D.S. Berenson is an attorney specializing in the home improvement industry and is a frequent speaker on legal topics at industry forums. His firm, Johanson Berenson LLP, in Washington, D.C., has represented many home improvement companies on a variety of issues over the years.

Replacement Contractor: During the last few years, laws were passed at the state level in Illinois, New Jersey, and Pennsylvania specifying the ways in which general contractors such as home improvement contractors can employ subcontractors. What should contractors in these states be aware of in defining their relationship with subcontractors to avoid audits or having to pay fines and back taxes?

D.S. Berenson: Without sounding glib, the most important thing is to be aware of the issue. The risk of a reclassification audit has huge ramifications for companies. It can apply to your workers' comp, unemployment, payroll withholding. It also takes into account whether that subcontractor, reclassified as a W-2 employee, is now eligible for overtime, sick pay, vacation pay, and other backdated benefits. Once you run that risk of having your 1099 subcontractor reclassified as a W-2 employee, you can get hit in a dozen different categories. So a former subcontractor can come to you and say: I should've been able to get overtime, 401(k), vacation, and on and on.

RC: So, in addition to fines and back taxes for either the state or federal government, there's also the risk of civil action?

DSB: Exactly. Say it's determined that the 1099 worker, whether a salesperson or an installer, should have been a W-2 employee. Now you have 1-800-sue-you type attorneys getting involved. We're running about five to six reclassification projects a month for our clients. Some are federal and state audits, some are private litigation. So there's a huge risk of a class action attorney coming in and saying all these people are employees, therefore you owe them all these benefits and overtime.

RC: What should contractors do to shield themselves from this kind of audit and from potential class action suits?

DSB: The first thing is to get an understanding of the specifics of the law in whatever state or states you're doing business. Every state is approaching the 1099 relationship a little differently. So you'll want to know the particulars of the state law as well as federal law governing subcontractor relationships. Look at the laws, how many workers you have that are 1099, how you're using them, and how important they are to your business. Then determine whether you can - or even want to - restructure that relationship in a way that defends against reclassification.

RC: Once you've studied the laws and have determined that you want to continue using 1099 workers, where do you go from there?

DSB: Come up with a list of protocols. Think of each one of them as a brick in the defensive wall you're building. First of all, you must have a written agreement. The worker must be hired as an entity, and paid as an entity. If we are speaking about an installer, then that worker would need to be independently licensed in those jurisdictions that provide licensing for contactors. You need to show that they are operating entities as going concerns. I like to show a copy of a tax return page establishing that the worker is filing state and federal taxes under a business name and a business I.D. The list of protocols we recommend goes on and on, depending on state and product lines. And if you don't implement the protocols, they're of no value to you. In the event of an audit, you need to be able to show files that indicate how you're treating 1099 installers and salespeople. If all you have are bits and pieces here and there, you're going to have a heck of a time overcoming that audit.

RC: What's the alternative?

DSB: The alternative would be to have an employee-based salesforce and W-2 installers. And there are benefits to that, but there are also costs, especially payroll costs. It can be a substantial burden. Now I am complying with OSHA, minimum wage, unemployment, overtime, all the things that go along with having a W-2 employee. And what if I can't afford to switch the whole workforce over to W-2? I may end up scaling back. But no one looks at it from this point of view. They are just looking at it from a legislative point of view.

RC: How likely is it that other states will pass similar legislation? Why?

DSB: There is legislation pending in about a dozen states right now. If the economy doesn't turn, the majority of the states will have legislation like this making it difficult to structure and maintain a 1099 relationship.