When is a contractor not a contractor, but a common-law employee, whose employer must withhold taxes, pay FICA and workers´ comp and unemployment and disability insurance - and offer the same benefits given to other workers on his level?

That´s the question that brings sweat to the palms of HR professionals (or should) whenever they see a requisition for a 1099 independent contractor. Still, in the 2000s, as economic and workplace trends are converging to add urgency to the worker-classification issue, senior executives surveyed by Veritude rank the importance of worker classification almost dead last in a list of workplace issues.

Though pay increases for US workers have been modest in recent years, the cost of direct-hire employees is rising rapidly due to benefits expenses, especially health care. So, executives are scrutinizing each requisition for a hire as never before. One result: Hiring managers often try to avoid some full-time hires by bringing on contractors or workers employed by staffing firms.

With this trend in mind, the IRS is pushing harder to capture revenue lost to misclassification of W-2 employees as 1099 contractors. At the same time, plaintiff´s attorneys are championing class-action suits that may ask for back employee benefits for thousands of workers who the employer misclassified as contractors.

Microsoft and FedEx Cases Are Warning Signs.
Two lawsuits in particular have drawn the attention of in-house counsel and human resources executives.

In the 1990s, temporary workers sued Microsoft, claiming they were common-law employees of the software giant and thus due benefits paid to their cohorts in the direct-employee workforce. Vizcaino v. Microsoft culminated in a December 2000 settlement in which Microsoft agreed to pay $97 million to thousands of these contingent workers.*

In 2005, four current and former FedEx drivers brought a class-action suit on behalf of the shipping firm´s 17,000 drivers, alleging that they are common-law employees, despite their agreements with the company, which describe them as independent contractors. The drivers say that FedEx´s many rules governing their work make them employees; the company says the workers knew what they were signing up for and that most of the contractors are satisfied with the agreement.

No employer wants to follow the path of FedEx or Microsoft into court. But avoiding that fate while meeting business needs isn´t easy. "Many companies have learned that they must become expert in the business of employment," say Christine Miller, a partner with McGinnis, Lochridge and Kilgore LLP of Austin, Texas.

The alternative is to hire a staffing firm to be the employer of record, withholding income taxes, paying employer-side Social Security tax and other obligations, and assuming much of the human-resources administration and employment liability."

Here are some of many considerations that human resources executives and risk managers can use in developing an approach to the worker-classification challenge.

If You Can Control a Worker, You´re His Employer.
The current IRS approach to determining the W-2 or 1099 status of a worker revolves around behavioral and financial control of the worker as well as other aspects of the worker´s relationship to the company. Employers that seek a determination of a worker´s status - or are asked to cooperate in an IRS inquiry instigated by a worker - fill out Form SS-8, which asks more than 30 questions about the relationship.

If an employer is found to have misclassified a worker as a contractor, the penalties can be substantial. "The IRS can levy penalties equal to 1.5 percent of the wages in question, plus the withholding, plus interest," says Kenneth Taber, a partner with Pillsbury Winthrop Shaw Pittman LLP in New York City. "There can also be criminal liability.

Further, if an employer fails to pay its share of the Social Security tax on an employer wrongly classified as a contractor, the penalty can be 20 percent of the tax due. And, the penalties for failure to withhold income taxes and pay Social Security can be doubled if they are due to the employer´s willful neglect.

"Usually the audits come up where employers have treated a class of workers as independent, the workers´ tax bill comes due and they don´t have the money to pay," says Miller. "So the workers tell the IRS, ´I´m not really an independent contractor,´ and the IRS comes in and does an examination of the facts and circumstances."

"Typically the result is that neither side is on rock-solid ground," says Taber. "The gray areas are so gray, it´s hard to know with a great deal of comfort that you´re OK."

Staffing Firms Assume Many Classification Risks.
To avoid the legal and financial risks of working with independent contractors, many employers fill their contingent-staffing needs with workers who are W-2 employees of staffing firms. By procuring workers through a third party, companies outsource the payment of payroll taxes, required insurance and, in some cases, employee benefits. This reduces or eliminates many of the risks of misclassification.

But using the employees of a staffing agency doesn´t mitigate all liabilities; some so-called co-employment risks remain. Under the Family and Medical Leave Act (FMLA), for example, client employers must take an agency temporary worker back after an FMLA leave if the employer is still using a temporary worker to do the job - even if it means bumping another temp worker who filled in, writes attorney Ronald Wainrib.

Human Resources and Legal Counsel Must Remain Vigilant.
In the 21st century, worker-classification issues likely will continue to swirl at the busy intersection of federal and state statutes, case law and IRS rulings.

There´s no simple solution; it´s often difficult to get a straight answer even from the government agencies that determine the status of workers. "We tell you, ´It all depends,´ and send you publications," says a federal spokesperson who declined to be identified.

In one six-year period, though, according to The Wall Street Journal, the IRS audited more than 11,000 companies that used independent contractors. As a result, 483,000 contractors were reclassified as employees, and their employers were assessed $751 million in back taxes and penalties.

Human resources executives and legal counsel therefore must stay on the worker-classification case. "On a regular basis, you should audit your own practices," says Taber.

* Disclosure: The author was a member of the class of former temporary workers that brought suit.

About the Author

John Rossheim is a journalist in Providence, Rhode Island who writes about workplace issues, employment trends and changing relationships between employers and workers.  John regularly contributes to Workforce Insights, an online resource about emerging labor trends and issues produced by Veritude.

About Veritude

The article originally appeared in Workforce Insights on Veritude.com. Veritude provides strategic human resources - the talent, technology and tactics that growing firms need in order to anticipate and adapt to changes in the workplace. Veritude is a wholly owned subsidiary of Fidelity Investments Company. Headquartered in Boston, the company serves clients throughout the United States and Canada and is part of Fidelity´s ongoing investment and leadership in outsourced HR services. To review other articles, research and expert analysis relevant to HR professionals seeking to stay informed, please visit www.veritude.com.  For more information, contact: inquiry@veritude.com or call:1-800-597-5537. 

^©2005 Veritude,LLC.  Reprinted with permission.