February 5, 2010Client Alert

New Federal Budget Raises the Stakes of Employee Misclassification

President Obama’s $3.8 trillion federal budget for the 2011 fiscal year will boost spending for several new initiatives within the Department of Labor (“DOL”). The DOL will receive $117.5 billion of the $3.8 trillion. Overall, this represents a 43% decrease in the DOL’s budget from Fiscal Year (“FY”) 2010. This decrease is based on an expected drop in unemployment insurance programs because of an economic rebound. At the same time, the DOL’s budget dramatically increases funds in the Wage and Hour Division.

Under its new budget, the DOL plans to hire more than 350 new employees, including 177 investigators and enforcement staff. After several years of decline, the FY 2011 budget builds on the FY 2010 budget policy of returning DOL programs to FY 2001 staffing levels. For example, the DOL’s Occupational Safety and Health Administration (OSHA) will receive $14 million more than it received in FY 2010. Likewise, the DOL’s Wage and Hour Division will receive $244 million, which is an increase of $20 million from FY 2010.

The DOL’s budget also includes an additional $25 million for a Misclassification Initiative to target employee misclassification. Along with more money, the budget allots 100 additional enforcement personnel and competitive grants to boost states’ incentives to address employee misclassification.

The federal government’s effort to target employee misclassification is the latest in a series of federal initiatives and state laws that have brought independent contractors under increasing scrutiny. For example, President Obama signed an IRS directive on January 20, 2010, that will increase IRS scrutiny of federal contractors’ classification of employees. States also have begun to pass legislation making it a violation of law to misclassify employees and imposing penalties on employers who knowingly misclassify workers. The Illinois Employee Classification Act prohibits the misclassification of employees as independent contractors and provides stiff fines for non-compliance.

By definition, independent contractors are self-employed. Because they are not employees, they are not covered by employment, labor, and various tax withholding laws. In some instances, employers reclassify employees as independent contractors to avoid taxes, payment of overtime and benefits, and workers’ compensation liability. The determination of whether a worker is covered by a particular employment, labor, or tax law hinges on the definition of an “employee.” Inadvertent misclassification is a genuine concern for many employers because state and federal agencies have applied different standards for classification.

The DOL, for instance, often relies on the “Economic Realities Test” or a hybrid of the “Right-to-Control” and “Economic Realities Test” to determine independent contractor/employee status. These tests take into account the degree to which workers are economically dependent on the business, in addition to considering the degree of control an employer exercises.

The IRS, on the other hand, uses a three-factor test for determining whether someone is an employee or an independent contractor. The factors focus on behavioral control, financial control and relationship of the parties.

As employee misclassification continues to come under scrutiny, it is important for employers to be careful in classifying independent contractors in light of the potential risks of misclassification. Along with payments of back taxes and potential interest also come heavy penalties, personal liability of corporate owners, possible criminal sanctions and the possibility of losing government contracts for federal contractors. Moreover, although agencies apply different standards for classification, the DOL has coordinated its efforts with the IRS, the National Association of State Workforce Agencies, the Federation of Tax Advisors, and agencies that administer state employment and unemployment taxes.

If you have any questions or concerns about independent contractor classification or the Misclassification Initiative, please contact one of the authors of this alert or your Michael Best attorney.

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