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Navigating The 1099 Independent Contractor Compliance Landscape


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        <h2><strong>Saving your company from ruins due to worker
<p><strong>Executive Summary</strong></p>
<p>Over the years, full-time employees in the United States have enjoyed
the fruits of long-term employment benefits where a good majority of the
baby-boomers practically worked for a single employer until retirement.Â
However, business circumstances have lead to a new trend in the industry
over the last 2 decades where companies have adopted a contingent
workforce comprising of independent contractors in almost every industry,
including IT or Information Technology.</p>
<p>From the business perspective, this was welcomed and embraced by
employers who saw opportunities to enhance their bottomline due to
perceived or realized cost savings from this new industry practice. The
use of these contingent workforce enabled high scalability for companies
to wind-up or wind-down resourcing depending on business demands. Add
to that the realized benefits due to decrease in amount of employment
taxes and costs of employee benefits, and exempting the companies from
responsibilities under the traditional labor laws.</p>
<p>However, as years pass by, the concept of contingent workforce was so
over-used which can lead to significant risk exposure for companies who
misclassify independent contractors. This was obviously attributed to
their lack of understanding on the underlying differences between an
independent contractor and an employee. The grey area had since grown
much wider and complicated as interested parties took notice of it and
started asking the right questions.</p>
<p>While most companies understood that such worker misclassification
have penalties such as increased tax liabilities, this is just the icing
and not the cake. Some employers have not yet considered the full
devastating impact of other problems it can bring to them such as unpaid
benefits, attorneys and court fees, etc. To sum it all up, the total
business impact of worker misclassification can actually cost these
companies their whole business.</p>
<p>However, proactive initiatives by companies to conduct third-party
audits bring in good value to their organizations. This is especially
so in order to understand better and mitigate risks involved in employing
these independent contractors. In the recent years, we can take a look
at actual cases related to workers misclassification and gain a deeper
insight on the complexity of the issues, and how your company can avoid
the pitfalls of erring companies in the business.</p>
<p><strong>FedEx: A Case of Independent Contractor
<p>The company received a bad news from the Internal Revenue Service
(IRS) on December 22, 2007 with regards to independent contractor
misclassification issue. The IRS has assessed approximately $319
million in back taxes by FedEx for tax year 2002 due to misclassifying a
great number of FedEx Ground/Home Delivery drivers as “independent
contractors― instead of as employees. FedEx has disclosed this
decision of the IRS in its recent filing with the US Securities and
Exchange Commission. The $319 million assessed liability was only for 1
tax year, you must understand, and it can still increase when the IRS
start looking at their other tax years for similar infractions. Class
action lawsuits against FedEx have also increased in number around the
country, and over 50 lawsuits were consolidated at a federal court in
South Bend, IN. The class action involving around 14,000 current FedEx
Ground/Home Delivery drivers nationwide may still grow with inclusion of
additional 10,000 former drivers. In California, FedEx’s position was
further challenged as the California Supreme Court released its decision
on the case Estrada vs. FedEx which affirmed an Appeals Court ruling that
FedEx Ground/Home Delivery drivers were indeed misclassified as
independent contractors instead of as employees of the company.</p>
<p>While FedEx has been largely considered as the common example for
worker misclassification, it used to be Microsoft Corporation who carried
that bill for a while back then. Sometime in the late 1980s, the
company employed around 1,000 workers under the category of independent
contractors. As part of their processes and procedures, those workers
signed an agreement that affirms their being independent contractors, and
that they were not entitled to the company’s Benefits Program for
employees. The IRS conducted an audit on the company during the 1989
to1990 tax year, and found that those workers classified by the company
as independent contractors should actually be employees. The IRS
findings were based on Microsoft’s inherent ability to “exercise
direction and control― over the services performed by those workers.Â
Thus, Microsoft decided to comply and paid employment (back) taxes for
the workers and even hired some of those workers as employees. However,
Microsoft’s woes did not end there when a group of those former
“independent contractors―, now employees, demanded for benefits that
they could have enjoyed during the specific period they were classified
as independent contractors. While the company disputed the claims,
around 8 of those employees sued Microsoft (Vizcaino vs. Microsoft) for
the right to participate in the Benefits Plans. Microsoft settled the
suit in December 2007 in the amount of $97 million.</p>
<p>Looking at the two examples above, the issues resulting to worker
misclassification infractions were not new at all. And they illustrate
the continuing legal trend in the industry with regards to worker
misclassification. Problems continue to hound the conflicting
interpretations of the legislation and the ambiguous guidelines followed
by federal and state agencies to enforce the law on worker
misclassification. In September 12, 2007, then Sen. Barack Obama
introduced Senate Bill 2044 known as the Independent Contractor Proper
Classification Act of 2007. The bill is still pending in the senate,
and related bills were also introduced such as HR 6111 and S.3648. With
the proponent of the bill now sitting as President of the United States,
it may not be long before S.2044 becomes a landmark legislation that will
affect all industries using and benefiting from contingent workforce.</p>
<p><strong>So, who are the Independent Contractors? Who are the
<p>In distinguishing between an independent contractor against an
employee, the degree of “control and direction― over the worker plays
a key part. This particularly with regards to the degree of control
exercised by the employer over the manner and means that service is to be
performed by the worker. A real independent contractor is a master
craftsman, they are qualified experts in their trade, with verifiable
professional credentials and do not need any degree of “control― over
their manner and means to perform their services.</p>
<p>Employees, however, would usually require basic to advanced training
or instructions on how to perform their work assignment. This also
includes instructions on designated hours of work, production rate, and
the work area assignment among others. Potential risks happen when the
employer’s degree of control over the work output (per independent
contractor relationship) crosses the line over the manner and means of
performance of the work output (showing an employee relationship). Not
all members of employer’s supervising team are appreciative of those
salient nuances which can really be ambiguous especially during times of
tight deadlines to meet.</p>
<p>It is when these dividing lines merge or the distinction blurs, such
can easily fall prey to scrutinizing eyes of the independent contractors
themselves, the employees, or other interested parties such as federal or
state agencies, union organizers, labor lawyers, etc. which may lead to
further scrutiny. And when these parties identify that a company may be
misclassifying workers, they will make allegations of an employee
relationship violation resulting to aggravated risks on the part of the
<p>Among the things often looked at in this case are the degree of
control exerted by the company over the worker’s time and work hours,
the degree of assistance given by the company’s employees to the
independent contractors to perform their services, and the company’s
control over the means or methods used to perform the work. That is,
the way to complete a work assignment versus concern only for the final
output. This is further aggravated where the so-called “independent
contractors― are provided training by the company. Depending on
pending circumstances and contributing factors, the company will be
liable for violation of the law concerning employment of independent
<p><strong>Impending Liability: Sword of Damocles?</strong></p>
<p>Numerous studies showed that the US government was losing hundreds of
millions of dollars in taxes annually due to this worker
misclassification practices in various industries. This lead to intense
deliberations in the legislative bodies and new bills introduced to
remedy the problem. While deliberations are still going on, let us
revisit what can be the potential risks carried by non-compliant
<li>Back taxes, with both employee and employer contributions.</li>
<li>Cost of settlement for benefits that should have been enjoyed by
affected workers had they been considered employees.</li>
<li>Pension contributions or profit shares that should have been enjoyed
by affected workers.</li>
<li>Penalties from federal and state agencies plus accrued interests over
the years covered in the violations.</li>
<li>Intentional misclassification of independent contractors which can
lead to punitive or triple damages.</li>
<li>Encouragement of potential union organization efforts by affected
<p>While we cannot guarantee that nobody will challenge any company’s
efforts to comply with proper worker classification legislations, what
happened to FedEx and Microsoft were just sneak peeks of a potential
upsurge on these cases that may come in view of the expected $1.58
trillion dollars budget deficit of the US government for the year
<p><strong>How can you protect your business?</strong></p>
<p>It is true that, no matter how much you comply, it is still possible
that someone or somebody will challenge you for a variety of reasons –
trivial or otherwise. Even the experts believe that the issues on
worker misclassification will continue to exist not necessarily due to
employers’ misgivings but also because of the changing legislations
concerning the matter which opens new avenues for debates. Be that as
it may, the sure thing is that there will continue to be a need for
careful and factual interpretations of these laws and their impact to the
<p>Today, a lot of employers have limited appreciation of what processes
do they have in place for properly classifying their workers, or how
their current independent contractors are providing services to their
company. The first thing they needed to do to review their existing
policies for worker classification. While their staff may be able to
follow what is already written on the policy manuals, interpreting the
ambiguities of various legislations for worker classification is usually
not these companies’ core competencies which open the door for
potentials risks to happen.</p>
<p>The IRS has Section 530 Relief Requirements for those employers who
engage independent contractors’ services. Obviously, the burden of
proof rests on the employers to support their qualifications to avail of
the relief under Section 530. Taking into consideration the broad
interpretations on each of the three (3) requirement areas, even an
employer who complied having “Reasonable Basis― can still fail under
Substantive Consistency or Reporting Consistency. The margin of error
is too narrow to allow for uninformed decisions on the part of the
employers. There can be so much at stake for too little to make as
benefits for taking the risks. You must always refer back to the
courts’ notion about the “duck.―</p>
<p>We can lay down a few steps for companies like yours to consider in
regards to employing independent contractors in your organization:</p>
<li><strong>Be sure to apply appropriate government guidelines.</strong>
Many federal and state agencies provide basic tests that are applied
during a tax audit. Follow the guidelines as completely as you can when
engaging independent contractors in your organizations. A lot of these
audit guidelines are public information and may be found on the
agency’s website. But be careful about the making ambiguous
interpretations, and be sure to ask or qualify your interpretations as
<li><strong>Only use independent contractors with an established business
already.</strong> Select independent contractors who have a good list of
multiple clients serviced over the years, and which can be verified or
validated. Require your prospective independent contractors to present
supporting documents such as client references, professional licenses,
marketing materials, and proof of insurance before signing them up for
services you require.</li>
<li><strong>As possible, only use independent contractors who provide
services which are not integral to your core business.</strong> Never
engage independent contractors for services that are similarly performed
by your regular employees. Doing so will be indicative of staff
augmentation instead of a defined project allowed for contracting.</li>
<li><strong>Be sure to create and execute proper contracts with each
independent contractor for each engagement.</strong> Make sure that the
contractual agreement you sign with an independent contractor clearly
defines the relationship of both parties to each other. Engage the
services of an expert to review your contracts to ensure that you are
compliant to federal and state government guidelines. Remember that
each state may have varying guidelines that you need to comply with. It
must be that your contract presents a business-to-business transaction
and veer away from any employer-employee language that hints about
supervision or management of the worker. The contract must include a
Statement of Work that details the contractor’s actual deliverables
(work output) and subject to acceptance by your company. You should
also include Non-Disclosure Agreements in contracting, and the standard
provisions about Intellectual Property Protection on the contract
<li><strong>So as not to lose track of compliance, be sure to address
worker classification for all projects that you do.</strong> Be mindful
that even while you deal with a real independent contractor, your
compliance can be diminished due to the ambiguity of your project scope
and definitions. To remedy this, having an expert eye to review your
documents can save you all the trouble in the near future. Problems may
not happen now, but it does not mean they will not happen at all if you
miss out on current compliance requirements.</li>
<li><strong>Always maintain audit files / records as references to
support your worker classification decisions.</strong> In classifying
workers as independent contractors, be sure to support this with as much
documentation that you can have – from evaluation of competencies,
customer references, proof of concept, etc. With the process in place,
you can be well prepared to support your worker classification decisions
in case of an audit. The more supporting documentation and processes
you have, the more credibility you have in the eyes of the auditors.</li>
<li><strong>Make it a rule never to engage a former W2 employee of your
company as a 1099 independent contractor.</strong> This is the most
common mistake committed by a lot of companies today. This is highly
risky because more often than not, these workers are re-engaged to
perform similar work that they used to do as W2 employees. It will for
your best interest to instead engage a real independent contractor with
excellent track record of delivering your required services. The
difference can save you the trouble supporting your worker classification
decisions during an audit later on.</li>
<li><strong>Explore about outsourcing your compliance
assistance.</strong> Ensuring defensible compliance to 1099 independent
contractor legislations require resources and strong expertise. The
ever changing legislations both on federal and state levels continue to
pose challenges for companies to ensure a worry-free path to
compliance. Engaging the help of experts improves your confidence on
compliance and weed out potential risks. Further, where an independent
contractor engagement is not feasible, there may still be other means to
acquire the talents you require for your projects minus the compliance
<li><strong>Be a good citizen of the country, and make no compromise
about it.</strong> This country has offered your company great
opportunities to do business and improve the lives of those who work with
you. Be a model citizen and pay your taxes honestly. Cutting corners
to save thousands or millions may actually cost you three-folds or more
in the near future. And being a good American is your best contribution
to our industry and our society at large.</li>

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