January. It's the time of the year for resolutions, of new hope, of organization and also ---- for income tax preparation. Companies are busy producing required documents for their employees and subcontractors before the month-end deadline. This newsletter will focus on "Joe The Plumber," not only one who recently found himself in the midst of a presidential campaign but who is also smack dab in the middle of a critical company decision: Should Joe The Plumber be classified as an independent contractor or employee?

Sincerely,
Laura Glennon

Case Study

As they grow, most firms either add staff or hire independent subcontractors to perform their work. Say you own a HVAC company and you have ten licensed plumbers on your payroll, and management places a hiring freeze on the company due to the economic downturn. Workers who leave due to attrition won't be replaced.

The ten employees handle the calls during normal business hours and are also on call after hours. Suddenly the economy starts to pick up, the company has more calls to service, but the hiring freeze is still in place. The employees begin complaining about being on call and want to be relieved of that burden. Besides, overhead costs are rising as overtime increases. Management decides to rehire Joe, who retired early at 55, to cover the emergency calls. This time Joe is hired back not as an employee but as an independent contractor. Management figures that he is only going to work a few hours a week and that he can just be a subcontractor. Besides, Joe won't add to the employee headcount if he's an independent contractor. They mistakenly believe they don't have to put him back on the payroll, pay his union dues or employment/unemployment taxes again since he'll just be working a few hours a week. In this case study, it's pretty easy to classify Joe: since he was already an employee for the firm and management will control his behavior in that he is to respond to emergency calls during a set period of time of day, Joe should be classified as an employee.

But what if management hires HVAC On Demand LLC, a local firm that specializes in providing relief services to its local HVAC contactors? HVAC has many qualified and licensed plumbers who work second and third shift. Some legal experts suggest that to hire HVAC On Demand for its subcontract overflow work, the hiring firm should either stipulate that HVAC On Demand becomes incorporated or signs an attorney-drafted contract clearly outlining the relationship and payment terms. This does seem cumbersome, but when a business directly pays an individual for work performed, "it's easy for the lines between independent contractor and employee to blur" (Lusky.) Only by working with an incorporated subcontractor (because the employees of that subcontractor are compensated through payroll) or a subcontractor with whom the hiring firm has an executed contract, can the hiring firm be distanced enough from the worker it hires.

In fact, one of the "red flags" with this controversy is the behavioral control the hiring firm has over the worker. It is common knowledge that firms must not dictate how and when an independent contractor performs his work for the hiring firm. In addition, it cannot specify who performs that work and where that work is done. Those decisions lie within the judgment of the independent contractor.

For many years now the number of workers classified as independent contractors has been rising. Some question if this trend is legitimate or if companies are just classifying workers in this way to dodge taxes. Federal law requires that federal and state income, and social security and Medicare taxes be withheld from employees but not from payments to independent contractors. In addition, overtime pay and unemployment taxes must be paid for employees, not contractors. Also, regular employee benefits, including workers' compensation, as well as work-site protections must be extended to employees but not to independent contractors.

According to federal statistics, the number of independent contractors rose 20% between 2000 and 2007 (Erlich.) Billions of dollars of federal and state revenue have been lost as part of the nation's tax gap that is attributed to misclassification. In a report to Congress in May 2007, the IRS alone estimated $2.7 billion lost in social security tax, unemployment tax, and income tax (Kisch.)

With federal and state budgets unbalanced and thus severely strained, our government officials are looking to close this tax gap. Massachusetts Governor Deval Patrick and Attorney General Martha Coakley have been widely reported as supporting a crack-down on employers as a means to generate new revenue.

Misclassification comes with stiff penalties. Last year FedEx Ground was ordered to pay $319 million as a result of misclassifying their drivers as contractors rather than employees. And that penalty only pertains to the audited 2002 tax year. FedEx isn't finished with their auditors yet. Their 2003-2006 books are due to be audited as well.

Corporate giants Microsoft, IBM, and Coca-Cola were also found to have misclassified workers and were ordered to pay millions of dollars in past taxes and past benefits, penalties and interest for thousands of individuals who were incorrectly designated as employees instead of contractors.

Legal experts warn that small and medium-sized businesses are not immune because of their size. They are just as vulnerable to the government's scrutiny for misclassified workers as these larger companies.

Also, certain industries, such as construction, seem to be under the radar more than others. Perhaps it's because "a 27-year old Ecuadoran carpenter fell to his death" while working at a 45-unit residential project in Woburn, Massachusetts (Erlich.) It was later revealed that the worker was paid in cash and the firm he worked for, a large national development firm, "had been cited by OSHA for failure to meet fall protection standards" three months earlier (Erlich.) The ensuing hearings revealed that this company was one of many that have moved employees off their books to status of independent contractor - all in order to avoiding paying taxes, insurance and benefits.

The IRS is purposefully vague when it comes to classification because no two workers are the same. Thus, classification is not a black and white issue. "The general rule is that an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result" (Internal Revenue Service.)

The Internal Revenue Service has published Form 15-A (http://www.irs.gov/pub/irs-pdf/p15a.pdf) that outlines conditions under which workers are employees or contractors. These Common-Law Rules lay out test factors to determine the type and degree of behavioral and financial control the employer exercises over the workers. Pages four through nine contain relevant information as well as industry examples.

IRS Form SS-8 (http://www.irs.gov/pub/irs-pdf/fss8.pdf) also can be submitted to the IRS by either a firm or a worker to request a determination of the status of a worker. There are five parts to the form: general information, behavioral control, financial control, relationship of the worker and firm, and a section for service providers or salespersons. The form is sent to the IRS, and the case is assigned to a technician who will review the facts, apply the law, and render a decision.

If the worker is deemed an independent contractor

Many legal and accounting professionals recommend either that the hiring firm:

• executes a contract between the hiring company and the worker, drafted by the hiring company's legal counsel, outlining the worker's specific responsibilities and payment terms

Or

• stipulates that the independent contractor forms a corporation as a condition of working together. In this way, the "hiring entity pays the corporation (not an individual) and the corporation, in turn, pays the individual worker. Payment of taxes then becomes the responsibility of the independent contractor corporation" (Lusky.)

In addition, the hiring firm needs to:

• obtain a signed Form W-9 from worker to determine worker's legal entity name and status
• issue a Form 1099-Misc by January 31 to worker for previous calendar year, if worker's company is unincorporated
• issue a Form 1096 by February 28 to Internal Revenue Service for previous calendar year

If the worker is deemed an employee

Implement normal hiring procedures, such as:

• having the employee complete an employee application and undergo normal pre-employment screening
• verifying I-9 status
• obtaining a signed Form W-4 from worker
• issuing a Form W-2 by January 31 to worker for previous calendar year
• issuing a Form W-3 by February 28 to the Social Security Administration for previous calendar year

Conclusion

The subject of worker classification is complex and carries severe penalties if firms are audited and are discovered to have misclassified their workers, either intentionally or unintentionally. The burden of proof always lies with the hiring firm. For these reasons, it is best to consult with your firm's legal counsel and accounting professionals to help guide you through this worker classification quagmire.

Andrews, Edmund L. "Democrats Seek Unpaid Taxes, Inviting Clash." New York Times 5 Feb. 2007, Late Edition - Final ed., sec. A: 1. NewsBank Public Library Collection. NewsBank. Chelmsford, Massachusetts. 27 Dec. 2008
http://query.nytimes.com/gst/fullpage.html?res=9B0CE4DE133FF936A35751C0A9619C8B63.

de la Housaye, Angela. "Knowing the law when hiring independent contractors is a must." San Francisco Business Times 29 Sept. 2006. 27 Dec. 2008
http://boston.bizjournals.com/eastbay/stories/2006/10/02/focus2.html?t=printable.

Erlich, Mark. "Selling out workers' safety." Boston Globe July-Aug. 2007, Opinion sec.: A.9. Accounting and Tax. ProQuest. Chelmsford, Massachusetts. 27 Dec. 2008
http://www.boston.com/news/globe/editorial_opinion/oped/articles/2007/07/07/selling_out_workers_safety/.

Johnson, Clint. "Walking a contractor-employee tightrope." Triangle Business Journal 2 June 2006. 27 Dec. 2008
http://boston.bizjournals.com/triangle/stories/2006/05/29/focus19.html.

Johnston, David Cay. "Tax Withholding Proposed for Independent Contractors." New York Times 15 Jan. 2004, Late Edition - Final ed.: 7. NewsBank Public Library Collection. NewsBank. Chelmsford, Massachusetts. 27 Dec. 2008
http://query.nytimes.com/gst/fullpage.html?res=9D01E2DD1130F936A25752C0A9629C8B63&partner=rssnyt&emc=rss .

Kisch, Victor. "Reduce risk, don't misclassify employees." Portland Business Journal 28 Mar. 2008. 27 Dec. 2008
http://boston.bizjournals.com/portland/stories/2008/03/31/editorial2.html.

Litterio, Christopher P. "Employee or consultant? The wrong answer could cost you real money." Mass High Tech: The Journal of New England Technology (Nov. 2005). www.masshightech.com. 27 Dec. 2008
http://www.masshightech.com/stories/2005/11/07/focus2-Employee-or-consultant-The-wrong-answer-could-cost-you-real-money.html.

Lusky, Heather & Mark. "Is the independent contractor really an employee?" Denver Business Journal 3 Feb. 2006. 27 Dec. 2008
http://boston.bizjournals.com/denver/stories/2006/02/06/smallb3.html.

Reuters. "FedEx Ordered to Pay $319 Million." New York Times 23 Dec. 2007, Late Edition - Final ed., sec. A: 33. NewsBank Public Library Collection. NewsBank. Chelmsford, Massachusetts. 27 Dec. 2008
http://www.nytimes.com/2007/12/23/us/23fedex.html.

United States. Internal Revenue Service. Form SS-8: Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. www.irs.gov. Nov. 2006. 3 Jan. 2009
http://www.irs.gov/pub/irs-pdf/fss8.pdf.

United States. Internal Revenue Service. Publication 15-A: Employers Supplemental Tax Guide. www.irs.gov. 2008. 3 Jan. 2009
http://www.irs.gov/pub/irs-pdf/p15a.pdf.

Varelas, Elaine. "Revisions in law may have altered contractor's status." Boston Globe 21 Oct. 2007, BostonWorks sec.: G. 10. Accounting and Tax. ProQuest. Chelmsford, Massachusetts. 27 Dec. 2008
http://www.boston.com/jobs/news/articles/2007/10/21/revisions_in_law_may_have_altered_contractors_status/ .