Preparing for Y2K-IX: What You and Your Subcontractors Need to do Before you Ring in the New Year

Category | Briefing Papers

A. Introduction

By now, many Minnesota contractors who subcontract with sole proprietorships and individuals are probably aware of the problem they face on January 1 2009. For those of you (i.e. contractors and subcontractors) out there that have not prepared for “Y2KIX,” it may be wise to get up to speed or risk incurring: (1) substantial fines, and (2) unnecessary labor costs. The “problem” has nothing to do with a “glitch” in computer programming; however, it has to do with a new state law governing when someone may properly be considered an independent contractor and when they must be treated as an employee.

Effective January 1, 2009 any individual, including any sole proprietorship operating under an assumed name or d/b/a, performing construction services for a construction contractor as an “independent contractor” and not as an “employee” must have an Independent Contractor Exemption Certificate (hereinafter referred to as an “Exemption Certificate”); if an individual has not obtained an Exemption Certificate before performing services for the contractor, the contractor must classify the individual as an employee.

This article is intended to provide (1) a discussion of the “benefits” of this new law for the construction industry (at least from the state’s prospective), (2) a basic overview of the new law and the Exemption Certificate application process, and (3) suggestions for ways contractors and subcontractors can remove any “glitches” in the system to ensure that their transition into Y2KIX is an easy one.

B. (Mandatory) New Year’s Resolution: No More Independent Contractor Misclassification

While many contractors are groaning at the thought of more state regulation, the “glass half-full” argument is that this new regulation will serve to level the playing field for all contractors across the state. According to a 2007 investigation by the State of Minnesota Office of the Legislative Auditor (“Auditor’s Office”), 1 in 7 Minnesota employers misclassify workers as independent contractors; and in the construction industry, the ratio jumps to 1 in 3.

Employers that improperly treat workers as independent contractors rather than employers have an economic advantage over employers that properly classify workers. This advantage is due to the fact that employers that classify workers as independent contractors can avoid employer obligations such as unemployment insurance, workers’ compensation, employer-provided benefits, Social Security, Medicare, Fair Labor Standards, Occupational Safety and Health Standards, and civil rights and tax laws. In particular, the Auditor’s Office estimates that the impact of misclassifying a drywall installation employee as an independent contractor is quite substantial: the total hourly base rate for a drywall employee is estimated to be 26% higher than the hourly base rate for someone hired as an independent contractor[1]. Result? Contractors that improperly classify workers as independent contractors can bid lower and make more money. While some independent contractor misclassification is an attempt to avoid labor and tax laws, we do not suggest that the high rate of independent contractor misclassification in the construction industry is malicious, or even intentional, for that matter. Much of the misclassification is a result of a misunderstanding the law and long-standing industry practices.

While this new law is supposed to make the bidding process more equal, it is imperative that all contractors, regardless of past hiring practices, prepare for this new regulation by (1) understanding the new law and (2) implementing strategies and procedures to avoid the unnecessary costs (i.e. fines and employee benefits arrearages) that could result from a violation of this new legislation.

C. Deciphering the Metadata: What does this New Law Require?

To reduce the chances that an individual is misclassified as an independent contractor, the Minnesota legislature has created a presumption that any individual hired to perform work for a construction contractor is an employee. More specifically, this new law applies to any “individual”[2] performing public or private sector commercial or residential building construction or improvement services (hereinafter referred to as an “Individual”). Business entities, including corporations (i.e. domestic, foreign, public service, or nonprofit corporations), limited liability companies, cooperatives, cooperative associations, limited partnerships and partnerships (hereinafter “Exempt Entities”) are not considered Individuals and, thus, do not need to obtain an Exemption Certificate. In addition, persons providing services in the construction sales[3], construction cleanup, and landscaping[4] areas need not obtain Exemption Certificates.

An Individual that does not wish to be classified as an employee when hired by a construction contractor, must (1) obtain an Exemption Certificate from the Minnesota Department of Labor and Industry (“DLI”) prior to providing services and (2) perform the services in a manner that meets the law’s nine-factor independent contractor test (hereinafter referred to as the “Nine-Factor Test”).

1. Step 1: An Individual Must Obtain an Exemption Certificate.

To apply for an Exemption Certificate, an Individual must submit (1) an application[5], (2) a $150 application fee, and (3) a slew of documentation demonstrating that the Individual meets the Nine-Factor Test.[6] In response to the argument proffered by the Builders Association of Minnesota that the application process places an undue burden on applicants, Judge Bruce H. Johnson, a DLI administrative law judge, commented that the hefty disclosures are necessary to ensure that “unsophisticated workers” are not pressured to sign an affidavit, swearing under oath, that they meet the Nine-Factor Test.[7] Regardless of whether you agree with Judge Johnson’s rationale for the law and its corresponding disclosure rules, it is important for both contractors and Individuals to be cognizant that the application process demands an extensive paper trail, which may take some time, and therefore should be factored into the application process timeframe. After all required documentation has been received, the DLI is allowed 30 days to determine whether an Exemption Certificate will be issued. Therefore, a contractor that has a project scheduled to start in early 2009 should be inquiring, in the upcoming weeks, as to whether Exemption Certificates will need to be obtained before work can commence.

2. Step 2: An Individual Must Comply with the Nine-Factor Test While Providing Services as an Independent Contractor.

Once issued, an Exemption Certificate must be renewed every two years; however, the Exemption Certificate may be revoked at any time if an Individual fails to meet his/her continuing obligation to (1) only perform services listed on the Exemption Certificate or (2) perform those services in a manner that meets the Nine-Factor Test. In order to meet the Nine-Factor test, the Individual must:

1. Maintain a Separate Business—the Individual has his/her own office, equipment, material, etc.;

2. File Appropriate Tax Filings—the Individual must have either (1) applied for a federal EIN number or (2) filed a business or self-employment income tax return in the previous year for which the person has the Exemption Certificate;

3. Perform Specific Services—the Individual performs specific services for the contractor for specific amounts of money and the contractor controls the means of performing services;

4.   Incur Expenses—the Individual incurs the main expenses related to the services performed;

5. Assume Liability—the Individual must be responsible for the satisfactory completion of services that the Individual has contracted to perform and is liable for failure to complete the services;

6.   Not be on the Contractor’s Payroll—the Individual must receive compensation from the contractor on a commission, per-job, or competitive bid basis and not on any other basis;

7.   Assume the Risk of Realizing a Loss—the Individual may realize a profit, but also must risk suffering a loss under the contract to perform services;

8.   Have Liabilities—the Individual has continuing or recurring business liabilities; and

9.   Track Revenue and Expenses—the Individual gauges the success or failure of his/her business on the relationship of business receipts to expenditures.[8]

Generally, adherence to the Nine-Factor Test ensures that the Individual’s business remains separate and distinct from that of the contractor’s business. How will this be monitored? The DLI has been delegated certain powers to police the conduct of Individuals that have been issued an Exemption Certificate. Pursuant to an investigation, the DLI may request or subpoena persons to give testimony or produce documentation, equipment or materials.[9] The DLI, however, plans to do the majority of its enforcement by conducting random audits at construction sites, contractor offices, etc. Therefore, the Individual’s obligation does not end and, consequently, the contractor’s risk is not eliminated when the Individual obtains an Exemption Certificate— contractors should anticipate, or at least be aware of, the added labor cost that could result if an Individual’s Exemption Certificate is revoked during the course of completing a contract to perform services.

D. Y2K-IX: How Should Contractors and Subcontractors Prepare?

Contractors and Individuals should prepare for January 1st and beyond during the final weeks of 2008. The following discussion delineates some strategies and procedures that could prove instrumental for helping Individuals and contractors get/remain in compliance with the new law.

1. Individuals May Want to Consider a New Identity, or at Least Get Certified.

Individuals may choose to organize under a business entity before January 1, 2009. After January 1, an Individual will be subject to a fine of up to $5,000 if he/she fails to obtain an Exemption Certificate before performing work as an independent contractor.[10] Individuals, however, could avoid the risk of incurring these fines, and the arduous Exemption Certificate application process altogether, by converting to a business entity (i.e. an Exempt Entity) by January 1, 2009.

Even if an Individual does not wish to be classified as an independent contractor because he/she prefers to reap the financial and social benefits of an employer-employee relationship, an Individual should nevertheless consider applying for an Exemption Certificate as soon as possible. Once an Exemption Certificate has been issued, one may still choose whether he/she wishes to be classified as an independent contractor or an employee.[11] The nature of construction industry demands that contractors consider every project expense; thus, a contractor will likely consider the implicit cost of classifying an Individual (without an Exemption Certificate) as an employee—a cost that will not be assumed when hiring an independent contractor. Therefore, while obtaining an Exemption Certificate does not preclude an Individual from choosing employee classification, it will, however, make the Individual more marketable to contractors.

2. Contractors and Subcontractors May Want Give Hiring Procedures a “Face-Lift.”

While the burden is ultimately on the Individual to obtain an Exemption Certificate, that does not mean that contractors are off-the-hook. A contractor could be fined up to $5,000 for any occurrence of (1) inducing an Individual by use of coercion, misrepresentation, or fraudulent means to adopt independent contractor status, (2) knowingly misrepresenting that an Individual is an independent contractor when the Individual has not been issued an Exemption Certificate or is performing the services that are not listed on the Exemption Certificate, or (3) failing to obtain a copy of the Individual’s Exemption Certificate before the Individual begins performance of the hired services. Further, although the Exemption Certificate must be renewed every two years, contractors must retain a copy of Exemption Certificates for five years from the date the contractor receives it from an Individual.[12] In addition to incurring a substantial fine for each violation, contractors will be liable for any arrearages of employer obligations owed to an independent contractor that should have been classified as an employee.

a. Contractors Should Verify that Exempt Entities are In Fact Exempt Entities.

Contractors should verify that workers (including sole proprietorships) claiming to be Exempt Entities are in fact Exempt Entities before signing a subcontract agreement. A contractor may be tempted to assume that an individual operating under an assumed name or d/b/a—such as “Drew’s Drywall Services”—is an Exempt Entity, when in reality the worker does not meet the definition of an Exempt Entity.[13] To be assured that a subcontractor is an Exempt Entity, a contractor should require that a subcontractor provide a Certificate of Good Standing, which verifies that the subcontractor is a registered entity in good standing with the state. If a Certificate of Good Standing is not available, a tax form (such as an SS-4 for a partnership) should be obtained. Further, if the contract’s term spans several years, a contractor may even want to include a provision in the subcontract that requires the Exempt Entity to periodically provide a Certificate of Good Standing. While these measures may seem extreme—especially for a subcontractor whom you have maintained a close working relationship with for many years—it could prevent the Individual and the contractor from each incurring a $5,000 fine.[14]

b. Contractors Should Maintain Current Records on Exemption Certificates.

In addition to requiring an Individual hired as an independent contractor to provide an Exemption Certificate prior to the date work is scheduled to commence, the contractor should maintain records of pertinent information regarding each Individual’s Exemption Certificate, including: (1) the Exemption Certificate’s issuance/expiration date, (2) the service(s) that the Individual is permitted to perform under the Exemption Certificate, and (3) the date that the contractor received the Exemption Certificate. A periodic audit of this information will reduce the chance that an Individual is operating under expired Exemption Certificate, or is providing services that the Exemption Certificate does not authorize.

Since the DLI reserves the right to revoke an Exemption Certificate at any time, the contractor will also want to implement measures to ensure that it is notified of any Exemption Certificate revocations. The DLI website maintains a database of all active Exemption Certificates and indicates, for a period of six months, when an Exemption Certificate has been canceled or revoked. In addition, the DLI must serve notice of revocation on any person identified by Individual that is receiving (or was scheduled to receive) services under the Exemption Certificate.[15] In order to reduce the risk that an Individual is performing services under a canceled or revoked certificate, a contractor should refer to the DLI Exemption Certificate database periodically to confirm that each Exemption Certificate is active and in good standing. Further, because an Individual may fail to report the contractor’s name to the commissioner, the contractor may want to include a provision in the subcontract requiring that the Individual report Exemption Certificate revocations and cancellations directly to the contractor.

Finally, in the interest in maintaining fixed job costs, the contractor should be cognizant of the Individual’s duty to comply with the Nine-Factor Test while providing services as an independent contractor. A contractor will not necessarily be fined if a hired Individual’s Exemption Certificate is later revoked, but it may, however, increase labor costs for the contractor. As mentioned above, a project that was expected to cost a flat labor fee will increase by roughly 26% if an Individual’s labor force is classified as employees of the contractor. Therefore, the contractor should implement procedures to ensure that the Individual remains in compliance with the Nine-Factor Test, which will in turn reduce the chance that a contractor will forfeit its ability to classify the Individual as an independent contractor.

E. Conclusion

Long story short: more regulation is good for keeping government employees and lawyers working, but not so good for clients.
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[1] Assuming an hourly base rate of $30, the study adds $7.82 to the employee’s hourly rate, which accounts for state and federal unemployment insurance tax, Social Security and Medicaid, workers’ compensation.

[2] Minn. Stat. § 181.723, subd. 1. Note that the impact this new law will have on contractors across the state cannot be fully ascertained at this time because Minnesota Statutes § 187.723, does not define the scope of its application or enforcement. The statute broadly defines “individual” as any “human being” without specifying whether an individual, hired by a Minnesota-based contractor, performing construction services exclusively outside the state will be subject to the new law. While the Department of Labor plans to issue advisement on this issue, this ambiguity may ultimately need to be resolved by the courts.

[3] Minnesota Independent Contractor Exemption Certificate Rules Section 5202.0120, Subp. 2 provides that an individual that “manufacture[s], suppl[ies], sell[s] products, materials, or merchandise” for construction of buildings but does not “install, connect, attach, or adjust” the products, materials or merchandise is not required to obtain an Exemption Certificate.

[4] Minnesota Independent Contractor Exemption Certificate Rules Section 5202.0120, subp. 3 provides that “landscaping” includes “placing soil, sod and mulch; planting seeds, plants, shrubs, trees and other vegetation…installing erosion control measures, retaining walls, boundary walls, fences, brick and stone pavers and aesthetic surface treatments.”

[5] Applications are available (as of September 1, 2008) at the Minnesota Department of Labor and Industry website (www.doli.state.mn.us/pdf/icec_applic.pdf).

[6] See the Minnesota Independent Contractor Exemption Certificate Rules 5202.0130, subp. 2 for a complete list of required information and documentation.

[7] Judge Approves Rules that Fight Misclassification of Independent Contractors, Workday Minnesota, July 8, 2008, http://minnesotabuildingtrades.org/judge-approves-rules-fight-misclassification-independent-contractors.

[8] See Minn. Stat. § 181.723, subd. 6.

[9] See Minn. Stat. § 181.723, subd. 9.

[10] Minn. Stat. § 181.723 subd.7(a)(1)

[11] Minn. Stat. § 181.723 subd. 7(b)(1) ( “[a] person shall not require an individual through coercion, misrepresentation, or fraudulent means to adopt independent contractor status”).

[12] Minn. Stat. § 181.723, subd. 7.

[13] An individual merely operating under an assumed name or d/b/a, without more, is not legally recognized as a business entity (i.e. a corporation, limited liability company, cooperative, cooperative association, limited partnership, or partnership).

[14] See Minn. Stat. § 181.723, subd. 7 ( an individual is prohibited from performing work as an independent contractor without first obtaining an Exemption Certificate; a contractor must obtain an individual’s Exemption Certificate before the individual begins work as an independent contractor); see also Minn. Stat. § 181.723, subd. 8 (any violation of this statute results in a fine of up to $5,000).

[15] See Minnesota Independent Contractor Exemption Certificate Rules 5202.0150, subp.3.

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