Is this worker an independent contractor or an employee? Misclassifying workers is easy to do, but increased attention in this area by the Internal Revenue Service (IRS), Department of Labor (DOL), Congress and the states should correlate with increased care on the part of employers.
The DOL and IRS entered into a memorandum of understanding on September 19, 2011, regarding the misclassification of employees. These agencies, along with 11 states (including Minnesota), agreed to enhance their information sharing and other collaboration efforts to target the misclassification of employees.
Additionally, the Employee Misclassification Prevention Act has been reintroduced in Congress as an amendment to the Fair Labor Standards Act (FLSA). This bill, if passed, would impose penalties for misclassification of workers, including double liquidated damages and civil monetary penalties for each person misclassified.
Finally, willful misclassification of workers as independent contractors, rather than employees, could result in fraud liability for the failure to pay employment taxes, such as FICA. Although most worker misclassification does not amount to fraud absent specific intentional action, the IRS has reported increased investigations into employment tax fraud during 2011. Examples of these investigations can be found on the IRS Web site.
As the IRS, DOL and state agencies step up enforcement against worker misclassification, the IRS is offering some partial relief. It has created a voluntary compliance program—the Voluntary Classification Settlement Program (VCSP)—through which an employer can reclassify its nonemployee workers as employees for federal employment tax purposes.
Employers may be eligible to participate in VCSP if they are not under investigation by the IRS, or under audit regarding worker classification by the DOL or a state agency. To participate, the employer must have consistently treated the workers as independent contractors or other nonemployees, including having filed required IRS Forms 1099 for each worker, for the past three years. Employees reclassified under this program must remain classified as employees in the future unless there is a change in the employment relationship.
Minnesota's Department of Revenue has created a temporary pilot program that follows the IRS's VCSP. This program is only available until December 16, 2011. Companies with Minnesota employees may participate in this program if the VCSP eligibility requirements are met. Under the program, the workers will be reclassified as employees beginning January 1, 2012. Participating employers will be required to pay a tax at a rate of 3% of the compensation paid to the affected workers for the 2010 calendar year.
Although the VCSP provides some employer protection, it is indeed limited. First, while the IRS will not seek employment taxes for the reclassified employees during the period covered by the VCSP settlement agreement, the states are not similarly prevented from doing so. Moreover, although the VCSP does not directly address other employment-related laws enforced by DOL agencies such as EBSA, the agency that enforces ERISA, or OSHA, these laws often have definitions of "employee" that incorporate the worker's tax classification, and therefore, may be implicated. Specifically, unlike an independent contractor, an employee has increased protections and rights under many federal employment-related laws such as ERISA, ADA, ADEA, FLSA, NLRA and Title VII, as well as many state laws. Reclassifying employees can result in the need to provide benefits to the "new" employees under tax qualified and ERISA employer benefit plans (prospectively, and possibly retroactively). The newly reclassified employees may have the right to overtime under the FLSA. Additional employees could even push the employer over certain thresholds, making federal laws applicable to the employer as a whole. For example, going from 14 to 15 employees will trigger the application of the Americans with Disabilities Act.
Nonetheless, amnesty from the IRS in an environment of increased enforcement and the corresponding reduction in employment tax penalties may outweigh the other potential employment consequences, especially where state relief programs are also available. Every employer's situation will be unique. Advice from knowledgeable employment law and tax law counselors can help each employer understand the landscape of possible employment and tax consequences related to worker misclassification.