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If you haven't heard the ever increasing buzz about worker misclassification yet, you will.

The issue of whether a worker should be classified as an independent contractor or an employee is a hot topic and getting hotter all the time.

The following provides key information to help you assess what you need to know and the steps you should take.

There are many parties interested in proper worker classification ranging from the IRS to the U.S. Department of Labor (DOL) to state governments to workers themselves.

It's much cheaper for employers to use independent contractors over employees because they avoid paying the following: employer portion of payroll taxes, workers' compensation and unemployment insurance premiums, overtime payments and the expensive benefits that often go along with hiring employees.  And franchise owners are known to be attracted to cheaper employees, especially with the costs of complying with ACA.

On the flip side, there's a growing financial risk if you misclassify employees as independent contractors, especially if you do so willfully.

In addition to the possibility of owing back pay (if minimum wage requirements haven't been met) and overtime, you could also face paying: back taxes, including the employee portion; penalties and interest; fines; retroactive employee benefits; costs of staff time and effort; and possible legal fees if faced with going to court.

Additional costs, less quantifiable but important nonetheless, include negative publicity for your organization and possible employee morale issues.

Even inadvertent misclassification can be expensive but imposed fines and penalties grow increasingly severe the more willful the nature of the violation. Both state and federal governments are paying greater attention to this issue than in years past. The IRS and DOL have even teamed up with at least eleven states to share information and resources in a joint effort to uncover violations.

So there's strong incentive these days for employers to do their best to get it right.

But, the IRS makes is clear that there is no magic formula or simple test as to whether or not a worker is an independent contractor. They emphasize that each case is fact specific.

In general, however, the best place to start is to consider whether your franchise owners have the right to control, not just the outcome but also how the worker performs the work. Whether or not you actually exercise this right is irrelevant to the worker's status. There are many times, for instance with highly experienced employees, when organizations provide little guidance or oversight. The real question is whether or not you have the right to do so.

So, how does the IRS decide upon the degree of control an employer has over how the work is performed? It comes down to looking at a number of factors that comprise three main categories: Behavioral Control, Financial Control, Type of Relationship. Remember, no one factor is decisive as circumstances differ; the totality of the situation must be evaluated. IRS guidance is abundant on IRS website for the control test.

You should also take a look at the DOL's Economic Reality Test. This test relates to whether the Fair Labor Standards Act (FLSA) applies. The seven factors it contains overlap those that the IRS looks at and likewise consider whether or not the worker has a bona fide business that does not provide services integral to yours. Be sure to familiarize yourself with all seven factors of this test in addition to IRS guidance.

So how do you prove that someone is indeed an independent contractor and not your employee? The best documentation shows that the person has a bona fide business quite separate from yours; that control over how the person does the work resides with the worker; that the work being contracted is not an integral part of what your business provides and the worker is free to make a profit or loss and be hired by others.

Keep a vendor file for each independent contractor just as you would for any other vendor or supplier, such as the folks who deliver your coffee supplies or service your copier machines.

Here are four important items that should be kept in that file:

A written contract--Always a good idea, the contract should outline the nature of the relationship, although saying the person is an independent contractor doesn't make it so. Indicate the project's expected results, the fee and date(s) of completion. Note that you don't control how the results are achieved; the worker uses his/her own equipment/tools; is free to hire others without your approval and that the person provides liability insurance to his/her workers, and is not eligible for benefits with your company. Note that the person has their own business and tax I.D. number. Make sure it is signed by both parties and create a new contract if the worker takes on a new project for you. Each project should have a separate contract.

Proof of a real and separate business--Keep any letters on business stationery, business cards, brochures, or newspaper advertisements. With so much done electronically these days, print off a copy of an appropriate page of the worker's web site, online advertisement of services or copies of emails detailing services offered.

Invoices--Every payment to an independent contractor should be based on an invoice. The worker should never submit expense reports to you as that would point toward the person being an employee. The worker's mileage or purchase of equipment or supplies should be part of their own business expenses, not yours. Keep every invoice and make sure it ties in with the Form 1099 you issue to the person for that calendar year.

Form W-9--Obtain this form when hiring an independent contractor and make sure it is filled out properly. If the person does not check the box exempting him- or herself from tax withholding, you are legally obligated to withhold taxes at 28%. An independent contractor should check the box file their own self-employment taxes on their own.

Due to lots of bad practices that organizations got away with in the past, businesses may think they are classifying workers correctly when they are not. Increasing scrutiny demands that the facts of each situation be reviewed.

Here are some seven red flags to watch for:

  1. After an employee terminates, you hire the person back to do work that resembles their old job, even on a temporary, project basis;
  2. If an intern is doing actual work, not just shadowing or learning; be sure to check DOL Fact Sheet #715 for the six criteria related to interns. In order to not pay interns minimum wage and overtime, all six criteria must be met.
  3. When you provide the equipment, supplies or office space the worker uses;
  4. If the worker replaces one of your employees or supervises any of your employees;
  5. If the worker receives any benefits or perks your employees receive, gets paid on a regular basis, or submits expense reports;
  6. If the relationship is ongoing and long-term;
  7. If a supervisor hires a worker and pays the person through Accounts Payable unbeknownst to human resources or payroll.

The last item happens more often than you might think, especially in larger organizations, but all organizations are vulnerable without proper communications and procedures in place. If the person administering payroll also issues 1099s and is thus aware of all workers, misclassification can be avoided. But if your organization is too large for that, make sure there are good channels of communication among payroll, accounts payable and human resources and train managers to get approvals from human resources when engaging any worker.

A final caveat is that state laws may differ from federal laws in important ways. It's possible for a worker to be classified as an independent contractor for IRS purposes, yet, by state definition, require workers' compensation or unemployment insurance premiums paid on his or her behalf. So be sure to check your state laws as well!

If your franchise system needs help with informing its franchisees about how to comply with myriad of Federal and State employment Laws, then connect with me on LinkedIn, Dean Haller.

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The Coverall decision caused a furor in the franchising world, when a Court decided that Coverall's  franchisees were independent contractors.

But there is much more at stake for franchisees than this one case.

Using contractors offers a lot of benefits, but you have to make sure you're doing it right," says 352 Media's Wilson. 

"You don't want the government to come calling and decide you owe a lot of back taxes for classifying contractors incorrectly. 

Be vigilant about reading the government's contractor classification guidelines and make sure your contractors actually fall within them."

The trade-offs and problems of contingent workers are nicely summarized by Steve King, at Small Business Labs.

"Federal and state governments claim they lose billions of dollars in payroll taxes due to under-reporting by contractors. 

They also claim they collect less in unemployment insurance and worker compensation taxes. Because of this, they are aggressively going after companies they feel mis-classify full time employees as contingent workers.

This issue has huge implications because: (1) companies of all sizes are increasing their use of contract workers; and (2) a growing number of people are choosing to work as independent contractors.

This used to be much simpler issue from the standpoint of the contingent worker - they almost always wanted to become full-time employees. 

But that has changed. 

A growing number of people are seeking the flexibility and work/life balance advantages contract work brings."

The Employee Misclassification Protection Act of 2010 (EMPA), amends the federal Fair Labor Standards Act (FLSA) to Increase government enforcement against employee misclassification practices by employers of all sizes, to curtail and penalize worker misclassification.

EMPA sets strict notice and record-keeping requirements on all employers, with costly penalties for non-compliance (up to $5000 per worker). 

It requires all states to develop and enforce their own employee misclassification enforcement programs through audits and other methods.

King again states that the problem on contingent workers is going to get bigger

"The most important trends of the last few decades is the growing use of contingent workers. This is a structural shift towards employer use of contractors, freelancers, part-timers, etc. instead of hiring full-time, permanent employees."

For more information, King says that "Staffing Industry Analysts are the leading, and maybe the only dedicated) analysts in this space. Their site, blogs and magazine also has lists, ads and references to firms that do contingent workforce compliance. 

In addition to Industry Staffing Associates, Workforce Week is another good source on services related to the contingent workforce. It has broader HR related coverage, but it seems like they usually have an article or two on contingent workers each week."

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