Classification of Workers as Employees or Independent Contractors: Five Things Every HR Generalist should know.*

January 17, 2008

The Manpower Employment Blawg post on $319 Million Fine for FedEx? highlights the enormous downside of misclassifying workers. There are many motivations to classify a worker as an independent contractor rather than an employee including payroll tax savings, benefit plan and insurance savings, increased workforce flexibility and headcount management to name a few. The test for worker classification isn’t crystal clear but there are some common errors. The first two points involve classification mistakes that are entirely avoidable and easily discovered by the IRS:

  1. Same Job but Different Classification.  If your employees are working next to your independent contractors, doing the same or similar jobs, you have a problem with classification. The problem becomes worse when the job being performed is an integral part of your business. I see this problem frequently in some industries such as  transportation, trade services  like telecommunications and HVAC, and construction.
  1. Retire or Fire Employee and then Rehire as Independent Contractor. Sometimes its attractive for both the employee and the employer to allow someone to “retire” and then be hired back as an independent contractor. The employee starts collecting a pension, social security and still has some income from the old job. There are many problems with this situation and it is easily discovered by the IRS since the worker will likely receive both a Form W-2 and Form 1099 from the same company in the same tax year.
  1. Misclassification has Benefits Plan and Insurance Issues.  A worker incorrectly characterized as an independent contractor may have been eligible to participate in your health, retirement and other benefit programs available to employees. In addition, the worker should have been covered under your worker’s compensation policy. Finally, there may be back wages for unpaid overtime, vacation and other benefits. On the other hand, incorrectly treating an independent contractor as an employee (although rare) has the opposite impact. The worker may have been provided medical and retirement benefits to which he or she was not entitled resulting in a violation of the terms of the plan.
  1. State Law Classification Test may Differ from Federal Law. As I have previously commented, state laws may differ from federal laws in classifying workers. Some states, like Pennsylvania, use a test that requires independent contractors to be free from control or direction over the performance of the services involved and be customarily engaged in an independent trade, occupation, profession or business. 
  1. Misclassification Fixes. The IRS provides for tax relief for misclassified workers if the employer can demonstrate a “reasonable basis” for treating a worker as an independent contractor rather than an employee. Reasonable Basis can be demonstrating as follows:
    • Reliance on court decisions or IRS rulings;
    • Prior IRS audit where similar workers were not reclassified
    • Treatment of workers as independent contractors by a significant industry segment;
    • Reliance on professional advice of a lawyer or accountant who knows the facts about your business.

Retirement Plan Blog post on What to do when an independent contractor is really an employee describing the pension plan self-correction procedures with the IRS.

* Not intended to be exhaustive.