Joining forces, the U.S. Department of Labor (DOL) and the Internal Revenue Service (IRS) recently announced a Memorandum of Understanding (MOU) to coordinate efforts to resolve employer practices of misclassifying employees as independent contractors. In addition, authorities from 11 states, including New York, Illinois and Washington, have either agreed to the MOU or have agreed to execute separate MOUs with the DOL’s Wage and Hour Division (WHD). At a signing ceremony hosted by the DOL, Secretary of Labor Hilda Solis stated the “message” of their coordinated effort was that these agencies were “standing united to end the practice of misclassifying employees.”

The MOU is one result of a report released by the General Accounting Office (GAO) entitled “Employee Misclassification – Improved Coordination, Outreach and Targeting Could Better Ensure Detection and Prevention.” In its report, the GAO described the impact of misclassifying employees as independent contractors on various factors, including:

  1. Federal programs, such as Social Security and Medicare
  2. State programs, such as unemployment insurance and workers compensation
  3. Misclassified workers who are not properly paid for overtime

The GAO estimated employee misclassifications cost the federal government $2.72 billion in 2006. In addition to increased enforcement by the WHD to combat the practice of misclassifying employees as independent contractors, the GAO recommended that the DOL and the IRS “establish a joint interagency effort with other federal and state agencies to address the misclassification of employees as independent contractors.”

This consolidated approach is further evidence of earlier announcements by these agencies of their intent to work together and should serve as warnings to employers. Pursuant to these MOUs, the DOL and its WHD will share with participating state agencies, as well as the IRS, when its investigations reveal instances of employee misclassification. Likewise, the IRS and state agencies will report instances of abuse of the independent contractor status to the WHD for potential enforcement activities under the Fair Labor Standards Act (FLSA). For example, should the IRS (or a participating state workers compensation program) audit an employer that classified workers as independent contractors and assess unpaid taxes (or premiums due) as a result of misclassification, these entities will, pursuant to the MOUS, share the misclassification information with the WHD. The WHD, in turn, is free to conduct its own investigation under the FLSA to ensure that such employees were paid correctly for all hours worked. The industries targeted by the WHD, the IRS and participating states are construction, day care, health care, lodging, janitorial and restaurant entities.

As part of its announcement, the IRS unveiled its Voluntary Classification Settlement Program (VCSP), on Sept. 21, 2011, for eligible employers who erroneously classify their employees as independent contractors. Under the VCSP, the IRS will waive part of an employer’s employment tax liability, as well as some interest and penalties, and will exempt the employer from an employment tax audit for misclassified workers in prior years. To qualify, an employer must currently treat misclassified workers as independent contractors, must have filed the proper Form 1099 documents and can not be the target of a classification audit by the WHD or a state agency. What the IRS fails to warn employers, however, is that it will notify the WHD and (possibly relevant state agencies) of the employer’s misclassification practices, thus in all likelihood triggering additional audits and investigations finding backwages due, penalties and other unintended consequences imposed by WHD and other state agencies.

To minimize a company’s entrapment in this independent contractor initiative, an employer should consider the following actions:

  1. Audit the company’s classification of independent contractors to assess whether any should be treated as employees. Be aware that the test of whether a worker is an employee rather than an independent contractor derives from the broad “joint employer” rules under the FLSA. Those rules look at the economic realities test to determine whether a person is “suffer[ed] or permit[ted] to work” and acts “directly or indirectly” on behalf of an employer’s interests. To complicate the area, the standards for the IRS and under various state laws are not necessarily the same and often differ.
  2. Review written agreements with independent contractors to document the job or tasks for a contractor to perform, identify expected results, provide contractor’s with the discretion to perform their work, etc. If an employer does not have a written agreement, he or she  should consider instituting them.
  3. Monitor the manner in which the employer treats his or her  employees versus independent contractors to maintain distinctions and to avoid over-utilization of independent contractors.
  4. Review relationships an employer may have if he or she uses “temporary” employees from a staffing company or leases employees from a professional employer organization (PEO) to assess any joint employment risks.
  5. To the extent that an employer seeks to reclassify independent contractors as employees and participate in the IRS’ VCSP, evaluate the hours worked and compensation paid to these workers as independent contractors to quantify potential back wage exposure under the FLSA before participating.
  6. Verify whether any state law might apply. For example, California recently enacted a comprehensive independent contractor statute including civil as well as criminal penalties.

While the IRS is on the hunt for tax dollars left on the table, the WHD is aggressively looking for violations of the FLSA by employers misclassifying workers as independent contractors to provide them labor law protections such as minimum wage and overtime as well as other state law benefits such as unemployment benefits and worker compensation. Employers should evaluate their worker classification practices and make appropriate changes to comply before one of these agencies knocks on their door.