The Green Sheet Online Edition
July 26, 2010 • Issue 10:07:02
Uncle Sam might want to pin worker misclassification on you
It is difficult to distinguish between an employee and an independent contractor, especially because of the ever-changing and often confusing rules the IRS uses to make that determination. However, if you misclassify employees as independent contractors, the odds that you will face expensive penalties are increasing.
Due to the sagging economy, legislators are seeking additional sources of revenue. State and federal officials are becoming more aggressive in investigating companies that misclassify employees as independent contractors.
For example, the U.S. Department of Labor and Department of the Treasury are pursuing a joint proposal to enhance their ability to penalize employers that misclassify workers.
Under the proposed 2011 federal budget, an additional $25 million will be provided to the Department of Labor to add 100 enforcement personnel and provide grants to states to enforce penalties for misclassifications.
The IRS intends to audit 6,000 companies to ensure compliance with worker classification rules. Additionally, many states are proposing legislation and creating task forces to investigate worker misclassification.
Why misclassification occurs
Employers have an incentive to classify workers as independent contractors, rather than employees, because by doing so they can avoid paying the employer contributions to Social Security and Medicare, unemployment insurance, payroll taxes, mandated minimum wages and overtime, and workers' compensation insurance.
Generally, companies using independent contractors also avoid providing health insurance and other benefits that are typically provided to employees, such as sick time, flextime and vacation.
Thus, the government alleges employers have strong incentives to classify as independent contractors workers who are really employees.
For ISOs and merchant level salespeople (MLSs), this means it is time to take a second look at your agreements to make sure that MLSs, for example, are being properly classified as independent contractors. The following tests can help with this process.
Criteria the IRS uses
The IRS uses two tests to determine whether a worker should be classified as an employee or an independent contractor. The first is a three-factor test that weighs the amount of behavioral control the employer has over the worker, the financial control the employer has over the worker and the type of relationship the employer and worker have.
While employees are dependent on their employers for everything needed to perform their jobs, independent contractors are in business for themselves; they control their own transactions and cover their own expenses. With this in mind, it is easy to see why the more control an employer has over a worker, the more likely it is that the worker will be classified as an employee.
The second IRS test involves 20 factors. Again, the more control the employer has over the worker, the more likely the worker will be classified as an employee. Below are the seven factors most relevant to the payments industry. No single factor is dispositive, and having a certain number in either category is not conclusive.
- Place of performance: If a worker performs job responsibilities at the employer's place of business, the worker is more likely to be designated as an employee; however, if the worker does not work at the employer's office and instead has a separate office or works from home, the worker is more likely to be classified as an independent contractor.
If you want to make sure your agents will be deemed independent contractors, your agents should have their own place of business. If they're working in your office, it is an indication that they are actually employees.
- Realization of profit or loss: If a worker has liability for losses, he or she is more likely to be determined to be an independent contractor. However, if your business does not have liability for merchant losses because you are exempt from bearing such losses as agreed between you and the processor, this factor may be irrelevant.
But if you take liability through your processing relationship and you want to make sure your agent will be deemed an independent contractor, you may want to pass that liability down to the agent.
- Instructions and training: While you can train your independent contractors about how the payments industry operates generally, the more instruction and training is provided to a worker regarding how to perform job functions, the greater the chance that the worker will be designated an employee. For instance, training a worker on how interchange works may not amount to an employer-employee relationship, but telling a worker what equipment to use, when to work and how to do a given job probably does.
If you want to make sure your agents will be deemed independent contractors, limit the amount of training required, and do not tell them how to perform their jobs.
- Work hours: If full-time work is required, the worker is more likely to be determined to be an employee. If there are no set work hours, it is more likely the worker will be determined to be an independent contractor.
If you want to make sure your agents will be deemed independent contractors, make it clear that they can perform their job duties on their own schedule without mandatory work hours.
- Exclusivity: If an independent contractor is exclusive to you, this is a big indication that the worker will be determined to be an employee. However, if the agent is permitted to place merchants with other processors, perhaps even under another name, the worker is more likely to be classified as an independent contractor
If you want to have some certainty that the worker will be available but still want your agents to be nonexclusive, consider using minimums. Minimum levels should be low enough that the independent contractor has a reasonable amount of time to acquire merchants for other processors. In other words, don't set minimums that are so high that agents will effectively be prohibited from marketing for other companies, even if they are technically "nonexclusive."
- Right to terminate: A worker will more likely be classified as an employee if the employer can discharge him at will, meaning for any reason or no reason at all. On the other hand, a worker that may only be discharged upon the occurrence of specific events (for "cause") will more likely be determined to be an independent contractor.
If you want to make sure your agent will be deemed an independent contractor, make sure your agent agreements run for a specific term, terminable early only for specific causes.
- Entity status: If an agent agreement is between your company and another legal organization, such as a corporation or a limited liability company, this is an indication that a worker associated with that organization will be deemed an independent contractor. Workers who are protected by a corporate form are generally considered to be self-employed and thus seen as independent contractors.
Using agents who are entities, as opposed to individuals, is one way to stack the odds in favor of their being classified as independent contractors. Remember, when entering into an agreement with such an agent, obtain proof of the legal status of the other entity, such as a good standing certificate from the applicable state or the entity's certified articles or certificate of formation.
Reasons to assess your practices
The factors listed herein may help you determine whether you are classifying your workers appropriately. If several factors indicate you exert behavioral or financial control over your workers' services, consider having your accountant or attorney review your practices.
Further, it is not sufficient to simply change the wording of a contract unless the underlying relationship also changes to mirror what the contract requires. In other words, if your contract reflects an independent contractor relationship but your actions reflect an employment arrangement, any investigating party will focus on the way the relationship actually works, not the way the contract says it should.
Companies caught misclassifying employees as independent contractors - even unintentionally - not only risk penalties, they can also be required to make retroactive payments for minimum wages, overtime, payroll taxes and interest that, but for the misclassification, would have already been paid for workers' past services.
The recommendations herein are general suggestions; they are not a substitute for legal advice. For specific information, consult experienced legal counsel. Sarah Weston is an attorney at Jaffe, Raitt, Heuer & Weiss PC and advises businesses on contract and regulatory issues in the merchant acquiring, stored value, automated clearing house and payment systems industries. You can reach her at 248-351-3000 or at firstname.lastname@example.org.
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