Employee or Independent? A Word of Warning for All Employers (Especially in North Carolina)

by Nancy Owen, PHR and Laura Pokrzywa

Though the issue is one of concern for all organizations, employers in North Carolina should be especially concerned regarding misclassification of an employee as an independent contractor.

According to the Internal Revenue Service (IRS), millions of workers across the country are currently misclassified as independent contractors. Some employers are careless with classifications because treating the employee as an independent contractor allows the employer to escape paying social security, medicare, unemployment and payroll taxes. In fact, the IRS estimates that some employers save more than $43,000 per year in taxes by misclassifying employees.

When it comes to misclassifications, the employer’s gain is the government’s loss. In addition, employees who are improperly classified stand to lose important workplace protections such as the minimum wage, overtime compensation, unemployment insurance, and workers’ compensation. In their continuing efforts to stem the tide of misclassifications, the IRS teamed up with the Department of Labor (DOL) to share information. But the teamwork doesn’t stop there. Last month, North Carolina’s governor signed into law the North Carolina Employee Fair Classification Act. A portion of this law addresses worker classifications and will take effect at the end of this year.

The definition of “employee” and “independent contractor” remain unchanged under North Carolina’s new state law, but it creates a new section of the North Carolina Industrial Commission. The Employee Classification Section makes it easier for the state to pursue employers who misclassify their employees by providing for the sharing of information among various state agencies.

State Licensing boards will also be required to ask applicants to disclose any investigations for state employee misclassification along with the outcome of the investigation. Failure to comply will result in denial of the license or permit.

North Carolina’s posting requirements will also change as of the end of 2017. North Carolina employers subject to the Wage and Hour Act will be required to post amended posters that address provisions related to independent contractors. The new language includes instructions for employees who believe they have been misclassified as an independent contractor to report the suspected misclassification to the state Employee Classification Section within the Industrial Commission. The poster offers further instructions for the employee to include the physical location, mailing address, telephone number, and e-mail address where alleged incidents of employee misclassification occurred.

As ECRM’s Renee Mielnicki, Esq. explains in a December 2013 blog post, “Employers are left to decide whether or not it’s worth it to misclassify an employee given the consequences. Even if misclassification is unintentional, the penalties remain the same. Some estimate that if an employer gets hit in an audit for misclassification, the penalty may be as much as 40% of the Form 1099 gross amount. For small business owners, this may force them to close their doors. The best practice is then to first determine proper classification as an employee or an independent contractor.” She also explained that employers who are audited by the IRS and found to have misclassified an employee will be forced to pay back taxes, with interest, and a penalty.

In an effort to help employers do the right thing, in 2015 the DOL’s Wage and Hour Division issued an Administrative Interpretation that sought to clarify the definition of “independent contractor”. The DOL’s 15-page Interpretation of the Fair Labor Standard Act (FLSA) referred employers to the multi-factor “economic realities” test developed by the Supreme Court and Circuit Courts of Appeals to determine whether a worker is an employee or an independent contractor under the FLSA. Please note that the DOL warns these factors should not be applied as a checklist but should be considered in total, as they relate to each other. No one factor should be over-emphasized. The factors typically include:

A.  the extent to which the work performed is an integral part of the employer’s business;
B.  the worker’s opportunity for profit or loss depending on his or her managerial skill;
C.  the extent of the relative investments of the employer and the worker;
D.  whether the work performed requires special skills and initiative;
E.  the permanency of the relationship; and
F.  the degree of control exercised or retained by the employer.

Employers who believe that they have misclassified workers as independent contractors may be able to correct the issue courtesy of the IRS’ Voluntary Classification Settlement Program (VCSP). If they qualify for the program, the employer may voluntarily reclassify a worker as an employee and pay a penalty of only 10% of the employer’s tax liability. No other interest or penalties will be charged. The employer also must agree to treat the worker as an employee in the future and pay the proper taxes.

In her 2013 article, Mielnicki offered a warning to employers who might be considering this program. “Before deciding to voluntary enter the VCSP program, employers should be aware of its potential downfalls. Misclassification could expose the employer to wage and hour violation claims by a worker now classified as an employee which could impose further liabilities for benefit or compensation claims. This is especially true in light of the IRS’s partnership with the DOL to share misclassification information. Then what should an employer do? Employers should first analyze whether their current classifications are correct. If they are not, before applying for the VCSP, the employer should weigh the potential costs of entering into the VCSP and the potential for exposure to other liabilities in litigation as compared to the costs of continued non-compliance and the potential of a future IRS audit.”

If you are an employer with questions, please contact East Coast Risk Management at 724-864-8745.

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