05/29/2010 05:12 am ET Updated May 25, 2011

One in Three Businesses at Risk in Independent Contractor Crackdown

As businesses regain their footing and think about hiring, careful attention should be paid to how their workers, both current and new hires are classified. Workers can be either employees or independent contractors, and the federal budget makes it clear that the government thinks many workers are misclassified. A joint enforcement effort by the Treasury Department (home of the IRS) and the Labor Department (home of the Wage and Hour Division, enforcers of the Fair Labor Standards Act) to reclassify independent contractors as employees is projected to add at least $7 billion to the government's bottom line over the next ten years.

Business and government have wrestled over the proper classification of workers as employees or independent contractors for years. Why? The New York Times, in an article citing reports of almost one in three businesses misclassifying employees as contractors, summed up the stakes this way:

Companies that pass off employees as independent contractors avoid paying Social Security, Medicare and unemployment insurance taxes for those workers. Companies do not withhold income taxes from contractors' paychecks, and several studies have indicated that, on average, misclassified independent workers do not report 30 percent of their income.

Some businesses intentionally misclassify workers. In the process, they take advantage of those workers, gain an unfair advantage on companies playing by the rules, and increase the tax burden on everyone. The crackdown on those abusers will be good for business. Unfortunately, many more businesses could be victims of the subjective nature of worker classification.

You see, there is no clear definition of "employee" in the Internal Revenue Code. Instead, we are told to use traditional legal concepts involving control of the worker in order to distinguish employees from nonemployees. The IRS developed a list of 20 factors to aid in classification inquiries. For those who love details, those 20 factors are included at the end of this post on No Funny Lawyers; for the rest of you and for business owners generally, the IRS boiled-down the 20 factors into three categories for proper worker classification:

Behavioral: If the business has the right to control only the result of the work, then the factor indicates a contractor. If the business has the right to control how the work is done, then the factor indicates an employee.
Financial: If the worker risks losing money doing the work, the factor indicates a contractor. If expenses of the work and the tools and supplies needed are provided by the business, the factor indicates an employee.
Type of Relationship: The existence of a contract and what it calls the relationship isn't generally a factor, but please don't claim a worker as a contractor when he or she has an "employment" contract with you. Beyond that, the presence of employee-type benefits (i.e. pension plan, insurance, vacation pay, etc.) indicates employment, but the absence of benefits doesn't mean the worker is a contractor. Long relationships and work that is the key to the business of the employer indicate employee status.

While the circumstances of each situation still need to be considered, two facts above all others put a classification at risk of a government challenge. One, the business has both employees and contractors performing essentially the same duties, and two, the contractor in question was formerly classified as an employee to do essentially the same work. Businesses rehiring positions eliminated during the recession could easily fall into one or both of those fact patterns.

If your business has either of those two facts against it, or if you have questions about the application of these factors in your business, then you could become part of that additional $7 billion in revenue the government is counting on from this effort. See your lawyer to review your situation before that happens.