Manufacturing | Distribution | Retail Practice
11.08.2016 | Client Alert
States as well as the U.S. Department of Labor (DOL), seeking to recover potential lost tax revenue and to protect workers, continue their crackdown on the misclassification of employees as independent contractors. These efforts by the states and federal government began almost a decade ago, and there is no indication that the efforts will abate in the near future. In 2015 alone, investigations by the Wage and Hour Division of the DOL resulted in more than $74 million in back wages for more than 102,000 workers across a variety of industries.
Utilization of Independent Contractors is Common in the Manufacturing/Distribution Sector
Although businesses in virtually every industry use independent contractors, the practice is widespread throughout the manufacturing/distribution industry for a number of reasons. The use of contract employees is not limited to the shop floor or the delivery fleet; contract employees are often utilized for janitorial, hospitality, mail room, and other support functions in a manufacturing plant or distribution warehouse.
The reality is that the manufacturing and distribution industry in the United States continues to face multiple challenges, most of which are economic in nature, that contribute to an increased use of contract labor. These challenges include, but are not limited to:
- A reduced demand for manufactured products; demand has not yet returned to pre-recession levels;
- A continued increase in imports from countries where the cost of labor is low;
- The increased cost of production as companies try to make “greener” products, both in response to government regulations and public demand.
Combine these factors with the fact that company owners and plant managers are under tremendous pressure to control costs at every stage of operations. It is clear that industry executives continue to struggle to meet the needs of the market in a cost effective manner.
Advantages for Both Sides
For the business owner, clear economic and business advantages exist with the use of contract labor. At the top of the list: Businesses are not required to withhold taxes, make Social Security and Medicare contributions, pay unemployment taxes, or provide workers’ compensation insurance to contract workers. That means there are less out-of-pocket costs for the business owner and the responsibility of paying those taxes rests with the independent contractor.
In addition, the astute business owner or manager knows that:
- Independent contractors do not qualify for minimum wage or overtime wages;
- Independent contractors, as a rule, are not included in employee benefit plans;
- Independent contractors do not have the right to unionize;
- He/she can better manage the work force – and thus overhead costs – during peak and slow periods of the year with the use of contractors.
Independent contractors – who tend to be individuals in creative disciplines such as graphic artists, website designers, and copywriters – may simply prefer to work for themselves. This preference may be due to the fact that:
- They have a specialized talent that can command higher fees as a contractor than as an employee;
- They prefer the variety and flexibility of working for different companies; and/or
- with proper advice, they can take advantage of tax deductions and write-offs that are available to them as independent contractors but not as employees.
All of these factors have contributed to the tremendous growth in the use of contract employees over the years and the renewed efforts by state and federal governments to capture those lost tax dollars.
Reasons for Concern
Why should the business owner be concerned? If it is determined that your employees have been misclassified, whether deliberately or unintentionally, you will be responsible for a host of expensive consequences, including unpaid taxes plus interest and penalties on:
- Unpaid federal, state, and local income tax withholdings;
- Unpaid Social Security and Medicare contributions;
- Unpaid unemployment insurance taxes;
- Unpaid overtime compensation or minimum wages;
- Unpaid sick and vacation pay; and
- Other unpaid work-related expenses.
Determining whether a worker is an employee or independent contractor under federal or state law is highly fact-specific and often dependent on a review of two key areas: Economic realities and the “right to control” test.
Though every case is reviewed individually, here’s one rule of thumb: The greater the control that an organization has over a worker, the more likely it will be determined that the worker is an employee, not an independent contractor.
Guidance for Classifying a Worker
If you are unclear on how to classify one or more of your employees, here are 10 questions to ask (National Law Review, November 21, 2015):
- Does the contractor perform work that is integral to your business (For example, if you are a distributor, truck drivers perform work that is integral to your business)?
- Do you closely supervise the contractors’ work (includes items such as scheduling, deliveries, and the like)?
- Is your contractor paid by time worked rather than on a project basis?
If your answer to these questions is “yes,” chances are the contractor will be viewed as an employee.
Now look at these questions. If your answer to these questions is “yes,” chances are an employer/contractor relationship exists. However, it is important to note that each case is reviewed on an individual basis and there are no hard and fast rules. Determination is subjective, not objective.
- Does the contractor operate his/her own business; have a business tax identification number; a business bank account; and other clients?
- Does the contractor bear the risk of profit or loss?
- Does the job have a fixed end date? True contractors work on a project basis with a fixed or estimated end date. If there is no end date to your relationship, chances are the contractor will be classified as an employee.
- Does the contract employee bring his/her own equipment? If using contract labor in your delivery fleet, is the driver using your truck or his own truck? Who sets the routes and delivery schedule?
- Does the work require unique skills? A true contractor will usually possess a specialized skill that is distinct from your general workforce.
- Do you receive an invoice from your contract employees? If you deliver a paycheck to a contractor, without evidence of an invoice, that contractor will likely be considered an employee.
- Is there a contractor agreement in place? Though there is no guarantee that a written agreement will determine contractor status, such an agreement goes a long way in indicating the intent to create this type of relationship.
Reclassifying a Worker
Should you decide that you need to reclassify employees, there are steps you can take. First, be certain that your contractors are properly classified and there is documentation in place that addresses the employer/contractor relationship. The employer/contractor relationship should be defined in an agreement that accurately reflects the obligations of each party.
You can reclassify your independent contractors as employees at the direction of the government (not optimal) or voluntarily, without government involvement. The IRS announced a Voluntary Classification Settlement Program (VCSP) in 2011, which allows businesses to reclassify 1099 employees for future periods with partial relief from federal employment taxes. Under the program, the employer only has to pay 10% of employment tax liability (at a reduced rate) for the most recent tax year (and there is no liability for interest and penalties). Eligible taxpayers that are accepted into VCSP will enter into a closing agreement with the IRS. This program allows a taxpayer to drastically reduce their prior year exposure, but will likely require costs to professionals to help the taxpayer go through the process.
The VCSP program has not been widely utilized. Instead, employers are more likely to voluntarily reclassify their workers without being a part of the VCSP program. In the case of a voluntary reclassification, the employer would be liable for employment taxes for all open years (but at a reduced tax rate). We do not recommend that employers voluntarily reclassify their workers unless the potential employment tax exposure is not material.
Employers (and their workers) can also request that the IRS determine the status of a worker. This determination can be done for any tax year for which the statute of limitations has not expired and is one of the few rulings that can be requested from the IRS for which there is no user fee. This process makes sense for a new class of workers. It should generally not be considered for workers who have been treated as independent contractors for some time as the process does not provide for any relief from taxes, penalties, or interest.
If you have been selected for an IRS employment tax examination to determine whether your classification of workers is correct, you may be eligible for relief from prior year employment taxes. Relief is available if:
- There was a reasonable basis for treating the workers as independent contractors,;
- You have treated the workers (and any similar workers) as independent
contractors consistently; and
- You have filed all required federal tax returns (including information returns) consistent with the treatment as an independent contractor. This relief provision only applies if the IRS raises the issue on audit and cannot be used by taxpayers affirmatively.
Still other employers prefer to use a reputable workforce management or staffing company from whom you hire employees. It is up to that company to comply with state and federal laws regarding employee or contract labor agreements. The DOL will also look at the position the contractor holds; if the contractor is in a management position, the DOL may see that person as an employee.
The on-going crackdown by state and federal governments is not meant to and will not bring an end to the use of contract employees in the United States.
But as an employer, you want to be sure that you classify independent contractors correctly or not misclassify employees as independent contractors. Misclassification has become a genuine and costly liability that should be avoided at all costs.
Questions? Contact your Berdon advisor. Berdon LLP, New York Accountants