Employee Misclassification: Independent Contractor v. Employee
Worker misclassification is rampant and continues to be an audit issue for the federal government and the state of New Jersey. Some misclassification cases have even made national headlines. It will likely become a bigger issue as clients begin to understand what benefits the new Internal Revenue Code (IRC) section 199A could bring to them if they are considered to be operating their own pass-through trade or business. While misclassifying workers as independent contractors can go far beyond employment tax savings, in most cases, by the time the federal government or the state catch up with the employer, the amount of tax, interest and penalties assessed can be devastating.
So how do employers get caught misclassifying their workers? Targeted and random audits are one way. But in many instances of injury, the worker does not have his or her own workers compensation coverage, and the injured worker applies for workers compensation benefits. This can lead to a dispute between the worker and the employer, and the state will likely step in to determine coverage. A similar situation may occur if the worker is laid off. The worker, even though characterized as an independent contractor, may apply for unemployment insurance benefits. If it is not obvious that the worker was correctly characterized as an independent contractor, an investigation of the employer may ensue.
The ABC Test
Since workers compensation and unemployment matters are within the purview of the state, the New Jersey Division of Labor and Workforce Development (NJDOL) is generally the entity that will investigate in these situations. NJDOL has a very simple three-part test — the ABC test — to determine if a worker is an independent contractor or an employee. The three parts of the test, all of which must be satisfied, are as follows:
- The individual has been and will continue to be free from any control or direction over the performance of services both under his contract and in fact;
- The service is either outside the usual course of the business for which it is performed, or is performed away from its business; and
- The individual is customarily engaged in an independently established trade, occupation, profession or business that is of the same nature as that involved in the service.
These three simple rules are nearly impossible to overcome unless the person is an independent contractor in the true sense of the meaning. The case of Carpet Remnant Warehouse v. Dept. of Labor, decided on Aug. 6, 1991, sets forth the New Jersey Supreme Court’s view on these three factors.
The primary reason that the federal government gets involved in misclassification cases is for employment tax reasons. However, independent contractor status allows employers to avoid many other requirements under the law, such as requirements under ERISA, the Fair Labor Standards Act, the Family Medical Leave Act, the Occupational Health and Safety Act and rules enforced by the Equal Employment Opportunity Commission. Penalties for violation of these acts can be steep.
Section 199A Implications
New IRC section 199A allows pass-through trades or businesses to exclude up to 20 percent of their earnings from taxation. This will give some employees the incentive to request classification as independent contractors. The section 199A regulations specifically indicate that if a person was an employee and is now an independent contractor performing services for the same company, they will be presumed to still be an employee for the purposes of section 199A for three years, even if they set up a separate company through which those services are performed.
It has been said that the rules of independent contractor versus employee are outdated and do not take into account the realities of work relationships in the new “gig” economy. Only time will tell as more case law develops in this ever-evolving area of the law.
Scott H. Novak, Esq., is of counsel at Post Polak, P.A., where he specializes in the area of tax law, with a focus on tax controversy, trusts and estates, planning and transactional tax matters.
This article appeared in the May/June 2019 issue of New Jersey CPA magazine. Read the full issue.