In this issue of Compliance Capsule, we begin a series on the differences between triggers of misclassification claims vs findings of misclassification.

Understanding the distinction between the two helps organizations focus their compliance efforts on what really matters.

While both are important to understand and to avoid, there are key differences between the two that shape and direct management best practices toward mitigating the associated risks. 

First, let’s define employee misclassification and the risk organizations face in terms that will help us understand and develop strategies for avoiding both triggers and findings.

Note: I refer to US agencies here for ease of description, but this definition and this explanation of risk can and do apply to all countries throughout the world - they just have different names for the agencies governing employee classification in their respective countries. 

Employee Misclassification Defined: When a company engages a worker as an independent contractor but manages them as an employee.

There is a lot more to what misclassification can look like but this is the simplified version. (See how the DOL and IRS define misclassification.)

Why is Misclassification a Risk?

There are two primary reasons why the IRS, the DOL (Department of Labor), and numerous other state and federal agencies, invest so much of their resources to identify and prevent employees being improperly hired as independent contractors: 

1. Tax Revenue: There is a material reduction in state and federal income taxes when a worker is paid as an IC vs. as an employee.

   
   

   The leading driver of lost tax revenue is because the IC worker can reduce their taxable income with their own business expenses, while an employee cannot.

   
   

   Additionally, the avoidance of employer side payroll taxes is a key driver for organizations to engage workers as ICs vs employees - it costs less to hire an IC.

   
   

2. Worker Rights: US employment and labor laws are in place to protect workers in the workplace from abuses by the employer.

   
   

   To name just a few key ones for context here - overtime pay, minimum wage pay, paid time off, maternity / paternity leave, safe working environment, Title IX protections, etc.

   
   

   Employees are the constituents of these employee-focused agencies (DOL, state workers compensation commissions, unemployment commissions, etc.), so its their job to ensure employees aren’t misclassified as ICs and left unprotected from employee rights.

As we delve into triggers and findings, we will refer back to this definition and the regulators’ objectives to demonstrate how each trigger ties back to the risk of misclassification.

And we will present management practices, tips and recommendations in the context of this definition of misclassification to help your organization avoid both and stay compliant. 

Misclassification Claim Triggers

Triggers are events or behaviors that initiate or may lead directly to an inquiry or investigation regarding a claim of potential employee misclassification.

Think of these as red flags or indicators of an underlying issue that the regulators of employee misclassification are on the lookout for.

Some triggers can be adequately controlled by the organization while others cannot be.

Some triggers are the result of the contractor’s actions and therefore out of the organization’s control.

It is for this reason that we classify triggers as client triggers - ones that the organization can mostly control themselves - and contractor triggers, risks the client organization has little to no control over. 

Client Triggers

Here I share a few real life examples of client actions or behaviors that can (and often do) trigger misclassification inquiries from regulatory agencies and some strategies to avoid or minimize their risk to the organization.

Conflicting Tax Filings 

The IRS (Internal Revenue Service) knows when a taxpayer with the same SSN (social security number) receives a W-2 wage statement and a form 1099-NEC (nonemployee compensation) in the same tax year.

These two tax filings are required to be filed by the employer organization with the IRS and state taxation departments.

The W-2 reports salary or wage-based income paid to an employee during the tax year and includes the tax withholdings the organization has made and paid to the IRS and state income tax departments.

The 1099-NEC is a statement of the income paid to an independent contractor and almost always indicates that no taxes have been withheld against the income paid.

When an organization makes these two tax filings for the same worker in the same tax year, this is what the IRS (other regulators) see and rightfully interpret it to mean: 

• The W-2 is evidence of an employer-employee relationship; and

• The 1099-NEC is evidence that the worker has been engaged and paid as an independent contractor or IC.

These are two conflicting data points that suggest a potential misclassification of a worker, one that was once classified as an employee and that is now being classified as an independent contractor.

The IRS monitors tax filings for just this kind of situation because it begs the following questions:

• Which happened first? Employee or IC?

• Is the IC performing the same work as they were when they were a W-2 employee?

• Are there other employees performing the same work as the IC?

• What happened to cause the change?

The IRS specifically addresses this situation, asks some of these same questions on the IRS.gov website. 

Also, it matters whether the worker was an employee first and then transitioned into the IC classification or vice versa.

When a company converts an employee to an IC, the IRS tends to look at this as an avoidance of employee tax withholdings and an avoidance of employer side payroll tax obligation.

These are the red flags that really capture their attention and lead them to making those initial inquiries.

Note that inquiries may be made to the company or directly to the worker.

To see how the IRS and other tax authorities look at this, consider the reverse, which is not a red flag.

When a company converts an IC to an employee, they are actually removing an IC and replacing it with an employee who pays more taxes, has taxes withheld and requires employer payroll taxes.

For the IRS and state tax authorities this is a win. The company has in effect reclassified the worker on their own. 

Next Issue

In the next issue of The Compliance Capsule we will take a closer look at some of the most damaging, yet relatively easy to avoid triggers of misclassification inquiries and claims: management practices.

And before we transition our focus to contractor behaviors that trigger claims, we will present our top 5 list of actions to safeguard the organization against unnecessary risks of employee misclassification. 

Until next Wednesday, stay compliant and be happy.