Independent Contractor Vs Employee - The Exponential Risk Of
Think twice before routinely classifying that next worker as an independent contractor or employee, or
be prepared to write the Internal Revenue Service a large check for unpaid taxes, penalties and fines,
should the worker be found incorrectly classified during an audit. In addition, employers in violation of
worker classification laws should also be ready to provide retroactive access to employee benefits
programs for incorrectly classified workers. And, if during an audit, a privately held company has
plans to go public, it could be faced with providing misclassified workers retroactive access to stock
options as well.
When it comes to worker misclassification, many have heard of the landmark United States federal
class action suit filed against Microsoft Corporation, Vizcaino v. Microsoft Corp., which helped clarify
the law nationwide regarding temporary worker classification. After years in litigation, Microsoft
agreed to settle for approximately $97 million to be allocated between the thousands of people who
provided services to Microsoft between the years of 1986 and 2000 while classified as independent
contractors or employees of third-party employment agencies. One can only imagine the amount of
resources drained from Microsoft and costs incurred from the intense legal battle.
And Microsoft is not alone in the worker classification legal battle. Hewlett-Packard (Marks v. Hewlett
Packard Company), Time Warner Inc. (Herman v. Time Warner Inc.), Allstate Insurance Company
(Equal Opportunity Employment Commission v. Allstate Insurance Company/Romero v. Allstate
Insurance Company), S.G. Borello & Sons, Inc. (S.G. Borello & Sons, Inc. V Department of Industrial
Relations) and many more have suffered the consequences of worker misclassification.
Perhaps FedEx Corporation's legal battle will become the newest landmark case, with approximately
30 state class action suits and an Employee Retirement Income Security Act (ERISA) class action
filed against the company; settlements are estimated by some to be $1 billion. Already a California
appeals court decision in August 2007 ruled in favor of the plaintiff and FedEx lost its appeal of a $5.3
million verdict. The verdict resulted from a class action that claimed FedEx treated its independent
contractors as if they were employees but did not provide them with payment and benefits that full-
time employees would receive. The ruling proved that the workers in question, delivery drivers for
FedEx Ground, were in fact employees of FedEx and not independent contractors due to the level of
control that the company exercised over them.
Growing concern about the topic of worker misclassification has prompted long-term research studies
on the issue. A report by the Department of Economics at the University of Missouri-Kansas City in
December 2006 estimated that approximately $125 million in income tax was lost annually in Illinois
due to employee misclassification. The four-year study also showed the rate of worker
misclassification by violating employers increased 21 percent from 2001 - 2005.
A 2007 report by the School of Industrial and Labor Relations at Cornell University concluded that the
state of New York is owed approximately $176 million in unpaid unemployment insurance taxes due
to employment misclassification for the years 2002 - 2005 in industries such as construction, finance,
insurance, wholesale and retail trade, and professional and technical services. Of the workers
studied, approximately 704,785 were misclassified by employers.
While to some, the issue of worker misclassification is relatively new, many feel it has taken far too
long for government agencies to ensure that workers are classified correctly and that they receive
appropriate protection under the law from discriminatory practices. This lack of worker protection
along with the pursuance by state and federal agencies to retrieve billions of dollars in uncollected tax
revenue has recently resulted in a significant amount of attention and legal action by decision-makers
across the country. For example, proceedings from the 2006 Allied Academies International
Conference in New Orleans reported that attendees of a recent White House Conference on Small
Business rated independent contractor classification disputes as the most pressing small-business
Likewise, Sens. Barack Obama (D-IL), Edward M. Kennedy (D-MA), Dick Durbin (D-IL) and Patty
Murray (D-WA) have made fair and proper treatment of United States workers and employers a
primary concern by introducing the Independent Contractor Proper Classification Act of 2007 last
September. This act will close IRS safe harbor Section 530 of the Revenue Act of 1978, a perceived
tax loophole that allows employers to classify workers as independent contractors rather than
employees to avoid paying full taxes.
To further address what is being referred to as a growing national problem, some states have been
proactive in enforcing worker rights. In February 2007, California Senator Alex Padilla introduced
Senate Bill 622, meant to prohibit the willful misclassification of employees as independent
contractors. The bill was ultimately vetoed in October 2007 by California's governor, Arnold
Schwarzenegger, but growing concern about worker classification in California will likely encourage a
similar bill to be passed in the future.
New Jersey, Illinois, New York and Connecticut are among states that have passed legislation to
ensure proper classification of workers. New Jersey's Construction Industry Independent Contractor
Act (CIICA), approved in July 2007, makes violators of the law subject to severe financial and criminal
penalties that could lead to imprisonment for employers who knowingly misclassify workers. In August
2007, Illinois accepted House Bill 1795, the Employee Classification Act, which mandates proper
classification of workers in the construction industry. Enforced by the Illinois Department of Labor,
financial penalties are issued for each violation and the agency has authority to ban violating
employers from receiving state contracts for four years.
New York Governor Eliot Spitzer issued an executive order in September 2007 to create the Joint
Enforcement Task Force on Employee Misclassification. The task force is comprised of the
Commissioner of Labor, the Attorney General, the Commissioner of Taxation and Finance, the Chair
of the Workers' Compensation Board, the Workers' Compensation Fraud Inspector General and the
New York City Comptroller, and shall coordinate the investigation and enforcement of all employee
misclassification matters for the state of New York.
In effect as of October 2007, Connecticut's Substitute Senate Bill No. 931 outlines penalties for
intentionally concealing employment related to workers' compensation premiums, including the
issuance of a stop-work order requiring the cessation of all business operations of the violating
And if all of the recent legislative action, lawsuits and case studies aren't eye-opening enough,
employers now have more to be concerned with, as current data analysis tools on the market, already
in use by several State Unemployment Insurance agencies, allow users to easily analyze the IRS
1099 abstract file with technology that searches and identifies triggers for an audit.
With this technology, a user can establish criteria for queries and can target employers for an audit if,
for example, a worker received only one IRS Form 1099 within one year but is paid what the agency
views as high-level income. In this case, the agency might suspect that the employer was concealing
full-time employment in order to avoid paying unemployment taxes. In the event that an independent
contractor is reclassified to employee status during an audit, the employer is responsible for all back
taxes, including employer and employee contributions and of course, applicable penalties and fines.
So when classifying that next worker, be sure to ask: Employee or independent contractor?
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