Another Independent Contractor Red Flag Issue Q&A

audit red flagA nonexempt employee working a second job as an independent contractor for your organization is a red flag for the IRS, the DOL, and state agencies. So, make sure that your employee’s second job really meets the independent contractor criteria or be prepared to pay overtime.

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Question: We have a nonexempt employee who has offered to do landscaping work outside of his normal 40-hour week for our organization. Can we treat him as an independent contractor when he is doing this work? We would normally hire an outside company for landscaping.

Answer: If the employee’s landscaping job meets the criteria for an independent contractor job, then you may classify him as such. If he does not meet the criteria, however, any additional work that he performs for your organization must be counted towards his 40-hour workweek and he must be paid overtime if he works more than 40 hours in both jobs in a single workweek. In addition, you then must withhold taxes for the position’s wages.

The independent contractor, or freelancer, classification is used for nonemployee workers who typically perform specialized work that your employees do not do and are retained for a specific period of time. Since they are not considered employees of the organization, these workers are not covered by the laws for minimum wage and overtime, payroll taxes, workers’ compensation, unemployment compensation, or employment discrimination and are not eligible for any benefits. But meeting criteria for independent contractor status is tricky because the Internal Revenue Service (IRS), the Department of Labor (DOL), states, and the courts all impose different standards for employers to satisfy.

You also should be aware that when current nonexempt employees perform two or more jobs for your organization, classification of the second position as an independent contractor often raises a red flag for the various government agencies above. These agencies are interested in ensuring that taxes are properly paid and that employees are fully protected by wage and hour laws guaranteeing overtime.

Independent contractor status usually is determined using one of three different tests: (1) the IRS 20-factor analysis, for coverage under federal withholding requirements; (2) the “economic reality” test, used to determine compliance with requirements of the Fair Labor Standards Act (FLSA); and (3) the common law “right to control” test, used by many courts to administer certain other statutes. Under all three tests, whether a person who performs work for the organization is an “employee” or an “independent contractor” primarily depends on how much control the employer has over the work relationship.

So, for example, if the employee provides the equipment to do the landscaping, is paid when he completes the job (as opposed to payment on an hourly basis), and sets his own work hours, then he is more likely to be an independent contractor. But, if you provide him with the equipment, require him to perform the job at a particular time, and pay him by the hour, he may appear to be an employee and should be paid as such.

Because of the complicated nature of the independent contractor criteria, you should consult with a tax expert or attorney who is familiar with them. In addition, you can request a determination from the IRS by filing Form SS-8, “Determination of Worker Status,” available online at www.irs.gov/pub/irs-pdf/fss8.pdf. You also can find helpful information on correctly classifying and correcting misclassification of workers from IRS Publication 15-A, “Employer’s Supplemental Tax Guide,” available online at www.irs.gov/publications/p15a/index.html .

If you determine that the nonexempt employee’s second job does not meet the independent contractor criteria, then you must count all hours he works in both jobs towards overtime. So, for example, if the employee works more than 40 hours in a single workweek while doing both jobs, you should pay him overtime. Calculating overtime can be a little tricky when an employee works two or more jobs for which the employee is paid different hourly rates since overtime must be based on the employee’s “regular rate of pay.” Typically, the employee’s regular rate of pay is the weighted average of the different rates.

If you use QuickBooks and are manually having to calculate weighted average overtime; Crew/Overtime Entry Solution will help you automate this time consuming and eror prone task.

One final warning: As of last year, the IRS and the DOL began targeting worker misclassifications more aggressively than they have in the past. Beginning in February 2010, the IRS launched its first Employment Tax National Research Project in 25 years, targeting 2,000 taxpayers each year for the next three years for “comprehensive” audits, according to an IRS press release. The purpose of the audits is to determine what the “employment tax gap” is, i.e., the difference between taxes that are owed and taxes that are not paid because of underreporting, underpayment, or unfiled taxes, and how to collect these payments. In 2005, the IRS estimated the overall tax gap to be a whopping $345 billion, and so clearly the agency is interested in increasing its collections. In addition, the DOL has added 350 field investigators in the last two years to enforce wage and hour laws and focus on job misclassifications.

So, if you want to classify an nonexempt employees’ second job as an independent contractor, you should make sure your classification is proper and not a shortcut to an expensive nightmare of agency audits, back taxes, back wages, and penalties.

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Redistributed with permission of:  Personnel Policy Service, Inc. 159 St. Matthews Ave., Suite 5, Louisville, KY 40207