Are You 'Class' Conscious?

Failure to properly classify your workers may result in serious and costly penalties


Security providers may employ two types of workers-employees and independent contractors. While these workers might look and act the same in the work they do, they subject employers to very different federal and state tax and employment laws and regulations. For example, employers must withhold taxes from employee paychecks and pay a portion of other taxes on the employee's behalf. Employers must also comply with complex record-keeping and reporting requirements for employees. None of these requirements applies to independent contractors because they are self-employed and are responsible for reporting and paying their own taxes. But employers that wrongly classify employees as independent contractors may face significant tax liabilities, including penalties and interest, as well as leave themselves open to claims for benefits, overtime pay and other liabilities.

A number of federal and state agencies, including the Internal Revenue Service, the U.S. Department of Labor, state tax department and authorities that administer unemployment compensation and worker compensation can all determine if workers have been misclassified. The more workers it has misclassified, the more costly the mistake may be for the employer, who may not only owe taxes and other payments to these agencies, but who may also be liable to these employees for overtime pay and benefits.

What's the buzz? How do you avoid mistakes?

Reducing the risk of misclassification is possible by knowing and understanding how federal and state agencies evaluate workers.

The IRS applies a 20-factor test to determine if a worker is an employee or independent contractor, focusing on financial and behavioral controls and the relationship between the parties.

Financial controls looks at whether the worker has an effect on financial decisions: Does the worker have a significant investment in tools or other assets? Does the worker incur expenses the employer is not required to reimburse? Does the worker provide services to others in the marketplace or are the worker's services performed exclusively on the employer's behalf?

Behavioral controls looks at whether the employer has the right to direct and control the manner in which the worker performs the work. Actual control is not important; the right to control is enough, even if the employer doesn't exercise the right. The more right to control, the higher the likelihood the IRS will classify the worker as an employee. The right to control exists where the employer has the right to tell the employee what work must be completed, where to do the work, what order work must be done in and what tools to use.

The relationship test focuses on the relations between the employer and worker. Is there a written contract stipulating terms and conditions? Does the employer provide benefits such as vacation pay, healthcare or pension benefits?

Both the Department of Labor and IRS are stepping up enforcement with random audits and levying financial penalties. States are also getting into the act with new laws penalizing employers for misclassification. Protect yourself from costly potential liability to these agencies and to your workers by conducting your own employment audit. To encourage businesses to properly classify their workers without worrying about big penalties, the IRS is rolling out a voluntary program. Employers who opt into the program will owe 10 percent of the tax liability that otherwise would have been due on employees' compensation for the past year, without interest or penalties.

Eric Pritchard is a partner in Kleinbard Bell & Brecker LLP, Philadelphia, a commercial law firm with a national practice in the electronic security and life safety industries. This column does not constitute legal advice; contact an attorney with specific questions.