Over the past several years we have been advising our labor and employment law clients to exercise caution in the appropriate classification of individuals who provide services for them. This comes in two parts: proper identification of employees as either exempt or non-exempt for overtime purposes; and properly classifying workers as either employees or independent contractors.
With respect to the proper classification of employees as exempt or non-exempt for overtime purposes, the Department of Labor (DOL) has been very active in reviewing how businesses categorize their employees and whether their pay and duties conform with the strict requirements for exempt status under DOL regulations. In most cases, these issues arise because the employees are not performing duties that qualify for exempt status. Many employers have restructured their work places to accommodate new technologies, expand performance requirements, and meet changing business demands. However, many times, changing the duties of an individual may destroy a person’s exempt status and result in overtime requirements.
The misclassification of workers also involves hiring persons as independent contractors when they are really employees. According to recent estimates, some 3.4 million workers are considered independent contractors who should be classified as employees. The Internal Revenue Service (IRS) has a vested interest in this misclassification as it estimates a tax revenue loss of $2.7 billion each year in withholding taxes. The failure to properly classify workers as employees as opposed to independent contractors not only has federal employment tax implications but also can affect a business’ unemployment tax and employment benefits programs and contributions. To obtain more rapid enforcement, the DOL and the IRS have entered into a memorandum of understanding (MOU) to share misclassification information with each other as well as with applicable state agencies. Consequently, employers should anticipate that whatever information is given to one agency will be readily available to all other state or federal agencies.
In addition to the announcement of the MOU between the IRS and the DOL, the IRS has recently launched a new Voluntary Classification Settlement Program (VCSP) that will allow employers to reclassify their workers as employees for federal employment tax purposes. The VCSP is available to businesses, tax-exempt organizations, and government entities that are not currently under audit by the IRS, or under review by the DOL or applicable state agency regarding the classification of workers. Additionally, the business must have treated the workers consistently as non-employees and filed all required Forms 1099 for the previous three years.
Participation in the VCSP requires a business to agree to pay 10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Section 3509 of the Internal Revenue Code. Businesses will not be liable for penalties or interest, and will be exempt from an employment tax audit for worker misclassification in prior years.
While the VCSP may provide some benefit to businesses with independent contractors whose status is actually uncertain by allowing those businesses to limit their federal employment tax liability due to the misclassification, it provides no limitation to exposure for unpaid overtime, unemployment tax, workers compensation, etc. Considering the new MOU for sharing information, the VCSP may potentially result in participants increasing their misclassification liability.