Good morning.

Are you tempted to save some bucks by laying off a few of your people and bringing them back as "independent contractors?"

Beware! The IRS — and more particularly for us Bay Staters, the Commonwealth of Massachusetts — is on the prowl with its list of inclusive criteria to define "employees." The penalties for misclassification are significant.

Best regards,

When I started this solo trek as Financial Managers Trust in 1983, I never really doubted that I could earn good money on my own. And before I was very far down the road, I got over being aggravated at paying both the employee's and the employer's share of the Social Security tax (a total of 15.3%). Yes, I had to pay for my own benefits, and making timely withholding tax deposits was an exercise in financial discipline, especially in the lean times.

But the autonomy, the freedom from the "control and direction" of an employer, the opportunity to set my own hours and to work for multiple clients, and, particularly, the fact that my income was a direct function of my own success or failure and not tied to any one person's determination of my value — all of these factors in the early years kept me on solid ground in the uncharted expanse of The Swamp. Back then, I was the pejorative definition of a consultant: "…a Harvard Business School graduate without a job."

Fortunately, I never really thought about whether or not I was legal, whether or not I officially satisfied all of the criteria as an "independent contractor." I figured — hey, my clients signed a contract with me, they pay me based on my invoice, they don't provide any benefits — how can there be any uncertainty about this? But apparently the IRS prefers dealing with employees rather than independent contractors: the feds don't make it easy to be the latter.

According to the IRS, you're still an "employee" if the company trains you, or directs your work, or if you work full time for a single entity, or if most of your work is done on the employer's premises. I managed to dodge those bullets by setting up a home office and an independent corporation, plus having an MBA and multiple clients, but there were another 16 factors [see IRS reference], that might have defined me as an "employee" in the eyes of the IRS.

However, the "economic reality" of my client relationship was that almost 100% of the time I was the one doing the teaching and training. My explicit goal has always been to work my way out of the engagement by helping the company grow to a point at which I couldn't handle all of the financial challenges on a part-time basis. At that point I usually have taken the lead in identifying and hiring my full-time successor. Always I work on a fixed-fee basis against a task list, and always I use my own equipment and software. Never has my status been challenged, and I have clear claim to status as an independent contractor.

Nevertheless, things have changed in The Swamp during the past 25 years. Employers including FedEx, TimeWarner, Expedia, and Comcast have tried to use independent-contractor (IC) designations to avoid paying Social Security and Medicare taxes, unemployment tax, health care, and other benefits, and they among others have been burned in court (to the tune of $319MM in FedEx's case). Workers have become much better informed of their rights, filing civil actions that can result in treble damages, attorneys' fees and costs. As suggested in a newsletter by attorneys Morse Barnes-Brown & Pendleton PC, if, for example, "a group of workers treated as independent contractors worked over forty hours per week without receiving one and one-half times their regular rate of pay, damages may include three times the owed overtime pay for a period going back as far as three years."

All of this was in the back of my mind last week when a new employee at one of my service company clients mentioned that her previous employer had, on its lawyer's advice, brought all of its ICs in house based on a significantly increased general risk of legal action by the Massachusetts Attorney General. I did a little on-line research. From the MBBP article:

"In December 2004 the Attorney General issued an 'advisory' which declared that the MICL [Massachusetts Independent Contractor Law], as amended, 'excludes far more workers from independent contractor status than are disqualified under the IRS common law test.' The Attorney General noted that, while the twenty factors considered by the IRS are considered flexible and can be adjusted to the circumstances of the work arrangement, Massachusetts law establishes a rigid, three-part test that must be met to overcome the law's presumption of an employment relationship."

So I went to the source, Advisory 2008/1 from the AG's office, which describes three "prongs," all of which must be satisfied in order for an individual to be classified other than as an employee:

1. "The individual must be free from control and direction in connection with the performance of the service, both under his contract for the performance of service and in fact…

2. "The service the individual performs must be outside the usual course of business of the employer… [and]

3. "The individual is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the service performed…" [emphases added]

"Earlier this month, executives at Pearson Education, a textbook publisher in Upper Saddle River, N.J., apparently decided to interpret the [Massachusetts Independent Contractor] law more broadly. Not wanting to risk prosecution by Massachusetts authorities, the company decided to discontinue work with all of its freelancers in the state.

"Freelance editor and writer John Sisson counted Pearson Education as one of his largest clients until he received e-mails from the company citing the Independent Contractor Law and notifying him that Pearson no longer would use Massachusetts contract workers.

"'I've lost business and I stand to lose more business,' said Sisson, a Newton resident.

"'It hurts firms in Massachusetts because it does not allow them to outsource the work they need to do and it hurts independent professionals who rely on that work,' Sisson said. 'The fact of the matter is that the attorney general's office is between a rock and a hard place. It's a bad law and they're in charge of enforcing it.'"