Misclassification of Employees is Payroll Fraud. Here's How To Stay Out of Trouble
The Internal Revenue Service and Department of Labor have been going after employers who misclassify employees as independent subcontractors - and the construction industry is squarely in their crosshairs.
In late 2011, the DOL and IRS entered into a formal agreement of cooperation in sharing information and data in order to enforce employment laws. If you have been improperly failing to withhold income taxes and contribute the employer portion of the Social Security and Medicare taxes, and failing to pay unemployment insurance premiums and workers compensation premiums for people functioning as employees, and one of them complains to the Department of Labor, you can expect the IRS to get wind of it, too.
Additionally, if you are using an unlicensed contractor, and closely directing their work, the Department of Labor and IRS will consider this individual to be an employee, not a contractor. If that person is injured while functioning as an employee, the employer is liable… and you had better have workers compensation insurance in place.
The distinction is especially critical in the construction industry, because of the innately hazardous nature of the workplace. Independent contractors are generally expected to provide their own insurance. Employees are not, but are covered under their employers' plan. Failure to comply with employee classification laws risks employees falling through the cracks - and severe consequences for employers.
A Pervasive Form of Fraud
The deliberate misclassification of employees as independent contractors is an epidemic form of payroll fraud in the construction industry - and law enforcement at both the federal and state level nationwide are focusing resources on eradicating it.
Some studies indicate that as many as one worker in twenty is misclassified as a contractor when he should be considered an employee - and that companies that do misclassify workers as independent contractors do so routinely. Among employers that have been caught conducting this kind of fraud, they do so for an average of 40 percent of their workers.
This creates a substantial pricing advantage for dishonest contractors - and makes it that much more difficult for legitimate construction contractors to compete on a level playing field.
The practice also severely undercuts the industry as a whole, according to some observers and market participants. Marek Brothers Construction CEO Stan Marek maintains that as long as dishonest contractors circumvent wage and hour laws, there there is no viable career path for young people who might otherwise consider going into the construction industry. "We will never attract young men and women into the construction industry until there is a career path," he told a panel of Texas legislators and regulators. "There's a tremendous need for skilled workers. A lot of kids don't want to go to college. But if the construction industry is dominated by businesses that exploit workers, Texas kids aren't going to sign up… It is a cancer that is eating the industry. It is killing us."
Penalties for Payroll Fraud
It's not just federal officials cracking down on employee misclassification and payroll fraud - state governments are also going after employers practicing this form of fraud, and a number of states have actually increased penalties in recent years.
Companies caught committing payroll fraud are typically charged back taxes and interest by both the IRS and state revenue officials. Companies are also fined up to hundreds of dollars per day per worker not covered by workers compensation insurance. Construction firms have also been hit with on-the-spot 'stop work' orders when state inspectors discover workers on site who aren't covered by workers compensation. This can lead to cost overruns, time delays and uncomfortable conversations with customers and prime contractors upstream.
In egregious cases, people have been sentenced to prison time. For example:
On September 6, 2012, in Richmond, Va., Mark S. Holpe, of Midlothian, Va., was sentenced to 18 months in prison and fined $40,000 for evading the payment of employment taxes on unreported cash wages he paid employees of Nature's Way Landscaping, Inc. Holpe pleaded guilty to evading the assessment of $326,196 of employment taxes. Holpe worked for Nature's Way, a business that did residential and commercial landscaping in the Richmond metro area. He was originally the president, but became the treasurer in 2007 when he sold a portion of the business. In entering his plea, Holpe acknowledged that the company had two groups of employees during tax years 2006 through 2009. Holpe admitted that he paid one group of approximately 30 employees $2,132,000 in cash wages during that period, without withholding social security taxes.
Staying out of Trouble
It is true that there is substantial gray area in defining who is an employee vs. who is an independent contractor. The IRS has published a 20-point series of tests to help determine how a worker should be properly categorized. In the construction industry, a lot of it comes back to who is holding the license: If you hire an unlicensed contractor, and you are directing their work and telling them what to do on a daily basis, and they are operating under your license, this is clearly an employee.
If that worker is injured, the employer is liable, and if workers compensation insurance is not in place, the medical costs could potentially push an employer into bankruptcy - even before back taxes, penalties and possible criminal prosecution is taken into account.
By way of further examples, your independent contractor may legally be an employee if any of the following factors apply:
- You provide tools, training and/or materials for the job.
- You are closely directing what time the worker or workers must show up on the job.
- You are 'counseling' workers in writing about tardiness or other disciplinary issues.
- You are dictating methods. Contractors don't tell subcontractors how a job is to be done - they just define the scope of work and leave it to the subcontractor how best to complete it. If you tell someone how to do a job, rather than just describing the end state, chances are you could be turning them into a legal employee.
- You expect any kind of exclusivity.
- Do you require any kind of company-provided training?
- Do you pay transportation expenses or provide transportation for these workers?
- Do you reserve the right to terminate the worker at will?
The complete IRS 20-factor test can be viewed here.
Note that not all 20 factors need apply for the IRS, Department of Labor or state officials to determine that an employment relationship exists. Officials can and have determined that an employment relationship exists even when just a few of the 20 factors apply.
Meanwhile, if there is any doubt or gray area, it's important to address it immediately - and maintain legally required workers compensation, medical and other coverage until you are certain you are engaged in a bona fide contractor-to-contractor relationship, rather than an employer/employee relationship.