's one in three.

Call them independent contractors, contingent workers, self-employed, free agents, consultants, freelancers or even "micropreneurs." What author Daniel Pink called the "Free Agent Nation" in his 2001 book of the same name is growing fast.

Here's why:

If a business employs an independent contractor instead of an employee, it can save about one-third of payroll costs by not having to pay Social Security taxes, unemployment and workers' compensation insurance taxes, and employee benefits such as paid time off and subsidized health insurance, according to an analysis by the National Employment Law Project.

A business also can staff up or staff down more quickly with contract workers -- a just-in-time work force -- than if it has to go through the time-consuming and costly effort of hiring and firing W-2 employees.

But it also can cost a lot if the business classifies wrongly.

"More and more businesses believe they can call someone an independent contractor because it's cheaper not to pay employment taxes or workers' (compensation) taxes," Koren said. "But they frequently find themselves owing back wages and back taxes, too."

On the flip side, misclassified workers can be helped or hurt, according to their status.

Truck drivers, home health aides and construction workers -- all in industries susceptible to accident and injury -- are among the most frequently misclassified workers found in investigations.

When they're treated as (or actually are) independent contractors, they're responsible for their own health insurance and medical care. If they can't work or lose work, they're not eligible for unemployment or workers' compensation benefits.

They're also not covered by minimum wage, overtime or most workplace anti-discrimination laws. But they are responsible for their own withholding and tax payments.

So when federal authorities talk about a misclassification crackdown, they're not only looking at employers. Workers who underreport or fail to pay their income taxes also will be caught in the enforcement net.

One study of employers and workers by the attorney general in Ohio estimated that state alone has 92,500 misclassified workers, which cost the state up to $35 million in unemployment insurance taxes, up to $103 million in workers' compensation premiums and up to $223 million in income tax revenue.

This month, the Kansas Department of Labor said it was "taking additional measures" to detect unemployment insurance fraud.

In addition to going after workers who perpetrate fraudulent claims, the department is targeting employers who intentionally misclassify employees as independent contractors to avoid making unemployment insurance contributions.

To understand how misclassification happens unwittingly, it helps to look at the basic rules, some of which haven't changed in decades. The Labor Department, for example, refers to 1947 and 1964 U.S. Supreme Court decisions in helping it distinguish between independent contractors and employees.

The Wage and Hour Division's guidelines say the distinction is a "matter of economic reality" that can be judged by analyzing seven significant factors (see below).

The imprecise language of those seven factors underlines the confusion. Courts have ruled on many occasions that there is no single rule or test for determining who is an employee and who isn't.

The Wage and Hour Division provides some further guidelines:

"There are certain factors which are immaterial in determining whether there is an employment relationship," the guidelines state.

"Such facts as the place where work is performed, the absence of a formal employment agreement, or whether an alleged independent contractor is licensed by the state/local government are not considered to have a bearing on determinations as to whether there is an employment relationship.

"Additionally, the Supreme Court has held that the time or mode of pay does not control the determination of employee status."

That says what doesn't matter, but it leaves open questions about what does.

Broadly, workers are employees if someone controls when and how they do their work.

That means the employer controls any or all of the tools and equipment used on the job, the coworkers hired and assigned to the job, the source of supplies and other services, the specific work assignment for the individual, and the order or sequence of the tasks performed.

Federal authorities categorize the relevant rules according to three types: behavioral, financial and the relationship of the two parties.

In general, workers are independent contractors if they're in business for themselves, can get customers on their own and control how they do the work.

Typically, but not always, independent contractors are paid flat fees for the agreed-upon work, often established by a signed contract. But compensation sometimes can be hourly.

These aren't the only determinations, though. Because of the tax consequences for both employers and workers, the IRS also has hefty regulatory interest in the issue.

For years, the IRS used a 20-factor test to distinguish between employees and independent contractors.

That advice has been supplanted by "common law rules," which refer to the same behavioral, financial and relationship criteria used by the Wage and Hour Division.

But both agencies emphasize that case-specific details often are needed to make a decision.

"Businesses must weigh all these factors when determining whether a worker is an employee or independent contractor," the IRS guidance says. "Some factors may indicate that the worker is an employee, while other factors indicate that the worker is an independent contractor. There is no 'magic' or set number of factors that 'makes' the worker an employee or an independent contractor, and no one factor stands alone in making this determination. Also, factors which are relevant in one situation may not be relevant in another."

If the IRS finds a classification violation, the employer could be found liable for unpaid taxes and mandatory insurance payments, severance pay for the worker, and payment of other benefits that were paid to employees at the time the wrongly classified independent contractor was employed.

Sen. John Kerry, D-Mass., late last year introduced a bill that he said was necessary to close a tax loophole in the Internal Revenue Code that provided a "safe harbor" for employers who wrongly classify employees as independent contractors.

About three-fourths of all states have recently passed or introduced legislation to clarify definitions or toughen enforcement of misclassification violations.

Despite the avalanche of attention, confusion remains.

Ron Trachsel with Allied Staffing, a temporary help and placement agency in the Kansas City area, says part of the confusion is because definitions are used imprecisely.

"A lot of people who are called independent contractors are actually employees of the staffing agencies that placed them on the job," Trachsel said. "There are many nuances, such as co-employment, where both the staffing company and the employer have responsibilities to abide by the labor laws."

Trachsel said signed indemnification agreements help ensure that the staffing company and the contracted employer "each do what they're supposed to do and are responsible for their respective actions."

Signed contracts help ensure similar understanding between employers and independent contractors.

And, in regard to imprecise definitions, Trachsel noted that the even the basic language his industry uses to describe workers has been affected by payroll downsizing and the shift toward a just-in-time work force.

"We used to call it 'permanent placement,'" he said. "We don't use that anymore. The term is pretty well gone because the promise of gold-watch 'permanent' is gone."

The term "direct hire" is now the operative phrase for when a worker lands a payroll job and becomes an employee.

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FIND OUT MORE:

For the Labor Department's Wage and Hour information about the distinction between independent contractors and employees:

--Go online to www.wagehour.dol.gov . Type "independent contractor" in the search box to find relevant information quickly.

--Call the Wage and Hour referral line at 1-866-487-9243 toll-free between 8 a.m. and 5 p.m. EDT Monday through Friday.

For independent contractor/employee guidance from the IRS:

--Go online to www.irs.gov to download Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. (The IRS says individual responses may take six months.) Type "independent contractor" into the search box to find it quickly.

--View an IRS "worker classification webcast" posted at www.irs.gov . Type "independent contractor webcast" into the search box to find it.

--Call the IRS Business and Specialty Tax Help Line at 1-800-829-4933.

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SEVEN FACTORS:

The U.S. Department of Labor's Wage and Hour Division looks at seven factors to help determine the difference between an independent contractor and an employee. They are:

--The extent to which the services rendered are an integral part of the principal's business;

--The permanency of the relationship;

--The amount of the contractor's investment in facilities and equipment;

--The nature and degree of control by the principal;

--The contractor's opportunities for profit and loss;

--The amount of initiative, judgment or foresight in open market competition with others required for the success of the independent contractor;

--The degree of independent business organization and operation.