LEGAL GUIDE
Written by attorney Lauren Rice Burgon | Feb 15, 2012

Employee and Independent Contractor Classification - Washington State Partnership with IRS

On September 19, 2011 the U.S. Department of Labor ("DOL") and Internal Revenue Service ("IRS") announced that they had entered into a Memorandum of Understanding to coordinate their efforts regarding employee misclassification. Washington State is one of eleven states that have chosen to cooperate with this endeavor.

The Memorandum of Understanding arises out of the "Misclassification Initiative" which DOL launched in 2010 to strengthen and coordinate efforts to identify and deter employee misclassification as independent contractors, recoup unpaid payroll taxes and ensure that employees are not denied the protections and benefits of employment laws.

Historically, state and federal agencies in charge of enforcing the numerous laws regarding employee classification have not shared information or coordinated their enforcement efforts. This is changing as agencies become more aggressive in their enforcement of these laws and as state and federal governments look for opportunities to enhance their revenues.

The Memorandum of Understanding will enable DOL, IRS and participating states to share information regarding worker misclassification. This may lead to multi-pronged scrutiny and enforcement proceedings from the DOL, IRS and various state agencies, not only of certain specific workers in a company, but potentially of all the company’s payroll practices.

The Memorandum of Understanding does not impose new requirements upon employers, nor change the criteria under which companies must evaluate their workers to determine their proper classification. Instead, it allows various federal and state agencies to communicate with each other and possibly coordinate their enforcement efforts.

Washington’s Employment Security Department has previously published the following guidelines to assist companies in determine if a worker is properly classified as an employee or an independent contractor:

Service performed by an individual for compensation is employment unless it is shown that:

  • The individual is free from direction and control over the performance of the service; and

  • The service is either performed: -Outside of the usual course of business for which the service is performed, or -Outside of all the places of business of the enterprise for which the service is performed; and

  • The individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in service contract.

Or, as a separate alternative, service performed by an individual for compensation is employment unless it is shown that:

  • The individual is free from direction and control over the performance of the service; and

  • The service is either performed: -Outside the usual course of business for which the service is performed, or -Outside of all places of business of the enterprise for which the service is performed, or -The individual has a principal place of business and is responsible for the costs; and

  • The individual: -Is customarily engaged in an independently established trade, occupation, profession, or business of the same nature as that involved in the service contract, or -Has a principal place of business that is eligible for a federal income tax business deduction; and

  • On the effective date of the contract of service, the individual is responsible for filing a schedule of expenses with the Internal Revenue Service; and

  • On the effective date of the contract or within a reasonable period after the effective date of the contract, the individual has an: -Active account with the Department of Revenue, -Active account with any other state agencies, and -A Unified Business Identifier (UBI) number; and

  • On the effective date of contract of service, the individual is maintaining a separate set of books or records that reflect all items of income and expenses of the business that the individual is conducting.

http://www.esd.wa.gov/uitax/taxreportsandrates/whoandwhattoreport/independent-contractors.php

Only days after announcing the Memorandum of Understanding with DOL, the IRS announced its "Voluntary Classification Settlement Program ("VCSP"). Under this "employer amnesty" program, eligible employers’ liability for past-due employment taxes will be limited to 10% of the liability that would have been due on compensation paid to workers in the most recent tax year. In addition, the employer will not be subject to any interest or penalties on these unpaid taxes and will not be subject to IRS employment tax audits with respect to worker classification for previous years.

Under the VCSP there is no requirement that an employer acted reasonably or unintentionally in misclassifying its workers. The employer must show that it 1) consistently treated its workers (or a certain group of its workers) as independent contractors; 2) issued all required forms 1099 to these workers for the past three years; and 3) is not currently under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers. In addition, the employer must enter into a closing agreement with the IRS affirming that it will treat these workers as employees in the future.

It should be noted, however, that the VCSP applies only to employers’ liability to the IRS. It does not address other issues related to misclassifying an employee, such as state tax withholding, workers’ compensation and unemployment insurance premiums, and penalties for labor law violations such as noncompliance with minimum wage and overtime pay regulations.

In addition, submitting a VCSP application does not ensure that the application will be accepted, and it is not clear whether merely submitting an application may effectively invite an audit of a company’s employment practices. Further, the IRS has not stated its position on whether it will share VSCP information with DOL, or whether VSCP filings will be subject to public disclosure.

There is no question that state and federal agencies are continuing to increase their scrutiny of worker classifications and strengthening their enforcement of applicable laws. It is more important than ever that any company that engages independent contractors evaluate these relationships to ensure that they will pass possible agency examination.

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