Employee or Independent Contractor and Why it Matters

Employee or Independent Contractor and Why it Matters Some companies choose to pay people who do work for them as an independent contractor, rather than an employee.  At the end of the year, the worker gets a 1099, rather than a W-2.  In some instances, this is justified, in others, it is not.  Why do companies choose to do this?  Paying an independent contractor means no wage withholding, no employment taxes, no unemployment insurance, no workers’ compensation, and no liability for pensions and fringe benefits.  Independent contractors pay self-employment tax, which has been under-collected for years.  
What many of these companies don’t realize is that it really isn’t a “choice” for them to make and the IRS and states have been cracking down on this for years.  The IRS uses a 20 question test to determine if an individual is an employee or an independent contractor.  They consider all facts.  The 20 question test can be found “http://www.irs.gov/pub/irs-utl/x-26-07.pdf” \t “_blank”  In this era of state budget gaps, the states have also gotten extremely aggressive in this arena.  The IRS may not even look at a company’s employee/independent contractor classification, but the state will come looking for its employment taxes.
New Jersey and California are two examples of states whose rules are very strict.  In New Jersey, three factors are used to determine if a worker is an employee or an independent contractor.  Here are the three parts of the test, directly from the statute:

Such individual has been and will continue to be free from control or direction over the performance of such service, both under his contract of service and in fact; and
Such service is either outside the usual course of the business for which such service is performed, or that such service is performed outside of all the places of business of the enterprise for which such service is performed; and
Such individual is customarily engaged in an independently established trade, occupation, profession or business.

Control, outside the ordinary course of business, location, independent trade.  New Jersey will make an occasional exception, but don’t expect one.
In 2011, California has made some significant changes to its laws regarding misclassification of employees.  In addition to other rules already in place, here are the new provisions:
California’s Labor and Workforce Development Agency can fine you for “willfully misclassifying” an employee from $5,000 to $15,000 per violation.
The penalty goes up to $25,000 per violation if you commit a “pattern and practice” of “willfully misclassifying” workers.
There’s joint and several liability for consultants (but excluding practicing lawyers) who advise employers on such independent contractor engagements.
It’s unlawful to charge misclassified independent contractors any fee or take deductions from the compensation paid to them.  Companies cannot deduct fees for goods, materials, space rental, services, government licenses, repairs, etc. provided to contractors who are reclassified.
Federal Voluntary Classification Settlement Program In 2012 and 2013, the IRS created a program called the Voluntary Classification Settlement Program (VCSP) to allow employers to voluntarily reclassify independent contractors as employees where warranted.  So far, nearly 1,000 employers have taken advantage of the program.  The program was communicated in a series of announcements starting in 2012 and has been expanded in 2013.

To be eligible for the VCSP, an employer must
currently be treating the workers as independent contractors;
consistently have treated the workers as independent contractors in the past, including filing 1099s (the 1099 requirement is waived until June 30, 2013);
not currently be under audit on payroll tax issues by the IRS;
not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers;
not be contesting the classification of the workers in court.
“http://www.irs.gov/formspubs/article/0,,id=242970,00.html” Form 8952 is used by employers to apply for the program.  It must be filed at least 60 days before the employer wants to start treating workers as employees.  Employers in the program generally pay just over 1% of the wages paid to the reclassified workers for the past year. Penalties and interest are waived and employers will not be audited on payroll taxes related to these workers for prior years.  It is important to note that a more serious crackdown program usually follows a voluntary program.  Now is the time to deal with this issue.  Call Scott Novak for guidance on your employee/independent contractor matters and audits.
For more information on the VCSP, see

“http://www.irs.gov/irb/2012-51_IRB/ar16.html”Announcement 2012-45, “http://www.irs.gov/irb/2012-51_IRB/ar17.html”Announcement 2012-46 and  “http://www.irs.gov/uac/IRS-Expands-Voluntary-Worker-Classification-Settlement-Program” \t “_blank”IRS IR-2013-23.