Five years ago, Microsoft settled with a group of workers who sued the software giant claiming they had been improperly classified as independent contractors. The deal cost Microsoft $98 million. These days, as companies of all kinds try to cut costs, the temptation to shift employees to the status of contract workers is enormous. Indeed, even as the economy has shed more than 5 million jobs, the number of independent contractors has actually grown to more than 9 million, suggesting some companies are doing exactly that.
Now the Internal Revenue Service has announced that it intends to crack down on what it calls "misclassified employees" with an audit program of some 6,000 randomly selected businesses that will begin in February. The IRS says that in addition to misclassified employees, it will be looking for other employee compensation violations, such as improper payment of executives' income taxes and unaccounted-for provision of company vehicles to employees or the use of company property by employees.
The IRS calculates that it may be losing as much as $20 billion a year because of misclassification of employees alone. Meanwhile, workers who are improperly classified as independent contractors end up having to pay their full Social Security tax bill, instead of only half, as well as the 2.9% Medicaid tax normally paid by employers. They also lose unemployment insurance coverage.
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For employers, the advantages of treating employees as independent contractors include not having to provide health and retirement benefits, in addition to enhanced flexibility and relief from payroll taxes and unemployment insurance premiums.
"Misclassification is always a hot issue, and it gets hotter when the government is facing a big deficit," says Terrie Weinand, chief operating officer and executive vice president of PrO Unlimited, a contingent workforce management company.
Bruce Schwartz, an attorney with the labor law firm Jackson Lewis, warns that any shift to contract labor has to be handled carefully or companies can get socked with big costs later.
"What we tell people is, if you're going to reclassify people from employee to independent contractor, do it for a business reason, not for tax reasons, and be able to justify the change," Schwartz says. "Where you run into problems is when you can't tell the difference between someone who's an employee and someone who's an independent contractor."
On the other hand, Schwartz notes that running afoul of the IRS on the employee classification issue is not all that bad in itself. "It's not a crime, they will generally look back only three years, and they generally don't even assess penalties," he says.
But Weinand disagrees, saying that besides being assessed for back taxes, companies can get socked with interest and penalties. "We find people being hit with stiff penalties," she says.
Far more serious than having to pay back payroll taxes, Schwartz says, is being assessed for unpaid unemployment insurance premiums or, as happened to Microsoft, being sued. And an adverse IRS ruling could conceivably lead to a challenge from the U.S. Dept. of Labor or a state labor department, or could inspire an employee lawsuit.
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