Watch How You Classify Employees

Most builders are probably familiar with at least two employee issues that involve skirting the rules: having employees masquerade as subcontractors and classifying hourly wage earners as salaried managers or administrators.

In both cases, the idea is to reduce payroll costs, but the strategies are fraught with risk.

The first issue, employees' masquerading as subs, involves people deemed subs who are, by definition, employees. According to the Internal Revenue Service, "the difference between an employee and a subcontractor depends on your right to direct and control the worker." To make the determination, the IRS examines three factors:

Behavioral control: Does the employer have the right to direct and control how work will be performed? Specifically, does the business determine "how, when or where to do the work; what tools or equipment to use; what assistants to hire to help with the work; and where to purchase materials and services"? If the answer is yes, the worker is considered an employee.

Financial control: This pertains to whether an employer directs and controls "economic or business aspects of how the work is done." This relates to "the existence of a significant investment in the worker; the extent to which the business reimburses the worker's expenses; whether the worker makes his services available to other businesses; the method of payment used by the business in paying the worker; and the opportunity for profit or loss by the worker." Again, if the employer has this type of control, the worker is considered an employee.

Relationship of the parties: Is there a written agreement or contract classifying the worker as a subcontractor (though "the substance of the relationship, not the label, governs")? Or is the worker provided benefits typically associated with an employee, including "paid vacation days, paid sick days, health insurance, life or disability insurance, or a pension"? If yes, the worker must be classified as an employee.

If the IRS decides that a worker treated as a sub is actually an employee, the business might be required to pay back payroll taxes as well as interest or penalties. For more information, go to www.irs.gov.

The second matter relates to how employees are classified. Employees classified as executive, administrative or professional are considered salaried and are exempt from the overtime provision of the Fair Labor Standards Act.

Employees who are not exempt from the FLSA (or applicable state labor laws) are entitled to overtime pay after 40 hours of work in a workweek "at a rate not less than 1 1/2 times an employee's regular rate of pay." In states with labor laws that address overtime, whichever standard state or FLSA that provides the higher rate of pay is used.

Builders who have avoided overtime pay by agreement with employees should be warned: "Overtime may not be waived by agreement between the employer and employees." The end result for violations: recovery of back wages, civil penalties, fines and possible criminal prosecution. For additional information on overtime regulations, visit the U.S. Department of Labor's Web site at www.dol.gov.

Saving money by reclassifying employees might provide short-term benefits to a company owner but could result in expensive remedies down the road.

Stan Ehrlich can be reached by e-mail at sfehrlich@rcn.com.