S TRANGE AS I T M AY S EEM : T HAT I NDEPENDENT C ONTRACTOR M AY B E Y OUR E MPLOYEE Naomi Haslitt, Susan Stahlfeld, Kristine Bingman I. INTRODUCTION: WELCOME TO THE MYSTERIOUS WORLD OF EMPLOYEE CLASSIFICATION. A. The setting. The American workplace is ever-changing. To battle high legal costs of employee benefits, many employers are attempting to classify workers as independent contractors. In certain arenas, however, classifying an employee as an independent contractor causes only additional headaches to the employer—increasing potential legal liabilities particular to the employee's independent-contractor status. B. Meaningful mystery. The designation of a worker as an independent contractor or an employee can have great significance for both the employer and the worker. Highly skilled workers use the independent-contractor status not only to shield themselves from being an "employee" (and all the obligations arising from that designation (e.g., going to employer-required meetings, filling the coffeepot, and even certain tax situations)), but also to give themselves flexibility to control when, where, and for whom they will perform services. C. More than meets the eye. It takes more than just the label to make a person an independent contractor. This designation is only one factor in the various state and federal tests used to determine whether an employment relationship exists, and it is not the determinative factor. Instead, courts, legislatures, and regulators have developed broader tests to determine whether a person who provides services is an employee or an independent contractor. D. General liability rule. Generally, an employer is not responsible for an independent contractor any more than it is responsible for its vendors and other business partners. Rather, the independent contractor is largely responsible for his or her own business liabilities in the same manner as any other business owner. On the flip side, the worker retains flexibility in his or her status as an independent contractor, but may also be subject to certain requirements and limitations based on the statutes and case law discussed below. E. Traps for the unwary. There is a lack of consistency among public agencies in determining the validity of an independent-contractor designation because of the multiplicity of federal and state agencies 2015 E MPLOYMENT L AW S EMINAR -1-
and their purposes. This can result in an unwary employer's incurring liability for improperly classifying its workers. II. TAX IMPLICATIONS FOR EMPLOYER WHEN IT INCORRECTLY CLASSIFIES A WORKER AS AN INDEPENDENT CONTRACTOR. Primarily, disputes over an employee's status arise when the IRS or state authority attempts to collect taxes from the employer. Government taxing agencies, such as the IRS or its state counterparts, may challenge independent-contractor status, attempting to loop workers under the traditional "employee" designation in order to collect taxes from the employer for those workers under the appropriate federal or state law. A. Federal tax liability. 1. IRS determination of independent-contractor status. In determining whether a worker is an employee under federal tax laws, the IRS focuses on evidence of behavioral control, financial control, and the type of relationship between the parties. Additional information is available in the Employer's Supplemental Tax Guide: www.irs.gov/pub/irs-pdf/p15a.pdf. 2. IRS challenges to independent-contractor status. The IRS has challenged employer classification of workers as independent contractors to collect taxes under the Federal Unemployment Tax Act and the Federal Insurance Contributions Act, and federal income taxes that were not withheld by the employer or paid by the worker. Courts have held that an employer is liable for all these payments when it misclassifies an employee as an independent contractor. See, e.g. , Bruecher Found. Servs., Inc. v. United States , 383 F. App'x 381 (5th Cir. 2010). When an employer is found liable for these taxes, it must pay the taxes, plus interest and penalties, which can result in substantial liability. In addition to IRS challenges, some courts have recognized the right of an individual to challenge his or her own status as an independent contractor and force an employer to pay FICA and FUTA taxes. Ford v. Troyer , 25 F. Supp. 2d 723 (E.D. La. 1998). This is not a right expressly recognized by the statute, however, and other courts have refused to recognize such a claim. See, e.g. , McDonald v. S. Farm Bureau Life Ins. Co. , 291 F.3d 718 (11th Cir. 2002). 3. Code Section 409A rules. The IRS issued regulations under Section 409A of the Internal Revenue Code about deferred compensation plans that apply to employees and can apply to an independent contractor if the worker falls outside the specific definition of "independent contractor" outlined by the regulations. Among other things, the Section 409A rules impose strict requirements on when deferred compensation may be paid, and impose a strict prohibition on accelerating payment of deferred compensation. If the rules aren't followed, then the worker will suffer adverse tax consequences, including immediate inclusion of all deferred compensation, a 2015 E MPLOYMENT L AW S EMINAR -2-
20 percent penalty tax, and penalty interest. Service recipients can potentially be on the hook related to reporting and withholding failures if Section 409A issues arise. To avoid application of Section 409A, the independent contractor must provide "significant" services to two or more unrelated service recipients while actively engaged in the relevant trade or business. Determining whether a worker satisfies this rule is a facts-and- circumstances test, but if the worker receives less than 70 percent of total revenue from any of the service recipients, the worker will be treated as an independent contractor. a. "Plans" includes many types of payments. The IRS regulations defines a nonqualified deferred compensation plan as "any plan . . . that provides for the deferral of compensation . . . . Whether a plan provides for the deferral of compensation generally is determined at the time the service provider obtains a legally binding right to the compensation under the plan, and is not affected by any retroactive change to the plan to characterize the right as one that does not provide for the deferral of compensation." 26 CFR § 1.409A-1(a)(1). Additionally, "plan" is very broadly defined, and can be "any agreement, method, program, or other arrangement . . . that applies to one person or individual." 26 CFR § 1.409A-1(c)(1). A plan can include an employment agreement that provides for deferred compensation (such as severance or bonuses), a separation agreement, a reimbursement arrangement, a bonus arrangement, stock options, and commission arrangements. b. Independent contractors may be included. If an employer provides any compensation to an independent contractor that may fall within the IRS definition of "deferred compensation," whether under a written or unwritten plan, the employer should check to see whether it might be a deferred compensation plan subject to Section 409A. If so, the plan should be structured to comply with the 409A rules, to avoid tax penalties for both the independent contractor and the employer. B. Washington tax liability. 1. State's determination of independent-contractor status. Misclassification of workers as independent contractors can also lead to liability for workers' compensation premiums and state unemployment taxes, as well as interest and penalties for failing to report hours and wages for such workers. The liability can be substantial. Different states have different tests for determining whether a worker is covered by workers' compensation or unemployment tax laws, and what entities are potentially liable for payment of those premiums and taxes. Even within a state, the different agencies can have different tests. In Washington, if an employer must pay workers' compensation premiums on a worker, then unemployment taxes must also be paid for that worker. 2015 E MPLOYMENT L AW S EMINAR -3-
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