April 19, 2010 | last updated May 29, 2012 6:48 pm

Self-Audit On Independent Contractors Can Avoid Surprises

Many companies utilize 1099 contractors to supplement traditional W-2 employee workforces. If done correctly, this can be a useful method for controlling labor costs and engaging needed expertise.

However, some companies either negligently or intentionally violate the law by misclassifying workers as contractors instead of employees.

In light of such abuse, federal and state agencies have announced plans to crack down on such arrangements, stepping up enforcement, and increasing penalties. As a result, the likelihood employers paying individuals on a 1099 basis will be audited by either the federal or a state Department of Labor agency has increased dramatically.

For government officials, this is predominantly an issue of lost tax revenue. Employers do not withhold income taxes from the pay of independent contractors. They also do not pay the employer portion of Social Security and Medicare, and do not pay unemployment insurance or workers compensation contributions for independent contractors.

Government authorities also cite a social component as a reason for this crackdown. In general, independent contractors do not enjoy the protection of wage and hour laws providing for overtime and minimum wage, or fall under the umbrella of employment anti-discrimination statutes. In addition, they are not eligible for employee benefits such as health insurance, company-sponsored retirement or incentive plans, paid vacation or sick leave.

Employers who misclassify employees as independent contractors may be liable for back taxes including unemployment, income taxes that should have been withheld and paid over to the government, and Social Security and Medicare taxes. In addition, companies found not in compliance will have to pay interest on these amounts and may be subject to additional penalties. If the misclassification is found to be willful, the employer may be subject to criminal liability.

The Connecticut Attorney General issued a statement in February proposing that, in addition to back taxes and interest, employers who misclassify workers be subject to a fine of $300 per day per independent contractor. If this or similar legislation is passed, Connecticut employers who rely on independent contractors could face significant liability.

The 'ABC' Test

There are strict tests for whether an individual is properly classified as an independent contractor. Connecticut law sets out a test commonly referred to as the "ABC Test" under which the worker must:

• Be free from the direction and control of the employer in the performance of the service, both under the contract of hire and in fact when performing the services;

• Perform the services outside of the employer's usual course of business or outside of the employer's place of business; and

• Be customarily engaged in an independently established trade, occupation, profession, or business of the same nature as the service being provided.

The federal government will consider similar factors including the employer's right to direct and control how the contractor performs the job; the financial relationship between the business and the independent contractor; any written contracts; whether the business provides the contractor with vacation or benefits; and the extent to which the contractor provides services that are a key aspect of the employer's regular business activity.

The most critical factors under both federal and state law are the extent to which the company controls when and how the independent contractor does the work, and whether the contractor is performing services that are traditionally performed by employees.

Next Steps?

Employers can conduct their own audit to determine if independent contractors are properly classified. However, it is a good idea to work with an employment attorney so steps can be taken to protect information developed during the audit, and ensure that classifications are consistent with applicable law.

A self audit should, at a minimum, include the following steps:

• Identify independent contractors;

• Review written agreements to determine how the contractor relationship is structured;

• Examine documentation related to how the contractor is paid;

• Consider the type of services performed by the contractor and whether employees perform similar services;

• Determine how the contractor performs the services, e.g., does the contractor perform the services on company premises; does the company provide necessary equipment and other resources; does the company direct when, where, and how the services are performed; and

• Consider how long the contractor has performed services for the company and whether the contractor was engaged for a specific project or is performing ongoing services.

Employers should also develop a formal procedure for hiring independent contractors, including working with counsel to ensure lawful use of contractors, establish guidelines for hiring contractors, and develop a written independent contractor agreement.

Mitchell L. Fishberg is a partner and Catherine Moreton Gray an associate in Robinson & Cole LLP's Labor, Employment, Benefits, and Immigration Practice in Hartford. Reach Fishberg at mfishberg@rc.com and Gray at cgray@rc.com.

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