Collabrusâ„¢ Expert Compliance Blog

While talking with clients, some questions seem to come up over and over again. In my experience these are universal concerns of businesses that have employees or utilize contingent or temporary help, consultants and independent contractors. So about once per week I’d like to discuss one of these common concerns.

This week’s Question:  Can an employee receive both a W-2 and a 1099 from the same business?

The simple answer is “Yes, it happens.” 

However, the real question should be “Is it legal?” 

Will the IRS, or other enforcement agencies, find it a violation leading to a misclassification issue and a possible tax assessment?”

The answer to that question is more complicated.

When I worked on the other side, we almost always considered a worker who received both a W-2 and a 1099 from the same employer as a misclassification of the 1099 payments. It was very difficult to convince an auditor that the 1099 income was not just part of the W-2 wages not properly reported. From the government’s point of view any justification or rationalization was just an excuse to not pay taxes. It really took a convincing argument to win the point.

There is more to the answer: 

It is very unusual for an employee to also correctly receive a 1099 from his employer, but it is legally possible. To qualify all of the following must exist:

• The individual has a legitimate independent business
• He/she has other clients not connected to the employer
• The work as an IC is not the identical, or similar, to what he does as an employee.
• When doing the 1099 work he must meet the common law test as an IC

For example, a software engineer also does work as an independent sign painter on weekends.  It’s his artistic expression. He advertises and has dozens of other clients and gets calls regularly for jobs. The software company he works for as an employee-engineer during the week hires him to paint some signs for a special occasion-a one time job. He quotes a flat price for the work (say $2,000), which is not connected to the pay rate he receives as an engineer during the week.  He does the work on the weekend, at his own time, and using his own materials and supplies.  He is paid for a completed job, not by the hour and not for rework. Nobody supervises his work-all the company wants is the final product as agreed to. In this case it would be correct for the employee-IC to receive a 1099 MISC for the $2,000 and a W-2 for his regular salary as an employee.

Caution

If you do this be sure to clearly document and save your evidence, because when a worker receives both a W-2 and a 1099 from the same business in the same year, it is a red flag to the IRS. The odds are very high you and the worker will be contacted to explain how this happened.  You will need to prove you are right.

Don’t let your company make the mistake of thinking it can’t get burned in an IC misclassification conflict…that it won’t happen… that if it does you will win…or that the cost will be small.

Don’t be a victim of the infamous Layered Defense Strategy Argument.

Over the years, I’ve met a number of clients who say they aren’t worried about being audited by either the IRS or California’s EDD. Typically, the conversation involves the director of HR, the VP who oversees the procurement process, and their in-house attorney. The attorney is usually the one who makes the argument.

The typical rationale goes something like this (I’m paraphrasing here):

“We’re OK with the small risk of not reporting our temp help and our consultants. We treat them all as IC’s. It doesn’t really matter if we suspect they are misclassified, because…”

1. “Only between 2 to 5% of employers are audited in a given year, so the odds of being selected for an audit are very low and in our favor. If I could consistently get 95% to 98% odds of winning in Las Vegas, I’d quit my day job.”
2. “If we are selected for an audit we’ll put up a vigorous defense and will probably win most if not all of the issues in court.”
3. “Even if we lose some of the issues, we have the option of just paying up at that time. The cost to us then will be much lower than paying for everyone now because of the “Present Value of Money Theory” a dollar will be cheaper in two or three years than today.  In other words, a $1 invested today will be worth $1.25(?) in three years, so we’ll pay them the $1 in three years and pocket the 25 cents (or something like that).”

I always politely listen to the argument, even though I’ve heard it many times before in its various different versions. The problem is the person making this argument has some information, but doesn’t understand the truth behind the statistics (always a dangerous combination!)

The primary problem with the Layered Defensive Strategy is reality hands you a different experience.

This strategy sounds flawless until it runs into reality. It typically takes a series of discussions before the company understands the flaws of this argument and changes their policy.  

Over the next few articles I’m going to take each part of the Layered Defensive Strategy Argument and explain its numerous defects. Generally, this argument is made by someone who has statistical data supplied by the government, but who has never actually engaged in combat with a competent employment tax or labor law enforcement agency or (in the case of a civil lawsuit) an opposing attorney who knows what’s happening. The experience can be an education.

Make an informed decision

After reading this series you may still decide to gamble that your consultants, or your contingent workers, or your independent contractors are being properly handled and that you have no risk. If you read these articles and still make that conclusion at least you are making what I call an informed business decision.  However, I would respectfully ask you to consider the alternative.

What to expect

In the next series of articles I’ll cover:

• The risks of being selected for an audit are higher than 2-5%-much higher if you are not properly protecting your company.
• That the costs of being right up front are less than paying for a mistake later.
• The real odds of winning and losing in court, or at an informal hearing, and the truth behind these odds.

After that you can make your own informed business decision…

SACRAMENTO-The annual dance in the legislature to get a state budget is having an affect on the state tax auditors ability to travel.

The Sacramento Bee recently reported that the “Franchise Tax Board auditors…spend less time auditing and more time filling out paperwork and figuring out the precise bureaucratic language that will justify work-related trips…”

This is because the governor restricted all state employee travel (including tax auditors) throughout the state until a budget is passed.  This means all state tax auditors, including Employment Development Department auditors are traveling less and making up things to do in the office.

This doesn’t mean they aren’t doing anything.

These generic restrictions happen almost every year in state government, during the traditional “California Budget Crisis.”  But it may not be all good news for employers who are in the middle of an audit.  In my experience the industrious state tax auditors will dig up their old cases, buried and forgotten in their desk drawers and on their laptop computers, and start to work on them again.  These are the cases where the business has already been visited and the business records examined.  In most cases the auditor knows what the outcome is going to be, but has been procrastinating.  What remains to be done is the “write-up” and a discussion (exit interview) with the taxpayer to explain the findings.  So if you were visited by a state auditor last year and heard nothing from him since, your luck may have changed.

When the budget is over

When the budget is signed, everything returns to business as usual and the auditors will be making appointments again. 

So enjoy the reprieve while it lasts.

I was doing some research for a project I’m working on, when I started running into example after example of class action lawsuits being brought against companies because they misclassified or miscalculated their worker’s status. 

Many of the examples below were from websites set up to solicit current and former employees and/or IC’s to join in the lawsuits against their employers.

Here’s just a sampling of what I found.

CVS-A nationwide class action was filed against drugstore chain operator CVS RX Services, Inc. (which recently purchased Longs Drugs), on behalf of current and former pharmacist employees who allege that the company has not paid them overtime for hours they worked in excess of their normal 40-hour workweek, in violation of the federal Fair Labor Standards Act. The action seeks compensation for up to three years of back overtime pay per worker and an equal amount in punitive damages. The action alleges that employees put in anywhere from 100 hours to 1040 hours of overtime per year.

Shelby County, Alabama, Board of Education-A collective action has been filed in Alabama against the Shelby County Board of Education. The action is brought on behalf of all former and current employees who have worked in excess of 40 hours a week, but who have not been paid overtime by Aiken County. The action is brought under the federal Fair Labor Standards Act and is seeking back pay as damages.

Big Lots Stores, Inc-A class action lawsuit has been filed in the Eastern District Court of Texas against Big Lots Stores, Inc., for alleged violations of the Fair Labor Standards Act (FLSA).  Big Lots Stores is a discount retailer who owns and operates over 1400 stores throughout the United States.  Specifically, the complaint alleges that class members were improperly classified as exempt employees and required to work in excess of 45-55 hours per week, but were not paid overtime for all hours worked in excess of 40 hours per week.

The employees filing the action are furniture department managers, furniture sales managers and assistant managers. Even though their job titles indicated they were managers, the class members claim that they are incorrectly classified as exempt employees because:

• Their primary duties consisted of non-managerial activities such as operating registers, processing forms, sales, stocking and re-stocking merchandise, janitorial duties and answering phones.
• They did not customarily or regularly exercise discretionary powers, and
• Did not regularly direct or manage the work of two or more full-time employees.

I discovered many more examples-too many to cover here-and from my experience there are thousands of these actions filed each year. Most you never hear about. That’s because they are settled quietly by the company in question to avoid the negative publicity and expensive legal battles.

It is clear from these examples that protecting the organization from employee misclassification risks is becoming a vital component of responsible company management.

Washington-In June 2008, I reported that the Department of Homeland Security (DHS) and the Social Security Administration (SSA) had joined forces to require private companies doing business with the federal government to ensure their employees are working here legally. At that time the federal government was also considering making this a requirement for all employers across the nation

The June order was aimed at cracking down on hiring of illegal immigrants. However, people who overstayed visas or came to the country legally but do not have permission to work, such as some students or those awaiting work permits, also could be snagged by this requirement.

This week the Department of Homeland Security changed its website to reflect that, at this time, only federal agencies and contractors/companies working on a federal contract would be required to insure all their workers were checked through the E Verify System. 

What is E-Verify? (Eligibility Verification Program) is an online system operated jointly by the Department of Homeland Security and the Social Security Administration. Participating employers can check the work status of new hires online by comparing information from an employee’s I-9 form against SSA and DHS databases. The DHS reports, “…more than 69,000 employers are enrolled in the program, with over 4 million queries run so far in fiscal year 2008.”

Using E Verify is voluntary for most employers

The DHS has apparently backed down on requiring all employers to use this system. At this time, using E Verify is voluntary for most employers, but on their website DHS is encouraging every employer to use this system.

The Department of Homeland Security website states, “E-Verify is an essential tool for employers committed to maintaining a legal workforce, and the number of registered employers is growing by over 1,000 per week….Companies can access E-Verify online and compare an employee’s Form I-9 information with over 444 million records in the SSA database, and more than 60 million records in Department of Homeland Security…”

Most employees fill out I-9 forms and submit accompanying documents that employers generally look over to determine whether the worker is legitimate.

I’ll keep an eye on this requirement and report any changes in the future.

SACRAMENTO-The Employment Development Department (EDD) announced this week that California’s seasonally adjusted unemployment rate was 7.3 percent in July. The non-adjusted California rate was 7.6 percent. These are 0.3 percentage point increases over June, and up 1.9 percent from one year ago. In comparison, the U.S. unemployment rate was 5.7 percent in July, up 0.2 percentage point from June, and up 1.0 percent from one year ago.

How does this affect employment tax audits and IC compliance?

The unemployment rate is climbing which means more people will be making claims for Unemployment Insurance Benefits. I’ve reported this previously, but it doesn’t hurt to repeat myself from time-to-time, that employment tax enforcement agencies get funded to a significant portion based on the number of people who file for unemployment insurance benefits. The more people who make a claim, the more money the tax agencies get to do audits. So as the unemployment rate increases so do the resources to conduct audits.

The fastest way to an audit

Another statistic is that nearly10% of unemployment insurance claims get blocked because wages can’t be verified. This is typically because the individual was working as an IC-not an employee-and the business did not withhold, report or pay taxes for the worker.

This is a major trigger for an employment tax audit, because only ex-employees are entitled to unemployment insurance benefits, so EDD is inclined to see the unreported claimant (your former IC) as misclassified. It’s a built-in bias. So whenever one of your ex-IC’s makes a claim for unemployment insurance, it’s certain your company will be looked at for a potential audit.

Typically, when economic times tighten businesses want to cut costs

One way businesses cut costs is by employing workers as independent contractors to avoid the costs associated with employees. This strategy is good if done correctly. However, in my experience, many businesses just call the worker an IC (it becomes a title) and still treat him/her as an employee. Doing this will guarantee a misclassification problem. In most cases the business wants to be legal but does not have the technical knowledge and experience to do it properly.

The two events collide

So just as times are getting difficult financially and the business decides to risk classifying workers as IC’s to cut costs, the government is gearing up its audit program, increasing the odds of getting audited-a formula for misfortune.

What I recommend

 My advice is to be sure you are correctly setting up your projects and selecting consultants who will truly qualify as independent contractors. If you don’t have the in-house skills and experience to do this, seek out a proven expert to help you do it right.

Continuing my series on “things the employment tax auditor might not tell you” we now arrive at a critical juncture. The auditor has examined your records and found a whole list of “exceptions” or alleged “misclassified workers. You’ve argued with him and brought out your best documents to prove you did it right but he’s got his mind made up and you’re expecting him to assess you for the past three years. At this point, you have polarized with the auditor.

However, it may not yet be time to polarize with the tax agency itself. There may still be a couple options at this point.

Most agencies recommend you ask for a meeting with the Auditor’s Supervisor

In my career the only time I’ve known the supervisor to side with the taxpayer, against his own auditor, is when the auditor did not discuss the findings of the audit and never gave the taxpayer an opportunity to provide documents or proof. In my experience, the supervisor will review the audit file and then meet with you to “do the dance.” What I mean is the supervisor knows he/she has to play the part of being objective and hearing you out and attempt to explain and justify the auditor’s findings. In the end, generally the supervisor simply gives you the same results the auditor did. 

The only exception to this is if you really have some powerful evidence that proves you are right. This is usually evidence the auditor did not see. (Have you created your Compliance Files yet?)  If the supervisor clearly believes they will lose at a hearing or trial, then there may be some give-and-take at this meeting.

The Taxpayer Rights Advocate (TRA)

At this point ask yourself the following questions:

• Did the auditor slip away without explaining the results of the audit to you?
• Did you suddenly get a bill in the mail without explanation?
• Was the auditor prejudiced concerning you or your business?
• Did it appear the auditor already had his/her mind made up from the beginning and wasn’t objective? 
• Did the auditor refuse to consider your point of view or to give your documentation the weight you feel it deserved?
• Did you call the supervisor and he just blindly backs up the auditor’s determination without giving you a fair chance? 
• Was the auditor rude or in some way unprofessional?
• Is the auditor contacting your clients and service providers, informing them you are being audited thereby hurting your reputation in the business world?
• Has an issue gone on for in excess of 30 days after the auditor promised to get it resolved?
• Is this causing your company financial hardship or burden?

If any of these things occurred, you can call the TRA then call your attorney anyway (see below).  Why call the Taxpayer Rights Advocate first? Usually the TRA will issue a “stop order” on the agency while the case is being reviewed. This is to protect you from any further harm (like further contacts with your customers and clients, collection of liabilities, etc.) The TRA does not cost you anything and often will put a hold on the forward movement of the case the same day you call or file your Form 911 (IRS form to ask for help). 

Of course, the Advocate ultimately works for the agency you’re asking protection from, so don’t expect miracles. Generally, the TRA will fix any auditor abuses or other errors and put you back the way you were just before the error. It’s called “making you whole again.” However, the case continues and this time the tax agency is more careful…

The advantage to calling TRA is the madness will stop.

Calling your attorney

Most attorneys would probably argue you should call them first. I won’t argue with that if you have a true legal expert in the employment tax area. Not someone who took his mandatory classes in law school and promptly forgot most of it after the Bar. Most attorneys really are not experts in common law and employment tax law. For most cases, many tax agencies don’t even send an attorney to the tax hearing to present their case, because the auditor or auditor’s supervisor has more experience and skill in presenting these cases than the employer’s attorneys. For example, California’s EDD wins over 80% of its cases at hearing and that’s without using attorneys. When they call in the attorneys the win rate approaches 95%. I believe the IRS has similar stats. So be sure you have a qualified labor law and employment tax law expert to represent you-someone who has successfully faced this agency before. Also note, it takes a significant amount of billing hours to represent one of these cases.

Calling the local, or federal, politician

This is almost always a dead end. The elected representative will probably never personally see your letter or receive your telephone call. Each elected official has a staff whose primary responsibility is to handle these complaints. The tax agencies have people who are experts in dealing with the elected official’s staff members. Many times they even know each other. All parties have a careful procedure they follow to “resolve” the issue you have raised. Most likely you will receive a carefully crafted letter supporting the tax agency’s position and the audit will go forward. 

You’re going to hate reading this, but it’s true. In most cases the elected official’s staff member asks the agency you are complaining about to draft letter for the politician’s signature. The letter will read as if the politician wrote it and explain his findings on the agency’s actions: A true case of the fox investigating the raid on the henhouse. So unless you really have a powerful connection this approach probably isn’t going to work for you.

Ultimately, your best defense is to be sure you have properly classified your workers and you have the needed documentation to prove your case for each individual. 

 

In this series I last left you with the auditor humming to him/herself in your quiet room-a busy little bee, digging through a pile of your dusty old accounting books. Whenever you checked in and asked “How’s it going?” you got a little smile and a short, non-committal response like, “Fine…”

Eventually, the auditor will emerge from the quiet room and ask to speak to the contact person.  This will be your first real glimpse into how bad or good the audit is going to be for you. Your contact person must be an expert on:

• Your company
• Common law
• The tactics of an employment tax auditor.
• Negotiating

Warning:  There is a category of auditor who will slip away, without discussing the audit face-to-face. I’ll cover how to deal with this coward in a later segment.

What to expect during this “talk,” and what you should be doing…

The auditor will have a list of names and payments to individuals not on the payroll. This list is sometimes called “Questionable Items” (an auditor term for a list of individuals who appear to be misclassified). For each individual the auditor will initially ask:

• What services did the individual perform?
• Where does he perform the work?
• Does he have other clients?

Let me short cut this by saying the auditor will drill down on the common law factors (and possibly some statutory factors) that the IRS and most states use to determine who is an employee or an IC.

Don’t be caught of guard

If you need to, buy yourself some time to prepare:

• Make an excuse why you can’t talk right now,
• Ask for a copy of the list (be honest-say you want to get the information on the individuals so you can be helpful)
• Set a new appointment to discuss them within a reasonable time.

You’re buying time to research, pull files and prepare negotiating points.

When you meet.

As you go through the list the auditor should explain his point of view on each individual’s “status.”  This is basically his attempt to “educate you” and to make his initial ruling. He may tell you which individuals he believes were properly classified, and which were not (Read: tax assessment). Remember, most government auditors err towards calling an IC a misclassified employee.

A tactic almost all auditors use is to group, or batch, individuals into general categories. The auditor will attempt to get your agreement to combine (sometimes hundreds) individuals into a single group. Then he/she will discuss one or two within the group and from that discussion generalize about the other 100. So if the one or two appear to be misclassified, the auditor will assume all 100 are misclassified. It’s an easy path for the auditor-time wise and stress wise. It’s a deadly trap for you.

NEVER AGREE TO BATCHING YOUR IC’S: Unless you just want to get it over with, pay an assessment and have the auditor be on his way.

If you have a group of individuals that operated almost identically to each other you may not be able to avoid grouping. However, I recommend arguing that each individual is unique and must be discussed separately. Your strategy is to wear the auditor down…

Bargaining

At this point most auditors will attempt to gain agreement on at least some of the individuals, so the problem areas are limited. This will work for you too, because you want the auditor to agree that some people were properly classified. The auditor’s drive to get agreement on some issues will make him/her open to a give-and-take bargaining. This informal bargaining usually only happens at this level of the audit and typically is your best chance to horse trade. 

I recommend that if you know there are some issues the auditor has raised which you will lose (you never volunteer issues), offer them up here for concessions from the auditor. If he doesn’t come through you are not bound by the informal deal and you can put them back on the table.

Stay mindful of any IC’s the auditor agreed were correctly classified. You may be able to point out similarities between the remaining individuals and the properly classified IC’s to your favor.

Typically, during this informal bargaining phase the auditor is basing his/her decisions strictly on the conversation and tossing the “obvious ones” into one pile or the other. The items tossed into the “Properly Classified Pile” may never be looked at again. So the clearer cut and convincing your description is at this point, the better for you. 

WARNING: Don’t get caught warping the facts.  You’ll lose credibility and the audit will get nasty.

Your best strategy is to resolve as many of these “Questionable Items” as possible at this point by: 

• Keeping communication open
• Argue strongly, with facts and documents
• Don’t give in if you believe you’re right
• Don’t polarize yet

If you make a statement that indicates there is documentation (contracts, etc) the auditor may ask for copies. This is where your Compliance File on each individual becomes your best tool. You may be able to bring out the documentation that supports your position and make the issue go away forever.

(Please don’t tell me you don’t keep Compliance Files on your IC’s)

What’s next?

What if you just can’t agree? In the next installment I’ll talk about better options than getting angry and shouting “See you in court!” I’ll also discuss the “coward” who slipped away without talking to you.

SACRAMENTO-A bill that would have made it mandatory for all California employers to provide sick leave for any employee (including part-time, seasonal and temporary workers) who had been on the job for at least 90 days was killed this week in the Appropriations Committee.

The bill was introduced by: Assembly Members Laird, Swanson, and Torrico and State Senators Cedillo, Kuehl, and Wiggins.

It was agreed we need to make hiring workers in California more attractive, not more expensive…

The bill ran into strong opposition from the California Chamber of Commerce, businesses throughout the state, and even with state bureaucrats.  All opponents believed the bill would unreasonably expand an employer’s costs and liabilities at a time when California needs to make hiring employees more attractive.

CalChamber Policy Advocate Marti Fisher pointed out, “California’s employers are already struggling with rising energy, health care and regulatory costs in the midst of a challenging economy. This bill would cause employers to make tough decisions that would hurt California workers and cost jobs.”

It would hurt California’s economy.

Thomas Sheehy, deputy director of legislation for the California Department of Finance, also opposed the bill, telling Senate Appropriations on August 4^th that, “…Because this bill would impose a significant burden on California employers at a time when efforts are being made to stimulate job growth and to improve California’s business climate, we can’t support this measure.”

It could still happen someday.

The bill has been put to rest for now, but it has been my experience that once these ideas get a footing in the legislature, they tend to show up again.

Keep watching-we will.

The State of Michigan has a significant number of workers who are being misclassified as independent contractors, hurting tax revenues and breaking state laws, according to a recent report given to Governor Jennifer Granholm.

The Interagency Task Force on Employee Misclassification said workers who are being listed wrongly by businesses as independent contractors rather than employees aren’t being covered by unemployment insurance or prevailing wage laws. In addition, taxpayers are being hurt because businesses that misclassify workers aren’t paying the taxes they should, and some misclassified workers aren’t paying the income taxes they legally owe.

Michigan is among many states (including California) that are working with the Internal Revenue Service to track down employers who are illegally misclassifying employees as a way to dodge paying unemployment and other taxes. Penalties for not paying taxes through fraud can include fines and other penalties.

“The misclassification of employees impacts employers, workers and government. Misclassified employees may not qualify for certain benefits; tax-abiding employers are placed at a competitive disadvantage, while government loses important tax revenues,” the report said.

An audit by the state looking at IRS forms Michigan businesses use to report payments to independent contractors turned up more than $23.3 million in wages that had been misclassified from 2003 through part of 2007.

The Government Accountability Office reports that employee misclassification on the federal level accounted for the underpayment of an estimated $2.72 billion in Social Security taxes, unemployment insurance taxes and income taxes in 2006.

“In Michigan, the state’s UI (Unemployment Insurance) Trust Fund has suffered significant losses due to unpaid UI taxes, while the state has lost important revenues because of employee misclassification,” the report said.

You can bet that in light of the current U.S. economic slowdown and declining tax revenues Michigan is not the only State that is doing this sort of calculation!