Businesses in the construction industry have historically relied heavily upon independent contractors to perform work. While it is sometimes clear that a party is a true subcontractor, such as hiring ABC Flooring Inc. or 123 Hardwoods LLC, it is equally as common to misclassify laborers who are legally employees as independent contractors.
Why do the state and federal governments, employers and workers care about this issue? In a word, money. Businesses without employees do not pay payroll and employment taxes, workers compensation premiums, health insurance premiums or other benefits. In turn, workers who are not employees are paid the full amount of their compensation without any amounts being deducted for these costs. Many people do not like being told when to pay their taxes or having money automatically taken from them. Independent contractors can hold their money and pay their taxes quarterly, or not at all (as the IRS fears).
If an employer is audited and found to have misclassified employees, the consequences can be severe. If a worker is deemed to be an employee, the government agency will demand that the employer pay the employment taxes and other expenses that it should have been paying all along on the workers’ income. The same could be true for unemployment taxes. In addition, penalties could be assessed beyond the amounts due, and the owners of a business found liable for unpaid employment taxes can be personally responsible if the business does not make the payments.
A business could also face other liabilities for misclassified workers. For example, I once had a client who paid all workers as independent contractors. A worker fell off a building and was killed. It was later legally determined that the worker was in fact an employee, but the employer did not maintain any workers compensation insurance. As a result, the employer had to pay out of pocket for significant personal injury damages to the deceased worker’s family. The state government also got involved and assessed fines for failure to maintain workers compensation insurance.
In 2011 the IRS announced a new program intended to assist employers to “voluntarily reclassify” independent contractors to employees. Named the “Fresh Start” program, it is designed to reduce the cost of reclassification and create a specific process for doing so. Any construction contractors who claim to use independent contractors or subcontractors should review this program and their own practices to avoid misclassifying employees as independent contractors.
Reviewing Employment Status
The following list of questions can be used in reviewing your personnel to determine if they are truly independent contractors or would legally be deemed employees. Every question to which you answer “no” is an indicator that the worker will be deemed your employee and not a true independent contractor.
1. Do they maintain a separate business with their own office, equipment and other facilities?
2. Do they have a separate legal entity through which they conduct business (corporation/LLC)?
3. Do they have a separate federal tax identification number, other than their social security number?
4. Do they have their own liability and workers compensation insurance policies, or are they otherwise exempt from maintaining workers compensation insurance?
5. Do they use their own tools, equipment and supplies?
6. Do they not wear any clothing containing your company’s name or logo?
7. Do they not drive your vehicles?
8. Do they also work for other companies?
9. If required, are they registered or licensed by your applicable state laws as subcontractors?
10. Do you sign contracts with them for each job and for specific amounts of money, or alternatively have a signed master subcontractor agreement covering all work they will perform?
11. Are they not paid on an hourly basis, but instead on a commission basis, a per-job basis, per unit basis or a competitive bid basis?
12. Do they control the means of performing their work, i.e., you do not tell them how or when to do their work (other than a project schedule with deadlines)?
13. Do they incur the main (or any) expenses related their work?
14. Do they have continuing or recurring business liabilities, e.g., overhead such as rent, loans, etc.?
15. Do they have any risk, i.e., can they realize a profit or suffer a loss on the work they perform and does the success of their business depend on not losing money? (If they profit by the same amount no matter how long it takes or the expenses involved in doing the work, then the answer to this question is “No”).
16. Are they liable for failure to complete the work properly, i.e., could you sue them for damages related to delays, to correct poor workmanship or other breach of contract?
Failing one element does not mean a worker would automatically be deemed an employee, but failing more than one would likely result in a reclassification. The factors and laws may also vary from state to state. For example, in Minnesota individuals working in the construction industry are deemed employees unless proven otherwise, and the financial ramifications and penalties for misclassification can be severe. Minnesota also requires construction subcontractors to register with the state, and failure to do so will result in the individual or the owners of the applicable entity being deemed employees of the prime or general contractor. To summarize the issue, having (or appearing to have) a separate business is really the key to the entire analysis. If the worker cannot profit or incur losses, has no recurring business liabilities or obligations, is told what to do and when to do it, and is paid in a way where it has no downside risk, the worker will be deemed an employee.
A Safe Harbor?
Despite the IRS Fresh Start program being touted as a “safe harbor,” I still would recommend against contacting the IRS to volunteer that you believe your business has been misclassifying workers. If you have any concerns after reviewing the factors above, I recommend discussing the matter with an attorney licensed in your state to develop a plan for addressing any weak spots and increasing the likelihood that all workers classified and paid as independent contractors will survive scrutiny in an audit.
*Originally published in Hardwood Floors Magazine http://www.hardwoodfloorsmag.com/business-management/flooring-employee-vs-contractor-know-the-difference-not-the-fine.html