Businesses in the construction industry have historically relied heavily upon independent contractors to perform work. While it is sometimes clear that a party is a true subcontractor, such has hiring ABC Plumbing, Inc. or 123 Electric, LLC, it is equally as common to misclassify and pay laborers who are legally employees as independent contractors.
Why do the state and federal governments, employers and workers care about this issue? In a word: money. Businesses without employees do not pay payroll and employment taxes, workers compensation premiums, health insurance premiums, or other benefits. In turn, workers who are not employees are paid the full amount of their compensation without any amounts being deducted for these costs. Many people do not like being told when to pay their taxes or having money automatically taken from them. Independent contractors can hold their money and pay their taxes quarterly, or (as the IRS fears) not at all.
The following list of questions can be used in reviewing your personnel to determine if they are truly independent contractors or would legally be deemed employees. Every question to which you answer “no” is an indicator that the worker will be deemed your employee and not a true independent contractor:
- Do they maintain a separate business with their own office, equipment, and other facilities?
- Do they have a separate legal entity through which they conduct business (corporation/LLC)?
- Do they have a separate Tax ID Number, other than their social security number?
- Do they have their own liability and workers compensation insurance policies?
- Do they use their own tools, equipment and supplies?
- Do they not wear any clothing containing your company’s name or logo?
- Do they not drive your vehicles?
- Do they also work for other companies?
- If required, are they licensed or they registered with the state where they do business?
- Do you sign contracts with them for each job and for specific amounts of money, or alternatively have a signed master subcontractor agreement covering all work they will perform?
- Are they not paid on an hourly basis, but instead on a commission basis, a per-job basis, per unit basis, or a competitive bid basis?
- Do they control the means of performing their work? For example, do you not tell them how or when to do their work (other than a project schedule with deadlines)?
- Do they incur the main (or any) expenses related to their work?
- Do they have continuing or recurring business liabilities, such as overhead items like rent, loans, etc.?
- Do they have any risk? In other words, can they realize a profit or suffer a loss on the work they perform and does the success of their business depend on not losing money? (If they profit by the same amount no matter how long it takes or the expenses involved in doing the work, then the answer to this question is “No.”).
- Are they liable for failure to complete the work properly? In other words, could you sue them for damages related to delays, to correct poor workmanship, or some other breach of contract?
Failing one element does not mean a worker would automatically be deemed an employee, but failing more than one would likely result in a reclassification. The factors and laws may also vary from state to state.
The subcontractor having (or appearing to have) a separate business is really the key to the entire analysis. If the worker cannot profit or lose, has no recurring business liabilities or obligations, is told what to do and when to do it, and is paid in a way where he or she has no downside risk, the worker will be deemed an employee. Having a solid subcontractor agreement is a must, and in some cases a “master” agreement can be signed to cover all projects upon which the parties will work with each other. The parties simply specify the scope of work and price for each new project, with the other terms being governed by the signed master agreement on file.
A narrow exemption exists under Internal Revenue Code Section 530 that can sometimes (although rarely) provide a “safe harbor” for construction companies using independent contractors. To pursue the exemption a business would need to meet the following three criteria:
- • The business has consistently treated the workers in question as independent contractors for a long period of time.
- • The business has always issued 1099 forms to the workers in question.
- • The business has a reasonable basis for thinking that the workers were independent contractors (even though legally they really are not).
Usually, the final element may only be proven if one of the following is true:
- • The IRS has previously audited the general contractor and determined that the workers were really independent contractors.
- • There is a very specific industry custom on the issue that can be proven to have existed for at least 10 years.
- • The general contractor has an opinion letter from an attorney or accountant who is proven to have extensive knowledge of the entity’s business practices and issued a specific written opinion that the workers in question truly were independent contractors. However, such an opinion letter is only even potentially effective if it was obtained at the time the business began treating the workers as independent contractors, and is of no use if the letter is obtained after that practice has already been in place.
In 2011, the IRS announced a program intended to assist employers to “voluntarily reclassify” independent contractors to employees. Named the “Fresh Start” program, it is designed to reduce the cost of reclassification and create a specific process for doing so. More information about the IRS “Fresh Start” Program can be found at www.irs.gov.
Despite the IRS Fresh Start program being touted as a “safe harbor,” use caution in contacting the IRS to volunteer that your business might have been misclassifying workers.
If you have any concerns after reviewing the information above, discuss the matter with an experienced attorney to develop a plan for addressing any weak spots and increasing the likelihood that all workers being classified and paid as independent contractors will survive scrutiny in an audit.