Companies large and small continuously seek ways to manage and control expenses. Business owners often focus on payroll expense because it is, for many businesses, one of the largest expense items. Replacing employees with independent contractors is one way to reduce payroll expense, but it is not without risk. The Internal Revenue Service uses a list of 20 questions to determine whether an individual is an employee or an independent contractor.
An affirmative answer to even one of these questions (except the question about profit and loss to the worker) may result in a finding that the worker is an employee, and misclassification can result in a requirement that the employer pay 100% of the misclassified worker’s FICA, FUTA and federal income tax for the period of misclassification. If the IRS brings in the state taxing authorities, the employer could also be required to pay 100% of state income and unemployment taxes, and worker’s compensation payments. Add on interest on the back taxes, and any penalties imposed by the federal and/or state taxing authorities, and the cost of misclassification can present an existential risk to a business.
Misclassification of Workers Revisited
I’ve written about this topic before, but two recent developments make this a good time to revisit misclassification and its consequences. The first concerns a federal appeals court case, and the second what could be the beginning of a trend among state taxing authorities to investigate how businesses classify workers.
In two cases involving FedEx Ground Package System, Inc. in August of this year, the United States Court of Appeals for the Ninth Circuit found that FedEx had improperly classified route drivers as independent contractors because the company exercised an impermissible degree of control over how its drivers’ appearance, dress and vehicles; how and when the drivers delivered packages, and what the drivers must do to “foster the professional image and good reputation of FedEx”. In short, FedEx had entirely too much control over what the drivers did in the course of a workday, and how they did it, to satisfy the classification test.
The FedEx cases apply to approximately 2,300 drivers in California and Oregon, but because the Ninth Circuit decision reversed a lower court decision with respect to 42 lawsuits filed across the country, the ramification of the Ninth Circuit decision will be felt far beyond California and Oregon.
Significant Impact on State Budget
Because businesses do not withhold for federal and state income taxes, and do not contribute to state unemployment and worker’s compensation funds with respect to independent contractors, misclassification of workers has a significant negative impact on state budgets. In an effort to reduce that negative impact, Virginia and Pennsylvania have recently announced interagency efforts to reduce misclassification and payroll fraud. Both states will undertake a review of relevant law and regulation, and examine current enforcement procedures. In a related development, Illinois reported that its enforcement efforts have been the most productive of any state, with more than 3,000 audits that identified nearly 20,000 workers who had been misclassified.
Taxing authorities in other states are sure to take note of the developments in Illinois, Virginia and Pennsylvania, as well as the Ninth Circuit decision, and we could very well see an increased focus on enforcement in other states as well.