Multiple Dipping for Dollars: New York Indie Contractors Rip Off System as ‘Employees’

As more and different types of frauds come to light involving public pension systems, CFEs and auditors must be on the lookout for miscast worker/employer relationships and determine if professional service providers actually are independent contractors illegitimately reported as employees.

In February 2008, a New York State Comptroller’s Office audit found that a Long Island attorney was reported as a full-time employee by five different school districts simultaneously. As a result of this “herculean feat,” the attorney was credited – for state pension purposes – with more than 1,270 days of work in each of two years according to a Feb. 15, 2008, article in Newsday, “5 School Districts Claimed Same Full-Time Lawyer.” That’s quite an accomplishment because a year only contains about 260 workdays.

While the attorney was being reported as an employee of the schools, his firm billed the school districts more than $2.5 million in fees for his services. As a result of the extensive service credits built up in the state pension system, the attorney received an annual state pension of nearly $62,000 and health benefits for life. The attorney defended his arrangement as “common practice,” a version of the familiar fraud rationalization that “everyone does it.”

A few days later, the audit identified two other Long Island attorneys who were reported as employees by six school districts; together they had been credited with more than 55 years of service in the retirement system according to the Sept. 4, 2008, Newsday article, “Nassau attorney removed from pension system.”

In a bit of hyperbole, one of the attorneys said, “Hundreds and hundreds of people over thousands of years have been doing this,” thus presumably tracing the practice to biblical times. Though this article uses New York state examples, it’s highly likely that similar abuses are occurring across the country, particularly when public pension benefits are involved.

THE INDEPENDENT CONTRACTOR  

The classification of workers as employees or independent contractors is a long-standing issue especially in tax administration. Typical misclassification involves treating employees as independent contractors. Employers often aggressively classify workers as independent contractors to avoid payroll taxes, paying benefits, and the complexities of employee reporting. Individuals sometimes prefer independent contractor treatment as well, wishing to avoid deductions and having the possibility of under-reporting their income due to less-stringent documentation.

UNCOVERING A NEW MISCLASSIFICATION 

In the case of the Long Island attorneys, the issue was that they were clearly contract workers, yet were misclassified as employees. Such misclassifications aren’t likely to result in employment tax challenges, but might have other costly repercussions, as the facts show.

In the public sector, reporting nonemployees as employees inappropriately qualifies the workers for public pensions and health benefits. In the private sector, participation in tax-qualified retirement plans is limited to common-law employees (regular employees of a given organization who don’t work independently). Thus, reporting independent contractors as participants in the pension program could lead the IRS to challenge the tax-qualified status of these retirement plans.

The government has created various tests to determine if an individual is an employee or an independent contractor. IRS Publication 15-A (Employer’s Supplemental Tax Guide, 2008) sets forth three categories of questions to guide employers to the proper classification:

• Behavioral controls: Does the employer control when, where, and how the work is done?
• Financial controls: Is it the employer or the individual who controls the financial aspects of the work? Does the worker have personal investment in the means necessary to do the work? How is the worker paid (hourly wage or flat fee)? Is he or she reimbursed for expenses?
• Work relationship: Is there a work contract? Does the worker receive benefits? Is the work arrangement expected to be permanent?

The IRS has also set forth a 20-factor test in Revenue Ruling 87-41, and the Supreme Court established a 12-factor test in Community for Creative Non-Violence v. Reid (1989). The government uses these tests to challenge the independent contractor classification of individuals, seeking to classify them as employees for tax-collection purposes.

EMPLOYEE FOR FIVE SCHOOL DISTRICTS 

The New York state comptroller’s report (2008M-47) on the case of the attorney employed full-time simultaneously by five school districts used criteria similar to those put forth by the IRS to find that the individual wasn’t an employee. The report cited eight examples in which school district officials didn’t exercise control over the daily work of the attorney.

• District officials didn’t supervise, control, or direct how the work was performed.
• Districts didn’t set the attorney’s hours, nor did they define a normal workday.
• Districts didn’t provide the attorney with a place to work; he worked from his private law office.
• The attorney didn’t work established hours; furthermore, the districts didn’t have any records of days or hours worked.
• At one district, the attorney’s salary was adjusted to offset the district’s contribution for FICA, Medicare, and pension contributions (which is inappropriate treatment of an employee).
• The attorney used his resources and supplies, such as legal reference materials.
• The attorney could have other individuals, paid by his firm, perform district work that was his responsibility.
• The attorney provided services to several districts concurrently, and also to the general public.

INVESTIGATIONS BROUGHT SEVERE PENALTIES 

Hearing that this was “common practice,” the comptroller’s office examined additional school districts and quickly identified the two additional cases. At that point, a federal grand jury, the FBI, and the Criminal Investigation Division of the IRS began investigating for possible fraud. The New York attorney general also entered the investigation.

Both the attorney general and the comptroller extended the search statewide and to municipal entities other than school districts, such as towns, villages, libraries, and the like. None of the grand jury, FBI, or IRS findings have been made public, but both the comptroller and attorney general have regularly reported their findings.

In New York, the comptroller is the sole trustee of the state employee pension plans. In the dual role of auditor of municipalities and trustee of the pension plans, the comptroller had revoked membership or rescinded service credit in the state pension plan of 45 individuals by the end of 2008. Most were attorneys, though a few accountants and other professionals were also involved, according to “DeNapoli revokes retirement membership for attorneys across the state,” at nysscpa.org on Dec. 15, 2008.

Membership in the pension-plan system was revoked for cases in which an individual’s entire pension record was due to misclassification as an employee. In other cases, some credit had been earned by legitimate state employment, and only the service credit attributed to misclassification was rescinded. Individuals already collecting retirement and health benefits saw them terminated, and they were required to repay what they had received. The comptroller’s office reported more than $1 million in such repayments.

The attorney general’s investigation generally targeted the law firms whose partners had been participants in this endeavor. At one point, the attorney general announced that within several decades, hundreds of lawyers had been unlawfully added to the pension rolls. This announcement coincided with a $600,000 settlement with two upstate law firms about inappropriate pension benefits for its members, according to “Cuomo gets lawyer pension settlements” at nysscpa.org on June 3, 2008, originally in the Albany Times Union.

A $50,000 settlement with a Buffalo, N.Y., law firm resulted from the 20-year practice of some two dozen of the firm’s lawyers being reported as employees by several Board of Cooperative Educational Services (BOCES) units. BOCES provides shared services to individual school districts in its region, according to “Firm pays $50,000 to settle state probe” in The Buffalo News on May 9, 2008.

In this case, the individual attorneys didn’t claim retirement credits. Rather, the districts used the employee status to get higher state aid benefits because aid formulas give higher reimbursement for employee costs than for independent contractor costs. The attorney general said, “This is a fraud that has gone on for years and in some ways is more insidious than just a single bad act.” To date, the attorney general’s office has reached settlements of more than $1.5 million with 65 attorneys and law firms throughout the state, according to “Landmark pension reform bill signed into law” in Newsday of Oct. 11, 2008, and www.oag.state.ny/media_center/2008/oct/oct16b_08.html. [Link might not be available. —Ed.]

SCHOOL PHYSICIANS: THE NEXT PHASE 

As school district attorneys have been carefully scrutinized, attention is now turning to other professional service providers who might have been misclassified as employees. Recently, four upstate New York physicians reached a settlement with the attorney general in which the doctors paid penalties of $50,000 for “abusing the state’s pension system and being improperly listed as public employees,” according to a Dec. 19, 2008, article in The Buffalo News. The doctors forfeited pension credits, including their own contributions to the pension fund. From 1985 to 2006, the school district had categorized the four doctors as employees, giving them health benefits and pension credits. It’s likely that many similar cases will be found across the state of New York and throughout the United States.

IS IT FRAUD? 

Certainly the employer-independent contractor rules are complex and not always clear-cut. Thus noncompliance might range from honest differences in interpretation, to intentional, and therefore fraudulent, abuse of the rules.

Many of the fact patterns in the New York municipality cases might support a charge of fraud, committed either by the professional service provider, the school district, or both. To date, there’s been no public report of fraud charges being brought, although the investigations are ongoing. However, the comptroller and the attorney general have revoked the inappropriately earned retirement credits, sought restitution for benefits already received, and received settlements from numerous law firms (and now physicians) for their actions. In addition, the attorneys, physicians, and school districts involved have been publicly identified in news releases.

WHO’S CULPABLE HERE? 

Certainly the individuals found to have benefited illegally and who were subjected to penalties were considered knowing perpetrators of the schemes. The culpability of the school districts is less clear. The practice in many cases had been long-standing, which led successive administrators to continue previous practices. Further, it appears that the state education department had unofficially condoned this arrangement through the years. While at least some school districts benefited in the form of increased state aid, these benefits were small in comparison to what the individuals accrued. As yet, no actions against, or restitution by, school districts have occurred. However, New York has put corrective regulations and legislation in place.

PREVENTION OF FUTURE CASES 

Identification of fraudulent activities typically results in a strengthening of controls or other preventative action. Two preventative steps were taken in this situation. First, the state comptroller, as sole trustee of the state pension system, issued revised regulations to clarify the employee/independent contractor classification for state pension purposes.

Six factors that indicate a person is an independent contractor and 17 factors that indicate employee status were set forth in the revised regulations. Municipalities must certify that individuals who provide professional services – attorneys, engineers, architects, accountants and auditors, and physicians – have been reviewed individually to determine their eligibility for membership in the pension system.

Secondly, the state of New York passed the Government Accountability and Fraud Stop Act, which bars attorneys from simultaneously serving as an employee and an independent contractor for a school district and precludes individuals who are independent contractors from receiving pension or health benefits available to employees.

The legislation increased the penalties for defrauding the state pension system. Pension fraud was made a felony, and violators are subject to treble damages (tripling damages allowed by state statute in certain types of cases). Obviously, the question of “is it fraud?” is clearly answered by the law’s title.

ONE LOOPHOLE REMAINS 

Though the new legislation, passed on June 23, 2008, resolved the question of work status for attorneys and other professional service providers for school districts, the issue still remains for other New York municipal entities. In many jurisdictions, a town or village attorney is an elected or appointed public position. Elected and certain appointed officials are entitled to membership in the state pension system. However, several issues came to light when this broad topic attracted attention.

First, while most common-law employees must submit time sheets, elected and appointed officials aren’t required to do so. Rather, a one-month sample of time worked must be reported annually. In one case, an attorney was reported to be a full-time employee of one village, and a part-time employee of two others. The three employers reported the attorney worked 590 days in one year. Without reliable time reporting, there was no way to accurately determine how much service credit the attorney should receive, according to “Private lawyers, public pensions, the loophole” in the Oct. 27, 2008, edition of Newsday.

Second, the attorney had drawn an annual salary of about $92,000 from the three villages combined, but his law firm had billed the villages more than $8 million in legal fees since 1994. The issue of simultaneously being an employee and an independent contractor, recently eliminated for school districts, is still alive and well for other jurisdictions.

Third, as is common in law firms, some of the tasks for which the attorney was paid an annual salary were in fact performed by other attorneys or employees in his law firm. This raises the issue of one person receiving employee retirement credit for work performed by others. That same attorney also served a local water district. At his request, he was listed as an employee, with an annual salary of $16,000 for attending board meetings. He was credited with 18 days in the retirement system, but board records showed that he had attended only 10 days of meetings and an associate in the firm had attended the other eight. In no other application is someone allowed to earn employment credit for the work of a substitute.

IMPLICATIONS FOR PRACTICE 

CFEs and auditors might be accustomed to examining classifications and looking for cases in which employees are misclassified as independent contractors. The cases cited here demonstrate the need for examiners to also be alert for contractors being misclassified as employees, especially within government entities. Governments increasingly are challenging professional service providers, and they are tightening controls. But, as evident in the village attorney example above, more than one loophole remains.

Ronald J. Huefner, Ph.D., CPA, CMA, is a distinguished teaching professor in the Department of Accounting & Law at the State University of New York at Buffalo. 

Sara R. Melendy, Ph.D., CPA, is an assistant professor of accounting at Gonzaga University in Spokane, Wash. 

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