Risk Management

A Loss of Independents?

Regulators have rewritten the rules regarding the use of independent contractors, forcing companies to make hard choices &spamp;#8212; and possibly...
David KatzDecember 1, 2011

As companies make greater use of independent contractors, the Internal Revenue Service is pushing to get many of those self-employed workers reclassified as employees.

For some workers, being an independent contractor offers freedom and a sense of entrepreneurship. For others, it’s simply a fallback position in troubled times. Most employers see plenty of advantages to using independent contractors, and many smaller companies say they depend on them.

All those factors have propelled the country toward becoming a veritable Freelance Nation. Indeed, there are 16 million “independent workers” in the United States today, according to a recent study by consultancy MBO Partners; the firm predicts that by 2013 that number will swell to more than 20 million. (MBO defines independent workers as “people who work at least 15 hours per week in nontraditional, nonpermanent full- or part-time employment and includes workers who identify themselves as consultants, freelancers, contractors, self-employed, and on-call workers, among others.”)

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For many companies, particularly small and midsize firms, the ability to classify certain workers as independent contractors provides what they regard as essential flexibility. If Aqua Spy, a small, private-equity-backed company that makes irrigation probes for farmers, had to reclassify the 16 independent contractors it employs in the spring and fall of each year, for instance, “it would critically threaten our business,” says Cynthia Jamison, the company’s interim CFO and a member of Tatum Partners, which provides companies with finance chiefs on a contract basis. “It would be devastating to our P&L, and would impact our need for capital, requiring more working capital,” and more liquidity.

If such reclassification were widely enforced, companies would have to start withholding federal income, Social Security, Medicare, and unemployment taxes from freelancers’ wages — not to mention possible payment of fees and penalties for previous misclassifications. Further, such firms would have to start paying for the same employee benefits and workers’ compensation that they currently do for full-time employees.

Carrot and Stick
How likely is it that such a scenario would occur on a broad scale? Not very — especially because the IRS, the Department of Labor, and the states themselves don’t have the staff needed to provide such enforcement. Yet even as the economy grows more reliant on temporary labor, regulators are becoming increasingly vigilant about getting employers to classify previously mislabeled workers.

The IRS, for example, has lately been wielding both carrot and stick. This fall the service introduced a voluntary program that might enable some employers to shed certain tax liabilities by dubbing certain independent contractors as employees. But that program came on the heels of a year-and-a-half-long crackdown by IRS agents on potential misclassifications, according to Kathy Mort, a managing director in PwC’s Washington, D.C., national tax services office.

Faced with burgeoning federal and state budget deficits, regulators see a vast pool of potential back taxes, fees, and penalties to be gleaned from the detection of employee-classification errors. Currently, the IRS estimates that 15% of all employers have misclassified a total of 3.4 million employees as independent contractors, resulting in an estimated annual revenue loss of $3.4 billion in 2010 dollars.

While many companies err on the side of caution and forgo the use of independent contractors, for those employers “that have [long assumed] that a large group of contractors is not going to be looked at, there’s a more significant risk than there ever was that someone — the DoL, the IRS, or state agencies — is going to look at them,” Mort says.

In September, Secretary of Labor Hilda Solis seemed to ratchet up that risk when she hosted a ceremony in Washington to sign a memorandum of understanding with the IRS and representatives of seven states “to end the business practice of misclassifying employees in order to avoid providing employment protections.” (The states are Connecticut, Maryland, Massachusetts, Minnesota, Missouri, Utah, and Washington.)

Under the agreement, the federal and state agencies are sharing information and coordinating their law-enforcement efforts with an eye to nabbing noncompliant employers. Rebecca Torrey, an employment and labor lawyer with Manatt, Phelps & Phillips in Los Angeles, says that within a month of that new policy taking effect a client was hit with two unpaid-wage claims. Noting that many other states are likely to sign on to the memo, she said the likelihood of companies fielding multiple tax, wage, and benefits claims from different agencies is rising fast.

Just two days after the IRS joined in the agreement, it followed up with an olive branch for employers: an announcement that it would begin offering employers that have misclassified their employees as independent contractors a chance to come clean with a minimal amount of tax liability.

The voluntary program will give employers the chance to properly reclassify as employees workers they had incorrectly treated as independent contractors by making a “minimal payment covering past payroll-tax obligations rather than waiting for an IRS audit,” according to the IRS.

Indeed, an employer that takes part in the plan would pay just 10% of the employment-tax liability on workers’ pay for the most recent tax year and not be charged any interest and penalties on the liability. Further, the taxpayer wouldn’t be subject to an employment-tax audit for the classification of the workers in past years.

In exchange, employers must agree to prospectively treat the specified class of workers as employees for future tax periods. They must also agree to extend the period of limitations on assessment of employment taxes for three years for the first, second, and third calendar years after the date when the taxpayer began treating the workers as employees.

A Risk in Coming Clean?
For many companies, the IRS program offers a good deal for getting out from under what could be a considerable burden. “Eligible businesses should consider taking advantage of this opportunity to limit their liability in this often unclear area of the tax law,” advises law firm Fulbright & Jaworski.

But there’s also abundant risk lurking in the act of worker reclassification. A company may ultimately benefit in terms of its federal tax bill if it voluntarily comes forward and admits it has been classifying workers as independent contractors when they should have been deemed employees. But such candor could expose the employer to claims by other federal and state agencies that could dwarf the IRS’s proffered tax breaks.

Faced with that choice, playing possum might be the best option for many employers, according to Jason Taylor, a Fulbright & Jaworski lawyer. If an employer is confident that its classification can pass muster with the IRS, it can choose to do nothing. Even if the employer is audited, the tax auditor might still offer the company a decent settlement: an assessment of 25% of the employment-tax liability for the audit year.

David M. Katz is New York bureau chief and senior editor for accounting at CFO.