Employee vs. Independent Contractor in the era of Tax Reform
There are growing concerns in the construction industry with respect to employers inappropriately classifying employees as independent contractors in order to reduce their costs of doing business and gain an edge in being awarded construction contracts. With the construction industry seeing very low unemployment, some do not believe the wages reported coincide with the industry’s growth; thus suggesting an increase in misclassification as independent contractors. Some commentators believe the recently enacted Tax Cuts and Jobs Act of 2017 (“TCJA”) could lead to even more misclassified employees. How big is the employee misclassification problem today and what is the government currently doing about it? These are the questions addressed in this article.
Generally, an employer/employee relationship exists “when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.” Treas. Reg. Sec. 31.3121(d)-1(c).
When a worker is misclassified as an independent contractor, the costs to society are considerable: the employee loses federal and state employment protections and benefits; the unlawful business whose taxes are illegally lowered is placed at an unfair advantage over the competition, and the government is deprived of substantial tax revenues. In a 2009 report, the Government Accountability Office estimated in one year alone, the federal government lost out on $2.72 billion in Social Security, unemployment and income taxes because of employee misclassification.1
To make matters worse, a new tax deduction in the TCJA could further contribute to employment tax losses. Effective for tax years beginning after December 31, 2017, partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships are generally entitled to a deduction of 20% of the taxpayer’s “qualified business income” under IRC Sec. 199A. Because Section 199A ties the availability of a deduction to some form of business ownership, some employees may seek to be treated as independent contractors or partial owners for tax purposes.
In an effort to prevent the misclassification of workers, the government employs a multi-faceted approach. The IRS detects misclassified workers primarily through the following four sources:
- The Determination of Worker Status (Form SS-8) Program. Under the “Form SS-8” program, employers or workers may request that the IRS determine the status of an individual.
- The Employment Tax Examination Program (ETEP). The ETEP allows the IRS to use specific criteria to identify companies likely to have misclassified employees
- General employment tax examinations. A general examination of an employment return may draw the IRS’s attention to a classification issue.
- The Questionable Employment Tax Practices (QETP) program. Through the QETP the IRS and the States share worker classification-related information.
The majority of the IRS’s employee classification related audits are conducted by the Small Business/Self-Employed Division. In the fiscal year 2016, IRS examined about 54,600 employment tax returns, which covered 0.2 percent of all employment tax returns filed in the calendar year 2015.2 Because such a small percentage of employment returns are examined, IRS must especially ensure that the examinations are as efficient and effective as possible. As reported to the Committee on Finance, U.S. Senate on April 18, 2017, the IRS recently completed a study through its National Research Program to learn how the Service can better utilize its limited worker classification enforcement resources.3
Whether a worker is an employee or an independent contractor is sometimes difficult to discern. Over time the IRS compiled a list of 20 factors from court decisions to determine worker status. These 20 factors, cited in Rev. Rul. 87-41, have been compressed into three general categories the IRS currently considers: (1) behavioral control; (2) financial control; and (3) the relationship of the parties. No one factor should stand alone in making a determination.
If a company has been found to have misclassified workers, it could be required, under IRC Sec. 3509, to pay 100% of the employer’s share of Social Security and Medicare taxes, plus an additional 40% on the same obligations and 3% of wages. Well-intentioned employers that have consistently treated workers as independent contractors may be able to lessen or avoid harsh consequences through the safe harbor of IRC Sec. 530 or the IRS’s Voluntary Classification Settlement Program.
Companies longing to save costs may want to think twice today before employing a strategy that entails misclassifying employees. Certain well-respected construction associations are lobbying politicians for solutions to the problems in order to level the playing field during these very competitive times.
State Approaches to the Problem
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Recognizing the severity of employee misclassification, New Jersey Governor Phil Murphy signed an executive order in May 2018, effective immediately, which establishes a Task Force on Employee Misclassification. The Task Force is charged with a number of responsibilities to combat employee misclassification, including:
- Examining and evaluating existing misclassification enforcement by executive departments and agencies;
- Developing best practices by departments and agencies to increase the coordination of information and efficient enforcement;
- Developing recommendations to foster compliance with the law, including by educating employers, workers, and the public about misclassification; and
- Conducting a review of existing law and applicable procedures related to misclassification.
The Task Force is to consist of at least twelve members, including three representatives from the Department of Labor and Workforce Development; three representatives from the Department of the Treasury; and one representative from each of the Department of Law and Public Safety, the Department of Agriculture, the Department of Banking and Insurance, the Department of Human Services, the Department of Transportation, and the Economic Development Authority.
The precursor to New Jersey’s initiative detailed above, New York Governor Andrew Cuomo instituted a statewide Task Force in 2015 to identify and resolve worker exploitation issues in multiple industries in New York State. A year later, a Joint Task Force was made permanent for the same purpose. To date, the Joint Task Force has launched nearly 16,000 wage theft and misclassification cases impacting nearly 150,000 workers, and recovered nearly $150 million in lost wages, which it returned to 125,000 workers victimized by wage theft.
Additionally, specific to the construction industry, the New York State Construction Industry Fair Play Act (effective October 26, 2010) imposes as standard for determining whether a worker is an employee or independent contractor in the construction industry, and provides penalties for employers who fail to properly classify their employees.
Under the Fair Play Act, individuals working for an employer in the construction industry will be presumed to be employees, unless they meet all three criteria below. The individual must be:
- free from control and direction in performing the job, both under contract and in fact;
- performing services outside of the usual course of business for the company; and
- engaged in an independently established trade, occupation, or business that is similar to the service they perform.
The law also contains a twelve-part test for determining when a sole proprietor, partnership, corporation, or other entity will be considered a “separate business entity” from the contractor for whom it is providing a service. If an entity meets all of the 12 criteria, it will not be considered an employee of the contractor, but will instead be a separate business that is itself subject to the law regarding its own employees.
In addition to other penalties applicable by tax law or employment law, an employer that willfully violates the Fair Play Act by failing to properly classify its employees will be subject to civil penalties of up to a $2,500 fine per misclassified employee for a first violation, and up to $5,000 per misclassified employee for a second violation within a five-year period. Employers may also be subject to criminal prosecution (a misdemeanor) for violations of the Fair Play Act, with a penalty of up to 30 days in jail, up to a $25,000 fine, and debarment from Public Work for up to one year for a first offense. Subsequent misdemeanor offenses would be punishable by up to 60 days in jail, up to a $50,000 fine, and debarment from performing Public Work for up to five years.
In 2016, the Pennsylvania Department of Labor and Industry, Bureau of Labor Law Compliance signed an agreement with the U.S. Department of Labor to coordinate efforts to prevent employee misclassification with respect to independent contractors or other nonemployee statuses. For Pennsylvania businesses, the agreement set the stage for intensified enforcement of worker classification rules.
With respect to individuals performing services in the construction industry, the Pennsylvania Construction Workplace Misclassification Act (“Act 72”), imposes additional criteria that must be met for the individual to be recognized as an independent contractor. Under Act 72, all of the following requirements must be satisfied:
- The individual has a written contract to perform the services;
- The individual is free from control or direction over the performance of the services involved both under the contract of service and in fact; and
- As to such services, the individual is customarily engaged in an independently established trade, occupation, profession or business.
The “written contract” must be specific to the project for which the individual will be performing services.
To show that an individual in the construction industry is customarily engaged in an independently established trade, occupation, profession or business, Act 72 requires that the following be shown:
- The individual possesses the essential tools, equipment and other assets necessary to perform the services independent of the person for whom the services are performed;
- The individual’s arrangement with the person for whom the services are performed is such that the individual shall realize a profit or suffer a loss as a result of performing the services;
- The individual performs the services through a business in which the individual has a proprietary interest.
- The individual maintains a business location that is separate from the location of the person for whom the services are being performed.
- The individual either (a) previously performed the same or similar services for another person in accordance with (1), (2), (3) and (4) while free from direction or control over performance of the services, both under his contract and in fact; or (b) holds himself out to other persons as available and able, and in fact is available and able, to perform the same or similar services in accordance with (1), (2), (3) and (4) while free from direction or control over performance of the services;
- Maintains liability insurance during the term of the contract of at least $50,000.
In 2015, the Miami Herald and McClatchy Newspapers published a report finding employee misclassification in Florida alone cost the government nearly $400 million per year in lost tax revenue, and that businesses in Florida’s construction industry were major violators.
Florida has now signed an agreement with the U.S. Department of Labor in an effort to share information and coordinate law enforcement activities on misclassification of employees.
Intentional misclassification of workers is a felony in Florida.
The State of Florida’s common law criteria is similar to, but independent of, the Internal Revenue Service (IRS) criteria for determining independent contractor status. The common law rules look primarily at the following 10 factors of the working relationship to determine if the worker is an employee or an independent contractor:
- The extent of control which (by agreement between the employer and the worker) the business may exercise over the details of the work;
- Whether the one employed is engaged in a distinct occupation or business;
- Whether the work done in a certain locality is usually done under the direction of the employer or by a specialist without supervision;
- The skill required in the particular occupation;
- Whether the employer or the worker supplies the instrumentalities (for example equipment, vehicle, materials), tools, and the place of work for the person doing the work;
- The length of time the person is employed;
- The method of payment, whether by the time or by the job;
- Whether the work is a part of the regular business of the employer;
- Whether the parties believe they are creating the relationship of employer and employee; and
- Whether the hiring party is or is not a business.
District of Columbia
DC’s Workplace Fraud Amendment Act of 2012, applicable specifically to the construction services industry, imposes penalties on DC employers for misclassifying employees as independent contractors.
- For purposes of this law, “construction services” are defined to include, without limitation:
[A]ll building or work on buildings, structures, and improvements of all types such as bridges, dams, plants, highways, parkways, streets, tunnels, sewers, mains, power lines, pumping stations, heaving generators, railways, airports, terminals, docks, piers, wharves, buoys, jetties, breakwaters, levees, canals, dredging, shoring, rehabilitation and reactivation of plants, scaffolding, drilling, blasting, excavating, clearing and landscaping. The term “construction services” shall also include moving construction-related materials on the job site.
D.C. Code Ann. § 32–1331.01.
An employer-employee relationship is presumed to exist when work is performed by an individual for remuneration paid by an employer unless to the satisfaction of the mayor, the employer demonstrates:
- the individual is an exempt person;
A. The individual who performs the work is free from control and direction over the performance of services, subject only to the right of the person or entity for whom services are provided to specify the desired result;
B. The individual is customarily engaged in an independently established trade, occupation, profession, or business; and
C. The work is outside of the usual course of business of the employer for whom the work is performed.
D.C. Code Ann. § 32–1331.04.
Any employer who violates or fails to comply with these requirements is subject to a civil penalty of not less than $1,000, and not more than $5,000, for each violation. Each employee who is not properly classified in violation of this subchapter shall be considered a separate violation. In addition to applicable penalties, an employer may also be subject to a stop-work order and may be ordered to make restitution, pay any interest due, and otherwise comply with all applicable laws and regulations.
D.C. Code Ann. § 32–1331.07.
Under Maryland’s Workplace Fraud Act, workers in the construction and landscaping industries are presumed to be employees of the person or business for whom they perform services. However, construction and landscaping businesses are not required to treat all workers with whom they have a working relationship as employees if the worker is, in fact, an independent contractor under the law.
The Maryland Workplace Fraud Act provides four exceptions by which the presumption of employement can be overcome:
- The worker may be an “exempt person.” An “exempt person” within the meaning of the Workplace Fraud Act is an individual who operates an independent business as a sole proprietor and who has no employees other than a parent, child, or spouse.
- The worker is an independent contractor if, based on an application of the ABC test to the facts and circumstance in the specific case, an independent contractor relationship exists:
- The worker is free from direction and control over the manner and means by which the work is done;
- The worker is engaged in an independent business or occupation of the same nature as that involved in the work; and,
- The work is performed outside the usual course of business of the person for whom the services are performed, or the work is performed outside of any place of business of the person for whom the work is performed.
- A business may subcontract some of its work by entering into a contractual relationship with another business entity, which may have its own employees, that do the same type of work as the business, at the same location where the business is working, without creating an employment relationship between two businesses.
- A business may subcontract some or all of its work to another business entity if:
- The work is done under a written contract that meets certain statutory requirements;
- The business entity provides an affidavit indicating that the individual or business entity is an independent contractor who is available to work for others;
- The business entity is registered with the Department of Assessments and Taxation and is in “good standing;” and,
- The business entity holds any and all required occupational licenses for the work performed.
Employers who are found to have misclassified workers have 45 days to pay restitution to misclassified workers and come into compliance by classifying the workers correctly, without additional civil penalties. In order to come into compliance, an employer may also be required to enter into agreements with governmental units including, but not limited to the Maryland Department of Labor, Licensing & Regulation’s (DLLR) Unemployment Insurance Division and the Maryland Comptroller, to pay any amounts owed on the employees’ wages for a period not to exceed 12 months preceding the citation. If the misclassification was unintentional or mistaken, employers who fail to come into compliance within 45 days may be assessed a penalty of up to $1,000 per misclassified worker. Employers who “knowingly” misclassify workers may be assessed a penalty of up to $5,000 per misclassified worker, which may be doubled if the employer has previously found to have been in violation of the Workplace Fraud Act. An employer with three or more violations may be assessed a penalty of up to $20,000 per misclassified worker.
Further, as of October 1, 2016, Maryland’s unemployment law was amended to create interest assessments on unpaid unemployment contributions, civil penalties for misclassification, and cross-agency reporting requirements in the event of an employer’s misclassification of employees. Under such amendments, employers who are found to have misclassified employees as independent contractors will not only be charged back unemployment contributions (which was the rule in effect), but they will also be assessed 2% interest if the contributions are not paid in full within 45 days of the order to make payment. Interest will date back to the date payment was initially due. Additionally, an employer who “knowingly” misclassified an employee will be assessed a civil penalty of $5,000 per employee ($10,000 per employee for subsequent violations), and a person who “knowingly” advises an employer to misclassify an employee as an independent contractor will be subject to a civil penalty of $20,000.
With State governments taking heightened measures to seek out and penalize employee misclassification, any company with independent contractors should review its classification of workers to ensure compliance!
Please contact Withum’s Construction Services Team with any questions or concerns you may have by filling out the form below.
Authors: Marcus Dyer, ESQ, CPA | [email protected] and CJ Stroh, Esq | [email protected]
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