California Labor Law and Misclassification with the IRS

Oakland, CA If your business uses independent contractors, you would be wise to determine that they aren't misclassified as employees before the IRS knocks at your door. According to federal law and the California Labor Law, "You may be at risk for an employment tax audit," says attorney Leonard Emma of The Law Office of Randall Crane.

There are many temptations for businesses to classify workers as independent contractors instead of employees. Emma says the main reasons are the following:

• to shift the cost of employment taxes to workers,
• to avoid paying employee benefit costs, and
• to eliminate responsibilities under employment laws, such as civil rights or wage and hour laws.

"However, employers who are determined to have misclassified their workers as independent contractors risk drastic tax liabilities to the IRS, among other potential liabilities, penalties and costs," warns Emma. "Worker classification is a high-stakes decision that affects all industries. The IRS and courts have found workers to be employees in job positions ranging from software engineer to truck driver and from real estate loan officer to exotic dancer."

The IRS recently stepped up employment tax audits in an attempt to close the tax gap, including audits in California, and one of the areas targeted for review is the classification of workers as independent contractors instead of employees. If your business uses independent contractors, you should consult with an employment attorney to evaluate your exposure.

Emma says that the IRS can determine whether your independent contractors are employees and demand unpaid employment taxes, so it's advisable that you examine how you have classified your workers sooner than later.

The IRS method for distinguishing between independent contractors and employees is complicated??"again, an attorney can help you navigate both the IRS "test" and the California labor code. Emma explains that the IRS considers a multi-factor test based on how much control the employer exerts over the worker. "The multi-factor test is broken down into three general categories: (1) Financial Control, (2) Behavioral Control, and (3) Type of Relationship. The factors include, among other things:

• the extent of instructions provided to the worker
• the extent of training provided to the worker
• the extent to which the worker has unreimbursed expenses
• the extent of the worker's investment
• the extent to which the worker makes services available to the relevant market
• how the business pays the worker
• the extent to which the worker can realize a profit or loss
• written contracts describing the relationship the parties intended to create
• whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay
• the permanency of the relationship
• the extent to which services performed by the worker are a key aspect of the regular business of the company

The test is applied on a case-by-case basis. Businesses that misclassify their workforce are subject to retroactive tax withholding, penalties and interest," says Emma, who adds that all hope is not lost if your business is audited and a tax examiner determines your workers are misclassified. "You may contest the finding and seek relief under the safe harbor provided by Revenue Code Section 530."

The Section 530 Safe Harbor

"If your business has been consistent in treating workers as independent contractors and has a reasonable basis for doing so, you may be eligible for 'safe harbor' relief under Section 530 of the Revenue Act of 1978," says Emma. "For employment tax purposes, a business may treat an individual as an independent contractor rather than an employee if:

• The business does not treat any other individual holding a substantially similar position as an employee for purposes of employment taxes for any period; and

• All required Federal tax returns are filed by the business on a basis consistent with its treatment of the individual as an independent contractor (e.g., using Form 1099); and

• The business has a 'reasonable basis' for not treating the individual as an employee."

IMPORTANT NOTE: Section 530 provides relief from payment federal employment taxes only but not, for example, lawsuits from workers.

Increasingly, worker classification is garnering more attention in the state of California. Many state officials are facing record budget deficits so they are starting to aggressively pursue companies that try to pass off regular employees as independent contractors. "Well-intentioned businesses will continue to get caught in the crossfire," says Emma, "and the financial exposure can be drastic."

If your business uses independent contractors, you should consult with an attorney to conduct an audit and evaluate your exposure.