Employee vs. Independent Contractor?

Miss-classifying employees as independent contractors can have significant, sometimes fatal, ramifications to the sale of your company, particularly if first learned of by Buyer during due diligence.

The problem is not only that it is difficult to ascertain the extent of the Seller’s financial liability, but that that it is very difficult to resolve all the resulting outstanding issues on a timely basis. Employees, ex-employees, and the state and federal governments may all have claims as a result of that miss-classification.

Two recent developments concerning that potential liability have jumped out at me:

First, and of particularly note for those of you that believe the concern is overstated, or that only early-stage companies fall into the miss-classification trap, the California State Labor Commissioner has filed suit against ZipRealty, seeking $17 Million in back wages, overtime pay and penalties. The essential allegation is that ZipRealty failed to pay minimum wages to its “employees”;  ZipRealty apparently claims that they were outside salespersons.  (See the story here.) [That may not seem like much for a publicly traded company, but as of this writing, it represents a significant portion of ZipRealty's market cap (approximately $39 Million).]

Second, and this is good news, the IRS has come out with a program that allows taxpayers to voluntarily reclassify their workers for future federal employment tax purposes, with limited federal employment tax liability for the past non employee treatment.  While it would not address the issues raised by the California Labor Commissioner’s actions against ZipRealty noted above, it addresses the very fundamental issue of past liability for failure to properly withhold taxes because of miss-classification, and is welcome news.  (The Wall Street Journal wrote about the IRS crackdown on miss-classifications generally here, and details of the program can be found in the IRS announcement here.)

What does this mean if you anticipate being a Seller in the next few years?  First, if you have miss-classified your employees, recognize that the potential liability is real, and may be significant…it can torpedo an otherwise attractive deal.  Second, do not stick your head in the sand.  Consult with your attorney and consider taking advantage of the IRS program to get a significant part of the problem behind you.  (It may be a difficult decision, however, as resolving the IRS claims will not address the potential liabilities for unpaid state unemployment insurance and workers compensation premiums, and the former independent contractors may have claims based on failure to provide them benefits otherwise provided employees.)  Nevertheless, do what you can to get rid of contingent liabilities.  Uncertainty can kill deals.