"New Worker Status Laws" By Alan Friedman, Music Inc.

The Cost of New Worker Status Laws

By Alan Friedman
Source: Music Inc. Sept. 2018

Like many others, the music retailing industry has long favored the treatment of certain workers as independent contractors. Years ago, music store operators saw the wisdom of integrating music education and repair services into their revenue-earning activities, yielding value-added and profitable revenues to the bottom line. Some of that profitability came from treating teachers and/or repair technicians as independent contractors instead of as employees. This classification allowed retailers to pay workers a gross compensation, and escape the payroll tax, reporting and employment benefits trappings associated with classifying workers as employees.

But over the years, both federal and state tax authorities have gotten wise to the billions of lost revenue dollars from not collecting employer-matched social security & Medicare tax, unemployment tax, and income tax on profits aggressively lowered by business deductions or not reported at all. The IRS responded by replacing their longstanding “20-factor” test with more stringent rules on worker classification, with the states implementing their own tougher rules on worker classification followed by an unprecedented increase in labor audits.

MEET THE NEW BOSS…SAME AS THE OLD BOSS

According to recent studies, the U.S. is made up of approximately 12.5 million independent contractors, who are typically defined as individuals who work with an organization but are not counted as employees. This classification prevents them from enjoying various employment benefits that permanent employees get, as well as protective employment laws for minimum wages, overtime, vacation and other benefits.

While most businesses do their best to be fair with all workers, business owners are keenly aware of the cost-saving exploitations they derive when working with independent contractors. But as many businesses are starting to find out, that cost savings could pale in comparison to a surprise labor audit assessment of back taxes, unpaid employment perquisites (like health insurance and 401(k) contributions), punitive interest and heinous penalties if the audit reveals worker misclassification.

Accordingly, it is critical for business owners to correctly determine whether individuals providing them services are contractors or employees. Any worker deemed an employee should have all Social Security, Medicare and federal, state and city income taxes withheld from their paycheck and remitted to corresponding tax authorities by their employer.  Additionally, employers need to pay all applicable federal and state unemployment tax, non-discriminating employment benefits and operate in compliance with all federal and state labor laws, including the U.S. Fair Labor Standards Act that establishes minimum wage, overtime pay, recordkeeping and youth employment standards for all employees.

While many business owners have grown tired of hearing about these ever-increasing stringent labor laws and audits, a recent edict on worker classification from the California State Supreme Court should have all business owners, whether California based or not, shaking in their boots…and wallets.

CALFORNIA DREAMING (of New Revenue)

Recently, the State of California made headlines when it stated it was making changes in their laws governing independent contractors. In a unanimous decision, hailed as a landmark move that will significantly change the California workplace, the California Supreme Court ruling now makes it much harder for employers to classify their workers as independent contractors.

On one hand, the new ruling means independent contractors now have a safeguard against exploitation with their employment rights protected by this new law. While there’s still speculation regarding the overall application of the ruling, there’s a renewed sense of stability in terms of pay scale, breaks and benefits an individual can expect when working with any given business.  But the increased payroll cost of abiding by this new ruling may impair an employer’s ability to hire and/or retain its workforce causing an unexpected decrease in employment.

ABC MAY MEAN IOU

The new California ruling addressed and revised the criteria for classifying a worker as an independent contractor. A new "ABC test” relies on the following points to successfully identify and classify a worker as an independent contractor:

A. If the employer can prove, without any doubt, they do not exercise control over the worker’s ability to perform a certain task.

B. If the worker is performing a task or job that is outside the functions of the business in question.

C. If the worker has an established trade or a business they customarily engage in.

For example, if a music store engages a plumber to fix the store’s toilet, the plumber will most likely meet all of the ABC test criteria and be considered an independent contractor. On the other hand, if a music store offers music lessons and engages dedicated music teachers, that music teacher will probably be deemed an employee by failing Test Item B above. Under these new guidelines, employers need to pay close attention to ensure any worker classified as a contractor meets ALL three ABC requirements. Otherwise, these workers are eligible to be reclassified as permanent employees in audit with all associated costs.

Interestingly, the new ruling gives rise to difficult decisions for businesses such as Uber and Lyft who usually classify their drivers as independent contractors. In fact, their business models are dependent on the use of independent contractors in order to enjoy low labor costs, minimal benefits and other legal loopholes associated with working with contractors.

But these drivers are working primarily for a company by following its rules and regulations and upholding the company’s standards. Under the new ruling, they arguably should be reclassified as employees and receive regular compensation and be eligible for overtime, medical benefits and more. It’s now speculated these kinds of businesses may have to completely overhaul their business model as the labor cost associated with changing from contractor to employees could be up 20% to 30% higher, with little leniency from taxing authorities who stand to collect substantial interest, penalties and fines for non-compliance. FYI, misclassifying workers is a punishable offense and gives rise to potential claims of tax fraud by taxing authorities.

MORE STATES TO FOLLOW

But the most notable is element of the ruling is the California Supreme Court is considered the highest authority court in the state and most influential court across the U.S. With California’s ruling following on the heels of a similar ruling made by the New Jersey Supreme Court as well as tough rulings already in force in Massachusetts and Illinois, more states are sure to follow.

The California ruling will undoubtedly motivate other states to start reevaluating their current tests and introduce better (or more stringent revenue-generating) ones. The California decision brings some long-awaited clarity, as hundreds of previously filed labor cases relating to employee misclassification can finally be addressed and handled in a judicious manner. But the great unknown is the ultimate financial cost to employers for future labor law compliance, and worse, the cost for not having adhered to prevailing rules of the recent past discovered in future audits.

Suffice it to say, music retailers are now highly advised to routinely self-audit and reexamine their employment practices to avoid ignorance of these labor laws that can seriously injure or destroy your business for noncompliance. Next month’s Part 2 will deal with the current federal rules on worker classification and what to do in the event of a state labor audit…stay tuned.

Alan Friedman, CPA, provides accounting and financial services to music industry clients. He is a frequent speaker at NAMM-U seminars and can be reached at 860-677-9191 or alan@fkco.com. Visit his website fkco.com