There are lots of reasons employers like to hire “independent contractors” instead of employees. A company’s budget may limit headcount, but allow for hiring “consultants.” Independent contractors do not require company-provided benefits. There is less chance of employment related litigation. Most wage-hour laws do not apply. And, yes, the employer does not have to pay its share of social security tax or withholdings.

Perhaps it sounds too good to be true because it is. The government is hostile to independent contractor relationships because it wants withholding taxes and also insists that employees receive all the wage-hour and other worker protections afforded to employees.

Therefore, the law does not permit employers to choose whether to classify a worker as an independent contractor or employee. Federal and state laws apply different tests to determine proper classification. The default position is that an individual worker is an employee until proven otherwise.

The consequences of mis-classification can be severe. The IRS and state taxing authorities impose significant penalties for failing to make proper withholdings (over and above the underwithheld taxes themselves). Then, to the extent a mis-classified contractor failed to receive overtime or other mandated benefits of wage-hour law, there may be significant liability for unpaid wages and penalties. Finally, pension and medical benefits denied to mis-classified workers can result in more liability.

Employers who have succumbed to the temptation of independent contractor mis-classification may be relieved to learn the IRS has begun an “amnesty” program. The “Voluntary Worker Classification Settlement Program” (available for review on the IRS’s website https://tinyurl.com/3h2wzzd) is a way for employers who have mis-classified employees as independent contractors to regain compliance with the IRS. To be eligible, an employer must “consistently have treated the workers in the past as nonemployees; have filed all required Forms 1099 for the workers for the previous three years” and not already be subject to an audit by the IRS or state agency.

The employer must agree to treat the previously mis-classified workers as employees going forward, and to pay a just over 1% of the wages paid to the contractor for the past three years to cover the back taxes owed. No interest or penalties will be due. In return, the IRS will not take action against the employer over the re-classified employees.

What’s the catch? The states are not bound by the agreement. Neither are the employees who may bring private wage-hour lawsuits, etc.

Employers seeking greater incentive to join the IRS’s amnesty program may wish to review the U.S. Department of Labor’s recent announcement on the same subject äóñ misclassification of independent contractors. On September 19, 2011, the DOL announced a “memorandum of understanding” signed by the IRS, DOL, and several state agencies.

Under the MOU, the DOL will share with the IRS information regarding its investigations of employers with mis-classified workers. The IRS will pass along to state taxing agencies information concerning mis-classified workers that it receives from the DOL. The IRS also will share with the DOL information it uncovers during tax audits that may indicate a criminal violation of federal laws that the DOL enforces.

The federal government is not alone in its recent focus on independent contractors. The California Legislature just presented SB 459 to the Governor. If signed, this bill would impose huge fines for “willful mis-classification” of independent contractors. If that’s not enough, the bill would require an employer found liable to post on its website and in public areas that it willfully misclassifies independent contractors. The bill also imposes personal liability on non-lawyer consultants who advise employers to mis-classify employees as contractors.

Employers should review the IRS and state law criteria for classifying workers as independent contractors. Doubts should be resolved in favor of employee status. Proper classification of independent contractors starts with a well-drafted independent contractor agreement. Employee/independent contractor status usually turns on the degree of control and independence the employer exercises over the worker. The IRS considers questions such as how much control the company has over the contractor’s work performance and work methods; whether the relationship is for a fixed project or goes on indefinitely; what benefits the employer provides and how the contractor is compensated; what is the nature of the work performed and it is a key part of the employer’s business. There are other factors as well, and state agencies may consider additional data.

Suffice it to say, employers should never mis-classify employees as independent contractors to save on payroll costs, benefits, or the administrative burdens of adding someone to the payroll. Given the scrutiny and potential liability employers will face in the months and years to come regarding independent contractor relationships, it would be wise to rely on experienced counsel for advice in this difficult area of the law.