The Proper Use of Independent Contractors

April 2009
By Nancy E. Joerg, Esq.

Look before you leap! In this poor economy, there are a lot of reductions in force. Companies may find they need people with certain skills, but they are understandably afraid of expanding their workforce with regular employees. A smart solution is to supplement the workforce with independent contractors, but companies are reluctant to use independent contractors because they feel it may be high-risk.

Now that President Obama is in office, we can expect to see some additional legal enforcement action regarding the use of independent contractors. The Independent Contractor Proper Classification Act was proposed in 2007 but not yet passed. It was supported by Obama in 2007 when he was a Senator. During his presidential campaign, Obama said he favored this legislation which indirectly limits and discourages the use of independent contractors. The Bill has not been resubmitted to Congress for consideration in 2009, although it may very well be introduced later in the year.

The good news is that you can dramatically limit your risk in using independent contractors if you have documentation to prove the workers are really independent contractors in the event of a legal challenge.

The underlying truth of independent contractor status is that all independent contractors must be, by definition, self-employed. The world of independent contractor status is "black-and-white." If an individual is self-employed, he/she is an independent contractor. If an individual is not self-employed, then that individual is an employee of someone else. This simple principle helps clients to understand the (sometimes intimidating) world of independent contractor status.

What are some indications that an individual is self-employed? Self-employment is often shown by the individual having a business name, business reputation, advertising, his/her own place of business, his/her own client base, paying his/her own expenses, filing taxes under his/her own business name, etc.

Below are ideas on how to have a generally strong independent contractor:

1. INCORPORATION: If the independent contractor is incorporated, this is a terrific fact for independent contractor status. If you are fortunate enough to have an incorporated independent contractor, then, of course, you should be issuing all checks to the corporate name. Try to only use independent contractors who are incorporated in good standing. Incorporation will not make your company bulletproof, but it is certainly a very strong fact for independent contractor status.
Check the Secretary of State's website on a yearly basis to verify that each corporation is in "good standing." In Illinois, for example, the website is www.cyberdriveillinois.com. In Minnesota, the website is www.sos.state.mn.us. Print out the proof of good standing and put it in the independent contractor's file.

2. BUSINESS NAME: If the independent contractor is not incorporated, and not willing to become incorporated, then you want to make sure that the independent contractor has a business name as a sole proprietor - and uses that business name as well. You should be making out checks to their business name and having them endorse those checks with their business name.

3. BUSINESS CARDS: The independent contractor should have a business card in his/her own business name showing that they are independent and holding themselves out to the public. The independent contractor should, of course, pay for the business cards.

4. INVOICES: The independent contractor should invoice you project by project on an invoice form that the independent contractor designed, obtained, and paid for themselves with the independent contractor's business name at the top of their invoice. Auditors are very impressed when independent contractors invoice companies (this is something that employees never do - so invoices are a nice way to highlight that this is not an employment relationship and not intended to be an employment relationship).

5. ADVERTISEMENTS: Have the independent contractor place an ad in a newspaper under the independent contractor's business name, advertising the services that he/she does. Don't place the ad for the independent contractor; the independent contractor should place his/her own ad. Be sure that you get a copy of the ad and put it into a file for the independent contractor. The ad can be in a small-town newspaper; it doesn't need to be an expensive ad. (When you clip out the ad, also clip out the date and name of the publication.)

6. BUSINESS EXPENSES: The independent contractor should ideally pay for every aspect of his/her business overhead. You should not be paying for any of the independent contractor's transportation costs, equipment, pagers, beepers, telephone bills, business cards, letterhead, etc.

7. INDEPENDENT CONTRACTOR FILES: Set up independent contractor files for each and every independent contractor. In those files, have such things as business cards, ads, invoices, etc. You must have well-documented independent contractor files which will help to show an auditor that the independent contractors are set up as independent businesses, separate and apart from your company. These files should prove that the independent contractors have their own business reputation, and, if you would close your doors tomorrow, the independent contractors could continue to function as self-employed entities.

8. WELL-DRAFTED INDEPENDENT CONTRACTOR AGREE­MENT: The independent contractor agreement should be tailored and unique to the specific relationship it depicts. Be sure that the independent contractor signs the independent contractor agreement with his/her business name and business title (such as Owner or President).

9. USE INDEPENDENT CONTRACTOR TERMINOLOGY: If you have anyone who works directly with the independent contractors, don't call that individual a "Manager" or a "Director" as those are words of supervision which indicate control and direction. You should instead use a word like "Coordinator." Check your website, applications, and all printed material to make sure you are not inadvertently referring to your independent contractors as employees in any way!
As companies increase their use of independent contractors, they need to have well thought out procedures in place to limit their liability in the use of independent contractors. Companies have tight controls in place that regulate the hiring of employees. However, companies often have no corresponding tight controls for contracting with independent contractors. This can lead to disaster when the auditor comes knocking on the door.

CONTACT NANCY JOERG FOR A SELF AUDIT OF YOUR INDEPENDENT CONTRACTOR RELATIONSHIPS: I have been working with many companies to write and evaluate their independent contractor agreements, independent contractor files, websites, manuals, etc. Consultation on the proper legal use of independent contractors is essential. A yearly review of all independent contractor documents and operations is a prudent practice.

For example, certain industries have exemptions and if the company does follow the law with regard to the exemption, the worker will be reclassified to employee status (when the worker could have been an independent contractor if the requirements of the exemption had been followed). Certain categories of independent contractors require, by law, certain information in the independent contractor agreement (direct sellers, truck drivers, etc.) in order to comply with the exemption.
Companies using misclassified workers may be hit with hefty tax assessments, penalties and fines. Therefore, companies must become very knowledgeable about the proper use of independent contractors.

Companies often mistakenly think that if the worker signs an independent contractor agreement then the worker is an independent contractor. This is entirely false. The worker must satisfy the legal criteria for independent contractor status. If the legal criteria is not met, then a government agency (the IRS, state department of unemployment insurance, etc.), or even the worker, may seek to impose legal liability on the company (despite the written agreement stating that the worker is an independent contractor).

Another issue to consider in an evaluation of independent contractor status is IRS Safe Haven protection. Congress passed Section 530 of the Internal Revenue Act of 1978 in order to give relief to those businesses that, in good faith, used independent contractors (because of a reasonable basis). This law is liberally construed in favor of the taxpayer, so it pays to be both aggressive and creative under this law.

It has been my experience over the years that when a company has even a small amount of experienced consultation on the independent contractor issue, they are able to dramatically reduce their liability in their use of independent contractors. There are many "practical steps" that a company can take to lower its risk in using independent contractors.

If readers would like assistance with evaluating and strengthening a potential independent contractor relationship, please contact Senior Attorney and Shareholder Nancy E. Joerg at 630-377-1554 or via email at najoerg@wesselssherman.com.

Should Your Company Take Advantage of the IRS Voluntary Worker Classification Settlement Program? Look Before You Leap!

October 2011

By: Nancy E. Joerg, Esq. 

On September 21, 2011, the Internal Revenue Service (IRS) kicked off its brand new Voluntary Worker Classification Settlement Program (VCSP). Under this revolutionary program, eligible employers can obtain substantial relief from federal payroll taxes they may have owed for the past if they voluntarily reclassify their workers who currently receive 1099s.

The IRS states that this new program will allow employers "the opportunity to get into compliance" by making a minimal payment covering past payroll tax obligations, rather than waiting for a possible future IRS audit.

ELIGIBILITY REQUIREMENTS:

 

To be eligible for the VCSP, an applicant company must:

• Consistently have treated the workers (i.e., independent contractors) in the past as nonemployees
• Have filed all required Forms 1099 for the workers (i.e., independent contractors) for the previous three years
• Not currently be under audit by the IRS
• Not currently be under audit by the Department of Labor or a state agency concerning the classification of these workers (i.e., independent contractors)

Also, a taxpayer company who was previously audited by the IRS (or the Department of Labor) concerning the classification of the workers will only be eligible for the VCSP if the taxpayer has complied with the results of that audit.

WHAT THE TAXPAYER COMPANY RECEIVES: A taxpayer company who participates in the VCSP will agree to prospectively treat the class of workers as employees for future tax periods. In exchange, the taxpayer company will pay 10% of the employment tax liability that may have been due on compensation paid to the misclassified independent contractors for the most recent year and will not be liable for any interest or penalties on the liability (and will not be subject to an employment tax audit with respect to the worker classification of the workers for prior years). 

CATEGORIES OF WORKERS: Some companies use many different categories of independent contractors. For example, a construction company may have categories of independent contractors including: drywallers, carpenters, painters, cement workers, door and window installers, etc. Companies may wonder whether they can enter into the VCSP for just one category of worker-the door and window installers, for example. The answer is yes. As a matter of fact, a company must agree when they enter into the Closing Agreement with the IRS under the VCSP that they will make all independent contractors in a certain category employees, such as all door and window installers, but the company does not have to agree to reclassify all different categories of independent contractors to employees under the VCSP. 

POTENTIAL PITFALLS: If a taxpayer company voluntarily reclassifies its independent contractors as employees, the company will likely be required to undergo costly changes such as adding workers compensation coverage, withholding income tax payments and taking Medicare and Social Security deductions from wages. Also, the company must agree to extend the statute of limitations period on assessment of employment taxes by the IRS for three years - for the first, second, and third calendar years beginning after the date on which the taxpayer company has agreed under the VCSP Closing Agreement to begin treating the workers as employees. 

Other unresolved issues may be liability concerning past overtime and other wage and hour violations, past employee benefits, etc. A lot to consider!

One big problem that I see is that once a company reclassifies its independent contractors to employee status, the possibility of using a Section 530/Safe Haven/Safe Harbor defense in the future will be lost forever as to that category of independent contractor. The VCSP would essentially require employers to forgo protections offered under Section 530. Employers with strong positions under Section 530 should be aware of what they are giving up!

You may wonder why a company would need to use a Section 530 defense in the future if they are no longer using independent contractors. The simple answer is that the company may decide in the future that it wants to go back to an independent contractor model after having tried the employee model for several years. If the company decides to go back to an independent contractor model, the company would no longer have the opportunity to use a Section 530 defense (because now they do not have consistent use of independent contractors which is a strict requirement of the Section 530/Safe Haven/Safe Harbor defense).

FORM 8952 - APPLICATION FOR VOLUNTARY CLASSIFICATION SETTLEMENT PROGRAM: There is an application online for acceptance into this VCSP program and interested companies might do well to review the two page application. It is interesting to read and see what a company must agree to and what information a company must give under penalty of perjury. 

Of course, just filling out an application to be accepted into the VCSP does not guarantee that a taxpayer company will be found eligible to enter the VCSP. One of the unanswered questions is - If a company is found to be ineligible for VCSP, could the information they have placed on the application be used by the IRS for audit leads? We know, for example, that when companies send in the IRS Form SS-8 to the IRS for an opinion on whether the worker is an independent contractor or an employee, the IRS occasionally uses the submitted IRS Form SS-8 form as a lead for an IRS audit of that company. Dirty pool?

The bottom line is that any company considering applying for the VCSP should think it over very carefully with an attorney who is exceptionally well versed in the independent contractor issue. This is not a step to be taken in a light hearted fashion. Currently the VCSP has no deadline or expiration date.

Questions or concerns? Call Attorney Nancy E. Joerg of Wessels Sherman's St. Charles, Illinois office: 630-377-1554 or email her at najoerg@wesselssherman.com.

IRS Targets Companies Using Independent Contractors

February 2010
By: Nancy E. Joerg, Esq.

For several decades, the independent contractor issue has been a cloud of anxiety hanging over the heads of the companies who use them. These companies worry - often with good reason - that they will be audited by the IRS and other government agencies.

Now, recent threatening announcements made by the IRS have created shockwaves across the United States. Per its own announcements to the public, the IRS is going on the warpath against companies using independent contractors (workers who are not classified as employees), unleashing 6,000 random audits starting in February 2010!

The IRS has stated that these audits will focus on five primary employment tax issues: worker classification (independent contractor versus employee), fringe benefits, reimbursed expenses, officer compensation and non-filers.

The IRS has announced that the audits in 2010 will likely focus on employment tax returns for the calendar years 2007 and 2008. (Of course, the IRS can expand the scope of the audit either backwards or forwards into other open employment tax years and into other tax issues).

In an intimidating observation, the IRS has remarked that there is very little that companies can do to avoid being targeted under this aggressive new audit initiative because the companies will be selected at random.

In an interview on September 18, 2009, IRS Chief of Employment Tax Operations John Tuzynski stated that the IRS will spend three years on the audits randomly selecting large and small companies across many different industries. (This announced audit initiative marks the first comprehensive examination of employment tax issues by the IRS since 1984.)

According to a report by the Government Accountability Office released in August 2009, only 3% of determinations submitted to the IRS showed workers to be true independent contractors. The IRS assessed over $64 million in taxes and penalties for worker misclassification in 2008. Improper classification, as viewed by the government, cheats the government out of employment tax revenue and the worker out of labor protection. The IRS point of view is that workers who are improperly classified as independent contractors can be unfairly denied health benefits, overtime pay and unemployment insurance granted to employees.

The IRS concludes there are numerous cases of misclassification that could result in increased money for the government and more benefits for workers, all of which will ultimately cost employers more money in the form of higher tax liabilities, reporting requirements and increased benefit expenses.

The announced IRS crackdown on independent contractor use is frightening to employers. The IRS has indicated these audits will be conducted by approximately 200 to 300 of its most experienced agents who will undergo further specialized training for their role in this employment tax audit initiative. These audits will very likely involve a line-by-line review of the company's employment tax returns. Businesses should review their compliance before these exams begin. Those with potential issues and concerns regarding the strength of their independent contractor relationships can beef things up in advance of these audits.

All companies who use independent contractors should take steps to:

1. Evaluate all independent contractor agreements with an experienced attorney.
2. Review your websites to make sure that, in your enthusiasm to advertise your services to prospective customers, you are not undermining your independent contractor relationship.
3. Collect key pieces of proof to show that the independent contractor is self employed.
4. Understand IRS Section 530 safe haven protection. (Section 530 is liberally construed in favor of the taxpayer, so it pays to be both aggressive and creative under this law.)
5. Know the IRS "tests" for your type of independent contractors. Not every type of independent contractor is treated the same.

 If your company is selected for an IRS audit, do not talk to an IRS agent or auditor without careful legal guidance. Just a few careless words can wreck the company's legal position as to independent contractor classification (especially for Section 530 safe haven defense). Establish a precise chain of command for responding to audit requests and other IRS communications. Control the IRS audit process by requesting additional time to respond to IRS requests for information, and narrow the scope of information requested where possible.

Now is the time to do a thorough "self audit"! Contact Nancy E. Joerg to set one up.

Questions? Please contact WS Shareholder and Senior Attorney Nancy E. Joerg at 630-377-1554 or najoerg@wesselssherman.com.

IRS Plans Increased Independent Contractor Crackdown!

March 2010
By: Nancy E. Joerg, Esq.

Frightening times are ahead for companies who use independent contractors.
 
If the Obama budget for 2011 passes, the Internal Revenue Service (IRS) will add 100 new enforcement personnel as part of a $25 million plan to crack down on the misclassification of workers as independent contractors. Obama officials hope stronger misclassification enforcement will add $7 billion to the federal government over the next decade.

Obama's very tough enforcement program comes from an executive order to reduce improper payments to independent contractors by "intensifying efforts to eliminate payment error, waste, fraud and abuse in the major programs administered by the Federal Government."

The IRS also recently kicked off a widely publicized three-year audit of 6,000 companies (2,000 per year). Unlike normal employment tax audits, the 6,000 audits are being chosen by pure statistical sampling. And if your company isn't chosen by the IRS this round, it may be chosen in the next!

Estimates are that companies can hold down labor costs by as much as 30% if they use independent contractors because they don't have to pay Social Security and Medicare taxes, provide vacation or sick leave, pay for workers' compensation and unemployment, or worry about minimum wage or overtime provisions.

On top of the IRS crackdown, many states around the United States are cracking down on independent contractor status. In Illinois, for example, new misclassification legislation (called the Illinois Employee Classification Act) and stricter enforcement of this new law resulted in a $328,500 assessment by the Illinois Department of Labor in December 2009 against a Chicago area housing contractor. The housing contractor allegedly failed to keep proper records under the Illinois Employee Classification Act and allegedly misclassified workers as independent contractors instead of employees under the Illinois Employee Classification Act. This case will be appealed, but even if the company eventually "wins," the legal defense costs will be significant.

It is clear that increased IRS and state focus on these independent contractor issues will also lead to more private civil lawsuits, as the damages available in such independent contractor misclassification cases make them attractive to plaintiffs' attorneys (for example, class action overtime lawsuits based on independent contractor misclassification is a fast growing legal concern for companies who use independent contractors).
 
Please contact Wessels Sherman Senior Attorney and Shareholder Nancy Joerg at 630-377-1554, or najoerg@wesselssherman.com, to work on lowering your risk in using independent contractors. At a minimum, have your independent contractor agreements reviewed and possibly redrafted. Go over the manner in which you relate to your independent contractors. There are many effective ways to reduce your risk in using independent contractors.


Questions? Please contact WS Shareholder and Senior Attorney Nancy E. Joerg at 630-377-1554 or najoerg@wesselssherman.com.

Independent Contractor or Employee Status? New IRS Audits Turn Up Heat on Misclassification

June 2011
By: Nancy E. Joerg, Esq.

Background of increased IRS auditing: In February 2010, the IRS began intensive audits of 6,000 randomly selected companies. One of the key areas of focus was and is worker classification - determining whether businesses are misclassifying workers as independent contractors to save on taxes and legal risks.

The IRS has pumped up its auditing efforts because it believes that the very challenging economy has encouraged more businesses to misclassify members of their workforce as independent contractors.
Narrowing the tax gap is the key motivation behind IRS proposals to crack down on misclassification of employees as independent contractors. Businesses must withhold income taxes, withhold and pay social security and Medicare and pay unemployment taxes on wages paid to employees, not to independent contractors. Employees are more likely to withhold and submit taxes than independent contractors (who are more likely to avoid tax responsibilities).

Why would employers want to classify their workers as independent contractors? Companies, especially small ones, increasingly use independent contractors because they provide greater flexibility with the size of the workforce and are usually cheaper - as much as 30% can be saved by avoiding payroll taxes, unemployment insurance, worker's compensation coverage, and benefits normally provided to regular employees.

In tough economic times, using independent contractors makes economic sense because it is usually easier to terminate them per the contract if the company needs fewer workers.

Consequences of misclassified independent contractors: The issue of proper classification of workers as employees or independent contractors can have severe financial consequences to the business that misclassifies its workers. Not only is the company subject to retroactive tax withholding, but also penalties and interest if the classification is incorrect. In many cases, the liability springing from an employment tax audit could end the life of the business.

Employment taxes are "trust fund taxes": This means that officers and owners of the company have personal liability for these taxes and cannot discharge them in bankruptcy if the business cannot pay. Thus, the IRS takes no prisoners. If employment taxes are misappropriated in any way and there is a misclassification, the owner is generally personally liable.

How do you properly classify a worker as an independent contractor? The IRS uses a 20-factor test to determine whether a worker is an independent contractor or an employee. Basically, the more control a company has over a worker, the greater the likelihood that the worker would be classified by the IRS as an employee.

The 20-factor test is not an objective test. Surprisingly, there is no special number of factors that a taxpayer company must pass in order to prove independent contractor status. Rather, the company must simply "do as well as it can" under the 20 factors (and then hope that the IRS agent is convinced that the workers at issue are independent contractors and not employees). Some factors are more important than others, depending upon the industry and the type of independent contractor at issue.

Section 530 relief in an IRS audit: For businesses that have historically classified workers as independent contractors, a special provision (Section 530 of the Revenue Act of 1978) provides a "safe harbor" exception from the usual 20-factor test. Under this safe harbor, the IRS may not reclassify workers as employees - even prospectively or for newly hired workers.

In certain circumstances, Section 530 can relieve businesses of employment tax liabilities resulting from worker misclassification, but the business must meet specific requirements under the law.
Section 530 has three requirements, all of which must be passed, in order to receive relief: 

1. The company must consistently use the kind of workers at issue as independent contractors (this means, for example, that the company has used the workers as independent contractors, and not as employees, through the years), AND
2. The company has faithfully issued IRS Forms 1099 where required, AND
3. The company has a reasonable basis for having classified the workers as independent contractors in the first place. (Note: There are many ways to prove this.)

 Steps businesses should take to avoid worker classification problems: With increased audit scrutiny from both the state and federal levels, employers should audit their independent contractor relationships to ensure that they will withstand inspection by the IRS. This is an area in which a little prevention can go a long way:

• Review all independent contractor agreements to strengthen independent contractor status;
• Follow the IRS "common law" 20-factor test carefully;
• Obtain a Form W-9 from the independent contractor, pay by check to the independent contractor's business name, and issue a Form 1099-MISC to the independent contractor's business name;
• Fill out an IRS SS-8 Form for each classification of worker to do a self evaluation of independent contractor status;
• If an individual is really an employee, do not try to classify the person as an independent contractor;
• Ensure and preserve Section 530 relief and eligibility;
• Watch for an IRS SS-8 Form request, payroll audit questions, or other signs of any IRS worker classification audit;
• Do not "flip flop" and change the independent contractor status in an inconsistent fashion. Maintain consistent treatment of independent contractor status to the greatest extent possible.

In the event of an audit: If your company is selected for audit, do the following: 1) pick a clear "chain of command" for responding to audit notices and other IRS communications; 2) immediately consult with an attorney who knows independent contractor classification issues including Section 530; 3) request additional time to respond to information document requests.

Please contact Wessels Sherman Senior Attorney and Shareholder Nancy Joerg at 630-377-1554, or najoerg@wesselssherman.com, to work on lowering your risk in using independent contractors.

IDES and IRS Audits: Why Does the Company Need to Prove Independent Contractor Status?

July 2009 
By Nancy E. Joerg, Esq.

When companies are audited by the Illinois Department of Employment Security (IDES) [or any state unemployment insurance agency] or the IRS, companies start out logically assuming that they are "innocent until proven guilty" on the independent contractor issue. WRONG!

The legal requirement for a company using independent contractors is that the company is presumed by the IDES or IRS to be the legal employer of the independent contractors. Therefore, when a company pays the worker to perform services, those workers are presumed to be the employees of the company upon audit. This means that every company that uses independent contractors should be seriously preparing, way before there is an audit or any other legal challenge, to prove that these independent contractors and not employees of the company.

How does a company prove that the independent contractors are not its employees? The "big picture" is to prove that the independent contractors are self-employed.

Effective proof consists of documents showing that the worker holds himself/herself out under his/her own business name, checks from the company made out to the independent contractor's business name with the independent contractor endorsing those checks with his/her business name, IRS Forms 1099 made out to the business name of the independent contractor, etc.

In addition, the IRS and the IDES (or any state unemployment insurance agency) have their own detailed checklist of rules and regulations to prove that the workers are independent contractors. The company must prove that the independent contractors meet the requirements of those rules and regulations.

There are many "practical steps" that a company can take to lower its risk in using independent contractors. Nancy Joerg can cost-effectively review your independent contractor agreement, your website, your independent contractor files, and any other documentation that you use with your independent contractors. Call Nancy at (630) 377-1554, or email najoerg@wesselssherman.com, to schedule a phone conference or a meeting.