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Employee Misclassification: The Stakes Are Higher than Ever

Strategic, proactive approach can fend off significant consequences



Make sure your head is nowhere near the sand these days when it comes to employee
classification. The event services industry is among those in the crosshairs of federal and state
regulators unapologetically targeting misclassification of employees (who receive a W2) as
independent contractors (who receive a 1099).
Whats the problem? Why is it happening? What are the consequences and how can you
avoid them? This LASSO White Paper answers these and other questions. We take you inside
one company that went through the sometimes painfulbut ultimately positiveprocess of
reclassification.
High beams are on
For many business owners, employee classification has been pretty much a non-issue. But
thats changing fast as the IRS, the federal Department of Labor (DOL) and the states focus
their attention and regulatory might on the issue. DOL launched a formal reclassification
initiative in 2011, which continues and extends to the states as well.
A 2009 report by the Government Accountability Office (GAO) concluded that
misclassification of independent contractors cost the federal government $2.72 billion.
Estimates of misclassification range from 10 to 50 percent or higher, depending on the
industry.
The heightened scrutiny reflects the desire of the federal government and municipalities to
collect taxes owed to them. But thats not the only issue. According to DOL, Misclassified
employees are often denied access to critical benefits and protectionssuch as family and
medical leave, overtime, minimum wage and unemployment insuranceto which they are
entitled.
Attorney Michael Sontag, a member of the law firm of Bass, Berry & Sims, PLC, explains, The
general rule is that an individual is an employee if the employer has the right to control or
direct the work thats done and how it will be done. This applies even if the workers have
freedom of action, which is typical in the event services industry.

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Some businesses mistakenly believe that bringing on staff for a brief period
even a couple of dayswarrants a 1099. But in fact, the key determinant is
whether the employer has the legal right to control the details of how services
are performed, not the duration of employment.
As part of the misclassification initiative, DOL and IRS are collaborating and communicating in
important ways. Consider the example of a videographer who worked for an event
production firm as an independent contractor. Years later, his application for unemployment
benefits was denied because the state labor department discovered he had not been
classified as an employee and, as such, was not entitled to benefits. The state informed the
IRS, which launched a review of not only his situation, but the employment status of everyone
else on the payroll.
Suddenly the business faced a litany of possible penalties including fines for each unfiled W2
or 1099, fines for each instance of misclassification, unpaid overtime and unpaid state and
federal payroll taxes. With a look-back period of seven years of compounded interest and
penalties, the cost can quickly spiral out of control. Employers charged with misclassification
can face criminal charges and civil penalties as well.
Why so much misclassification?
Most business owners slip into the problem over time rather than set out to deliberately
misrepresent. Employers have cyclical needs and dont want to put large numbers of people
on the full-time payroll, Sontag explains.
As the business expands, a sound tech who had worked one day a month may soon be flying
across the country to help produce events eight, nine or 10 days a month for the same
company. Before long that individual is working 30 or more hours but continues to receive a
1099.
With the Affordable Care Act (Obama Care) now the law of the land, the 30-hour threshold
also triggers a requirement that the employer pay for that workers health care. This
represents a serious complication and another opportunity for employers to misstep.
Reclassification case study
Attorney Sontag helped a national technology and staging company grab the
misclassification bull by the horns and wrestle it to the ground. According to the owner of
the 20-year-old business, there were over 200 independent contractors on the payroll when
classification was red-flagged during a routine, annual audit by an outside accounting firm.
The owner asked his attorney, Sontag, who agreed that the number of 1099s was high and
that concern was warranted. Together they conducted a thorough review of federal and state
rules and an analysis of all contingent workers to assess the role each played in the business,
how they were managed and who controlled their work activities on a daily basis.

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While the contingent workers pursued a wide variety of tasks, the decision about
classification ultimately hinged on the common denominatorthe fact that the
company controlled their diverse activities. Despite determining that they should
all be considered employees, Sontag and the owner acknowledged
considerable ambiguity in the test questions involved.
A complicating factor was that the qualifying tests used by the federal government to
determine employment status differ from those used by the states, which are dissimilar from
one another. The owner explained: Its easy to get a false sense of security in our industry.
For example you may pass a state audit for independent contractor status and believe
mistakenlythat you are clear on the federal level. Just because a tech or producer provides
his or her own equipment or is incorporated does not necessarily mean that individual is an
independent contractor. In our case we needed to consider them employees because we
were controlling the work.
The decision, he says, hinged on doing what was right and lawful, not on doing what was
best for the business.
Satisfactory compromise
Sontag laid out the options clearly. He explained that the owner could continue along the
path he had been on for years and maybe never hear from the IRS. But if some day he wanted
to sell the company, a prospective buyer might identify this as a potential liability that could
negate a sale. He adds, I also knew that the more we grew, the worse the problem could
become.
Sontag structured a solution in which the employer took advantage of a safe harbor
provisionSection 530 of the IRS code. Under this voluntary option employers are relieved of
their liability to pay past taxes for misclassified employees if certain eligibility requirements
are met. In exchange the 1099s are permanently reclassified as employees. The IRS also
offers the Voluntary Settlement Classification Program (VSCP), another amnesty style option.
As for the cost of reclassifying, the owner concluded that though the business would have to
start paying taxes for the employees, this was a financial tradeoff worth making against the
possible exposure of keeping them as 1099s because the risk is far greater. He also
considered the high cost of going to the mat with the IRS.
Peace of mind played into the decision as well. If we sat around and hoped nothing ever
happenedthe proverbial head in the sandI didnt want to wake up one day and see IRS at
the door with the potential to look back seven years. This way we had less exposure and
more control over the outcome.

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Surprisingly, the cost of converting to W2 status was not as high as the business
owner had feared. One reason was the savings on overtime previously paid to
1099s. Independent contractors receive overtime after eight to 10 hours a day
depending on the state, but when they become employees, they receive
overtime only after the 40th hour in a given week.
New landscape
Things have changed and inaction is no longer an option. Federal and state agencies are
more aggressive on the issue of classification and many employers in the event services
space have not yet adapted their policies to this new landscape. The Affordable Care Act
adds yet another new dimension.
The good news is that there are significant benefits to be gained by making these hard
choices. For the business owner in this case study these included:
Knowing the business is on solid legal ground.
Sidestepping a potentially thorny and costly employment issue that could have
become a larger business problem.
Attracting an upgraded workforce with younger, talented employees signing on.
Giving employees the sense that they are a real part of the organization and it success.
A potentially better client experience because employees are more engaged.
As you grapple with the classification issue, make sure you have the tools and expertise to
support your growing company and keep it out of some potentially very hot water.
Learn more at www.lassoworkforce.com.

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