False economy: Don't misclassify employees as independent contractors

Misclassifying a computer professional can lead to severe IRS legal penalties and fees

The computer industry creates many opportunities for independent contractor relationships. Computer professionals can often work independently with limited or no employer guidance (and may prefer to do so), and they have the technological resources and acumen to successfully work remotely, so there is no need to show up at the office. They are also uniquely situated to simultaneously provide computer-related services to multiple businesses. That is the good news.

The bad news is that misclassifying a computer professional as an independent contractor, as opposed to an employee, can lead to severe IRS legal penalties and fees (fines, penalties, payment of back taxes, etc.). This is true even if the classification was based simply on a lack of understanding of applicable laws and regulations -- and it certainly is true that properly classifying a worker as an independent contractor is nuanced, involving fact-specific inquiries. But take care: Federal and state government agencies are aggressively on the lookout for such misclassifications.

The IRS has reported that the federal government loses billions of tax dollars from misclassifications. The government has set a goal to recoup up to $7 billion in unpaid employment taxes over the next 10 years. It is no wonder, therefore, that state and federal governments are cracking down on misclassifications. The following are just a few examples of this heightened focus: the IRS plans to audit 6,000 employers over a three-year period; President Obama's fiscal year 2011 budget sets aside $25 million for the Department of Labor and the Department of the Treasury to investigate worker misclassifications; and Congress recently introduced the Fair Playing Field Act of 2010 to close a safe-harbor loophole related to independent contractor classification issues.

Classifying workers as independent contractors might be tempting to employers that see the opportunity for substantial savings, but the potential penalties for misclassifying a worker as an independent contractor can be significant enough to overshadow those savings.

To properly classify workers, various legal standards apply, but the key factor is the right to control the worker, which exhibits itself in various ways. An employer generally has the right to control both what an employee will do and how it will be done, whereas an independent contractor has some level of control over these issues. However, no single factor usually proves or disproves a proper independent contractor classification. Companies must evaluate federal and state laws to properly classify a worker as an independent contractor, and legal guidance is strongly recommended. To provide some understanding of the issues involved, we offer this basic primer on independent contractor classification.

As an employer contemplating classifying a worker as an independent contractor, you might ask yourself the following questions:

How long do I anticipate requiring the services of this worker?

Independent contractors are usually hired to perform a discrete project during a set period of time with a starting and ending date. A Web site designer, for example, could be hired to complete one discrete project, i.e., to design a company's Web site. Unlike most employment relationships, independent contractors are not typically hired to continuously perform services for an indefinite period of time.

Who determines what equipment and programs will be used?

Independent contractors have significant freedom or control to determine what materials and equipment are used during the project, and the methods and techniques to achieve the final work product. To illustrate, a Web site designer is not typically instructed on which programs to use or how to create the desired end product. Conversely, in many employment relationships, employees are required to adhere to company policies, protocols, procedures, methods or manuals as to how to achieve the final work product.

Who supplies the materials?

Independent contractors usually supply their own materials, pay for many, if not, all of their own expenses, and are not typically trained by the company. A Web site designer, for example, supplies the computer and programs needed to complete the project and pays for his Internet access. Employees, on the other hand, are usually provided company materials or equipment to complete their job.

Is the worker free to work for others while working for me?

Independent contractors have freedom to work for other customers or employers during and after the project. Alternatively, employees usually work for one employer and may have restrictions on their employment opportunities with other companies during and after the employment relationship.

Is there a written independent contractor agreement in place?

Independent contractors usually have a formal agreement in place describing the independent contractor relationship, setting a price or fee for the final product, and the terms of the project. Beware, however, as a contract stating that a worker is an independent contractor will not, alone, establish independent contractor status. Alternatively, employees oftentimes are employed at-will and are governed by company policies and procedures setting forth the terms and conditions of employment.

Real-world litigation examples help to demonstrate the application of the above tests and how misclassification disputes easily occur. For example, in the case of Schwartz v. Blue Cross, a computer programmer sufficiently alleged "common-law employee" status, even though he was characterized as an independent contractor, when the programmer alleged that the company had the right to and did control the manner and means by which he performed his work. He was able to show that the company controlled his hours, assignments, training and professional development; provided him with the tools and instruments necessary to do his job; evaluated his performance; and ultimately terminated his employment. In Colvin v. CIR, a computer hardware salesman was determined to be an employee rather than an independent contractor, even though the computer hardware salesman provided his own vehicles and maintained a home office. In this case, the company had the right to control the salesman's performance, the risk of loss on commission-based pay system was negligible, the company had the right to terminate his employment and did so, the employment agreement referred to "employee" and "employer," the salesman did not check the W-2 box indicating that he was a statutory employee, and the salesman was eligible for the company's health insurance plan and 401(k) plan.

In short, it is highly recommended that your company's policies, practices and agreements regarding classifications are reviewed for legal compliance. And as stated above, with the increased focus on this issue, the overseeing federal and state agencies will more likely find misclassification mistakes and impose stiff penalties for doing so.

Scott Callen and Jennifer Neumann are attorneys with Foley & Lardner LLP and members of the firm's Labor & Employment Practice. They can be reached at scallen@foley.com and jneumann@foley.com, respectively.

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Copyright © 2010 IDG Communications, Inc.

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