INDEPENDENT CONTRACTOR AND 1099 CLASSIFICATION

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BY: SAMER KHOULI, PRESIDENT

White paper provided by TargetCW, Contingent Workforce

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INDEPENDENT CONTRACTOR DEFINED

An Independent Contractor (IC) agrees to do work or perform a service for another, retaining total and free control over the means or methods used in doing the work or performing the service. ICs do not have the same legal status as an employee. Per Internal Revenue Service (IRS) requirements, an employee receives a Form W-2. In the case of an IC, Form 1099-MISC (Miscellaneous Income) is issued. Based on this tax status, ICs have been regularly referred to as 1099s. Independent contractors may call themselves by a variety of names freelancers, consultants, self-employed, entrepreneurs or business owners the vernacular will not make a difference in the eyes of the law.

RISKS
One of the primary risks is misclassification as the consequences can be economically devastating. Not only must the business pay the IRS all back taxes owed with interest, there may be additional penalties adding up to 35%. Audits by state agencies are even more common than IRS audits. State audits frequently occur when workers classified as ICs apply for unemployment compensation once their services are terminated. An investigation by the state unemployment compensation agency will ensue and the company will be subject to fines and penalties if it is determined that the ICs should have been classified as employees. Another major disadvantage of hiring independent contractors is a lawsuit for negligence if injured on the job. This type of legal action is normally prohibited by employees as they are covered by workers' compensation. An unclear or undocumented company policy regarding the role that an IC contributes to the organization is also a potential risk. If the IC believes he/she is not being treated fairly or feels entitled to benefits that the company employees receive, then the IC may pursue legal remedies and/or regulatory agency interference. Having a solid program in place reduces this risk.

If an employee (W-2) and an Independent Contractor (1099) performs the same work, you are looking at a possible misclassification.

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FROM THE DEPARTMENT OF LABOR: IDENTIFYING EMPLOYEE MISCLASSIFICATION (http://www.dol.gov/_sec/stratplan/StrategicPlan.pdf)

Wage and Hour Division (WHD) will be a key partner in a joint Department of TreasuryDepartment of Labor initiative to detect and deter the misclassification of employees as independent contractors and to strengthen and coordinate federal and state efforts to enforce labor law violations arising from misclassification. Individuals wrongly classified as independent contractors are denied access to critical benefits and protections such as family and medical leave, overtime, minimum wage and unemployment insurance to which they may be entitled as regular employees. Employee misclassification also generates substantial losses to the Treasury, Social Security, Medicare, and Unemployment Insurance Trust Funds. In its last comprehensive estimate of the scope of the misclassification problem for tax year 1984, the Internal Revenue Service estimated that 15 percent of all employers misclassified a total of 3.4 million employees as independent contractors. These misclassifications resulted in an estimated annual revenue loss of $1.6 billion in 1984 dollars ($3.4 billion in 2010 dollars). While the precise extent of misclassification is unknown, studies suggest that it may affect 10 to 30 percent of employers. A number of recent studies conducted by worker protection organizations, researchers on behalf of state governments, and DOLs Employment and Training Administration suggest that misclassification while occurring in many industries is more prevalent in several high-risk industries: construction; janitorial; home health care; child care; transportation and warehousing; meat and poultry processing; and other professional and personnel service industries. The construction industry, in particular, is cited in each of the studies as rife with employee misclassification. As indicated above, WHD will raise its directed investigation level and increase its presence in these key industries and will target employers who are identified as having misclassified employees or groups of employees.

FINANCIAL RAMIFICATIONS OF MISCLASSIFICATION

Back taxes can total: 15.30% Social Security Tax (on income up to the cap, plus 2.9% of income above that cap) 20.00% Federal Income Tax +6.20% Unemployment Insurance 41.50% of the ICs pay rate Auditors have the ability to go back three years. Fortunately, for those companies, if the IRS feels they did not intentionally ignore the law, the fines are less substantial (section 3509 of the Internal Revenue Code). Be advised that any relief of tax liability provided by the IRS, such as Section 530 of the Revenue Act of 1978, is of limited applicability in the staffing industry.

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Section 530, also referred to as the "Safe Harbor Act," was amended in 1986 to not relieve engineers, designers, drafters, computer programmers, systems analysts, or other similar skills or lines of work of tax liability.

Misclassification = $$$ penalties $$$ and personal liability

Additional fines can be imposed by the IRS depending on the situation. Following are potential violations and associated fines: VIOLATION Failure to file Form W-2 or 1099-MISC Failure to file quarterly returns Failure to pay taxes Failure to obtain Social Security numbers POTENTIAL FINE Minimum fine is $50 for each form failed to file; the maximum is $250,000 per business or $100,000 for small businesses 25% of the unpaid tax liability 0.5% of the unpaid tax liability for each month up to 25% $50 for each missing Social Security number

There are also significant fines if the IRS believes a company has committed fraud or were negligent, plus fines for many other situations. In addition, any responsible person (including corporate officers and employees or members or employees of a partnership) with authority over the financial affairs of the business who willfully fails to collect and pay taxes may be held personally liable for the total amount of the uncollected tax under the "100 percent" provisions of the Internal Revenue Code. Another point to keep in mind is that ICs who wrongfully benefited as a result of being paid on a 1099 are virtually free from penalties. The IRS may audit them and require them to eliminate any business deductions they took; however, the main focus is on the entity with the deepest pockets, which in most cases is the company. Furthermore, if a company classifies workers to avoid paying overtime wages according to the Fair Labor Standards Act, the company can be subject to penalties, from the payment of unpaid overtime premiums to liquidated damages, fines of $10,000 and six months imprisonment for willful violations. Unpaid overtime premiums alone may represent substantial monetary liability depending upon the size of the work force and the length of time that the company has failed to pay appropriate overtime wages.

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ELIGIBILITY CRITERIA
There is no single, clear-cut test for classification. Different legal tests for determining worker status are used by various government agencies, including: Internal Revenue Service, state unemployment compensation insurance agencies, state workers' compensation insurance agencies, state tax departments, United States Department of Labor, and the National Labor Relations Board.

Each of these agencies is concerned with worker classification for different reasons and has different biases and practices. Each agency normally makes classification decisions on its own and need not consider what other agencies have done, though they are often strongly influenced by it.

Agency Determinations State workers' compensation, unemployment compensation, and tax agencies use various tests to determine worker status. Many use the common law right to control and direct tests based on 20 factors but emphasize different points than the IRS. Some use an economic reality test that focuses on whether a worker is economically dependent upon a hiring firm. Many state unemployment compensation agencies use a special statutory test, also called the ABC test. This test focuses on just a few factors: whether the hiring firm controls the worker on the job, whether the worker is operating an independent business, and the location where the work is to be performed as determined by the client.

IRS Determination Under the IRS test, workers are employees if the people they work for have the right to direct and control them in the way they work both as to the final results and as to the details of when, where and how to work. In contrast, ICs are not controlled by the companies that utilize them. A hiring firm's control is limited to accepting or rejecting the final results an independent contractor achieves.

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The IRS has developed the 20 factor test to measure control under the common law test.

20 factor test includes whether a worker:

1. Can earn a profit or suffer a loss from the activity 2. Is told where to work by the hiring firm 3. Offers his or her services to the general public 4. Can be fired by the hiring firm 5. Furnishes the tools and materials needed to do the work 6. Is paid by the job or by the hour 7. Works for more than one firm at a time 8. Has a continuing relationship with the hiring firm 9. Invests in equipment and facilities 10. Pays his or her own business and traveling expenses

11. Has the right to quit without incurring liability 12. Receives instructions from the hiring firm 13. Is told in what sequence or order to work by the hiring firm 14. Receives training from the hiring firm 15. Performs the services personally 16. Hires and pays assistants 17. Sets his or her own working hours 18. Works full-time for the hiring firm 19. Provides regular oral or written progress reports to the hiring firm 20. Does not provide services that are an integral part of the hiring firm's dayto-day operations

Other considerations include the preference that the IC should invoice based on projects, not hours and appropriate indicia of the IC (business cards, checking account, insurances, business filings). ICs would not typically be included in company meetings, e-mail distribution lists, provided benefits, or other specific employee privileges. Sometimes this mandate to exclude can be difficult to manage in and of itself. This mandate extends to using company equipment, phones, and other resources. From a high-level perspective, IC compliance can be simple and straightforward or rather complex based on the project and the IC. There are no hard fast rules or criteria; you have to subjectively analyze all the data to make a recommendation and the data is not all weighted equally. Sometimes a worker will fall short in one area and fail the test other times a worker will fail in many areas and still qualify.

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Principles The rule of economic autonomy indicates that no one company should contribute to the majority of the ICs compensation. In other words, the IC should have several clients, none of which is a majority contributor to the ICs income. Next is the concept of care, custody, and control. This indicates that the IC should be able to accomplish the work in any way he/she deems necessary without the clients intervention or control. Once the contract is executed with the IC, the IC is free to do whatever it takes to accomplish the project, including incurring expenses, hiring personnel, making schedule modifications as long as it remains within the scope of the contract. You do not chose to utilize an IC to save on taxes, you chose an IC because the needs of the project are best filled by a qualified, compliant IC.

THE BENEFITS

Businesses typically save money by hiring ICs instead of employees. In addition to salaries or other compensation, employers usually must pay employee expenses such as: federal payroll taxes, including Social Security tax, and federal unemployment insurance tax, state unemployment insurance premiums, workers' compensation insurance premiums, employee benefits, such as health insurance, vacation time, sick leave, retirement/profit sharing plans, life/disability insurance, and administrative overhead, office space, and equipment.

The above mentioned expenses account to approximately two or three times an employees hourly rate. Utilizing an IC eliminates these costs. Although an IC usually will charge more than an employee, the savings can still be substantial. In addition, when utilizing an IC instead of an employee, you have reduced exposure to certain types of lawsuits, such as those alleging job discrimination or wrongful termination. Finally, and most important for many firms, ICs provide a level of flexibility that cannot be obtained with employees. You can pay an IC to accomplish only a specific task, allowing your business to get specialized expertise for a short period of time. You need not go through the burden (not to mention potential severance costs and lawsuits) of a lay-off or termination of an employee. Moreover, an experienced IC can be productive immediately, eliminating the time and expense involved in training employees or having to expend energies with the internal onboarding process. In terms of compliance, usually an IC is utilized because they have the skills necessary to complete the contracted project.

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BEST PRACTICES
If your organization is structured in such a way that ICs will be an integral part of your contingent workforce model, then it is recommended that you do one of the following: 1. Hire dedicated personnel 2. Outsource to an experienced Contingent Workforce Provider With so much at stake, it is important to have a solid plan for managing the liability of ICs. Using an employment attorney is one way to reduce the risk and liability, but it does add significant cost and on-boarding time to have legal review, not only the project, but the capabilities of the IC to be compliant. In our experience, it can take weeks before final approval is given, thus negating some of the benefits of using an IC to meet the timely needs of a project. Other models include creating an IC workflow, which is then reviewed by Human Resources, company executives, then finally on to legal for final determination. This does not fully mitigate IC risk since the company is still issuing the 1099 document, which falls back onto the company. Using an outside company for IC management is probably one of the best solutions if the company truly offers an unbiased classification model. The advantages include higher turnaround time, specialization, up-to-date knowledge, consolidated invoicing, document management, contract requirements enforcement, and issuance of the 1099. Most companies will charge a one-time classification fee or a markup so the total cost may exceed the cost of doing it in-house, but the benefit of risk reduction is definitely very attractive. Most companies offer the added benefit of payrolling the IC if he does not qualify, which allows your contingent workforce to run through one organization. One of the most important principles to remember is that the project should dictate the type of worker you hire.

This document is intended to provide a general overview of the subject matter. We advise you to seek legal counsel as you develop internal policies and procedures. Please feel free to contact us directly with any questions; TargetCW (619) 704-7727 or samer@targetcw.com.

HELPFUL GUIDELINES
After considerable review and input from various employment and legal sources, TargetCW has compiled guidelines in determining whether or not the following positions are eligible for Independent Consultant/1099 Status.

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DEVELOPER, PROGRAMMER, OR OTHER SOFTWARE PROFESSIONAL

GENERALLY QUALIFIES AS AN INDEPENDENT CONSULTANT/1099 GENERALLY WOULD NOT QUALIFY AS AN INDEPENDENT CONSULTANT/1099

Works offsite and has other employees working for the company

Works onsite at the client company utilizing company equipment

Works on multiple projects at various companies

Fails the Economic Autonomy test by working at only one company

Niche specific program/design/development that IS NOT a part of the core competency of the company (e.g. defined intranet creation for a gaming company) Client company has no other employees that perform similar work to the contractor Short assignment or a defined position that needs to be filled

Program/design/development for the core product/service of the organization (e.g. database administrator for a software related company) Contractor works alongside employees and/or in conjunction with employee tasks and projects Open-ended or long-term assignment (six months or more) filling multiple positions

The pay is generally invoice or project based; there is possibility of profit or loss on the side of the contractor Licensed or certified in the field with extensive experience and specialization

Paid on an hourly or salary basis with no penalty

More of a generalist in the field although may be highly skilled

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RECRUITER

GENERALLY QUALIFIES AS AN INDEPENDENT CONSULTANT/1099

GENERALLY WOULD NOT QUALIFY AS AN INDEPENDENT CONSULTANT/1099

Works offsite and has other employees working for the company

Works onsite at the client company utilizing company equipment

Has various clients and DOES NOT utilize client-provided resumes/leads

Fails the Economic Autonomy test by working at only one client and sources utilizing clients resumes. General recruiting for various positions

Niche-specific recruiting where no other recruiter at client company sources that type of candidate Client company has no other recruiters or other recruits; DOES NOT recruit for similar or related positions; not filling reoccurring positions Short assignment or a defined position that needs to be filled

General recruiting along with other recruiters at the client company

Open-ended or long-term assignment (six months or more) filling multiple positions

There is loss or gain from filling the positions with the appropriate candidates in a timely manner Represents him/herself as an employee of an agency doing sourcing for said agency (1099s own firm).

Paid on an hourly or salary basis with no penalty

Represents him/herself as a representative/employee of the client company sourcing for said company.

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LEGISLATIVE UPDATE (12/09/2011)

Independent Contractor Classification has been reviewed by legislatures in both federal and state governments. California passed SB 459 which imposes penalties as high as $25,000 per violation. In addition contractors in the construction industry have even more stringent penalties. SB 459, doesnt help clarify or give guidelines to business, but rather imposes higher penalties on those mis-utilizing ICs. There is also information that protects contractors from recourse by those utilizing ICs. The department of Labor is also on the prowl for misclassified workers. They estimate that 30% of ICs are mis-classified and that the IRS is losing billions of dollars because of mis-classified workers. There is a memorandum of understanding that is signed by 11 agency leaders that hopes to reduce the number of misclassified workers and penalize companies that mis-classify ICs. It is more important than ever to have a clear IC program that appropriately classifies your contingent workforce.

Independent Contractor and 1099 Classification White Paper

Samer Khouli 2011