It has been a long standing practice for employers to classify their service providers as independent contractors instead of employees. This practice was beneficial to the employer as it was able to avoid paying payroll taxes, workers’ compensation and other insurances mandated by law. Some employees also preferred the classification as it allowed them to take some deductions, not otherwise available to employees.

A recent twist in US laws may change this common practice, as employees’ incentive to agree to an independent contractor classification may be significantly impaired. US’ new Affordable Care Act (a/k/a Obama Care) provides that any employer with 50 full time employees (or more) is required to grant those employees health benefits under the law. Failure to do so will result in hefty fines. As a result, the classification of employee vs. independent contractors becomes highly significant.

In most cases, the distinction is clear and unmistakable. However, in some cases things are not so simple. The tests for determining the correct classification vary from State to State and from the IRS determination. That said, the common denominator in all tests is the level of control asserted by the employer over the service provider. For example, did the employer set the work hours or is the service “per project”, is the employer providing a permanent place of work, equipment (like a computer or cellular phone), is the employee subject to supervision by the employer’s staff, does the provider have other customers other than the employer etc. The more the employer seems to control the time and manner of the service, the higher the likelihhod that the provider will be deemed to be an employee and not an independent contractor.

In recent years, the IRS, as well as the State tax authorities, have increased enforcement over such classification. At the federal level, if the IRS believes that the provider is an employee and not an independent contractor, the employer will be obligated to pay his share of payroll tax, even though the provider already paid those directly to the Treasury as a self-employed individual. In addition, in a State audit, the State can impose penalties on the employers who erroneously classified employees as independent contractors and as a result, failed to make workers’ compensation and insurance contributions. In recent years, unlike prior years, the tax authorities also began sharing information such that a State audit could result in a Federal IRS review, and vice versa. To date, most of the misclassification audits were raised as a result of provider’s claims for unemployment benefits, or injuries occurring at work. In those cases the provider, who was classified as independent contractor is claiming that he, in fact, was an employee and such claim normally prompts an audit of the employer, not just with respect to the complaining employee, but of the entire operation.

With the new health laws now in place, the employers’ incentive to classify more employees as independent contractors is higher than ever, given the large cost associated with providing health care benefits. Simultaneously, many employees who, without such employer benefits are unable to afford health care, have a great incentive to be classified as employees and enjoy the new law’s benefits. Accordingly, many employers may find themselves exposed to claims by employees of wrong classification. Such claims are expected to bring both Federal and State authorities to conduct a thorough review of the relationship and, where applicable, impose large penalties under the healthcare regime, as well as the current tax and employment law regimes.

The lesson learned from this new state of affairs is clear. Each employer must conduct a re-evaluation of its employees’ and independent contactors’ classification and re-classify properly, when the tests so merit. The sooner the better!