ndependent Contractor vs. Employee
“Show me where it says I can’t do that”. Those words can strike fear in the hearts of compliance professionals when uttered by a mortgage company senior executive.[1] Sometimes, it’s relatively easy to point to an answer to such a question when there is a clear regulatory or legal prohibition, but sometimes you just have to explain why something is unwise because it poses too many risks. Risk can be hard to measure, but the benefits of any new course of action can also be equally difficult to assess.[2] In that regard, one might say, “Sure, you can jump off that bridge, just think of all the fun you’ll have before you break your neck landing“, or as this outstanding bank compliance expert explains, “Yes, you can, but you might go to jail if you get caught”.
With that said, the seemingly evergreen mortgage industry question of whether loan originators can be employed[3]as independent contractors instead of as employees (paid via IRS form 1099 instead of W-2)[4] has been making the rounds again. Oxymoronically[5], I’ve heard people call them “1099 employees”, but that moniker only highlights the complications from the tax and employment law perspective. In addition to fielding client calls, I have seen the question popping up in mortgage news forums such as Rob Chrisman’s daily, a compliance email list,[6] and perhaps even promoted by wholesale salespeople to broker shops.[7] It bears repeating that this blog is not to be taken as legal advice and there’s no attorney client relationship created between this blogger and any reader[8], but my sense is that mortgage companies choosing to go the independent contractor route may have done a poor job of assessing the risks against the benefits or have failed to consider all of the risks.
Consider all the risks.
For example, each loan originated by an independent contractor is, by definition, a third-party origination (a “TPO”; i.e., a brokered loan). That raises a bunch of issues I will discuss later. Also, while most folks are likely to look at state licensing regulations for any outright prohibitions (there are some states where there’s a hard stop[9]) it is important to dig deeper. Others might ask what the CFPB or the Dodd Frank laws have to say about originator employment. Dodd Frank, however, only addressed the licensing and background requirements for originators (and compensation based on loan profitability). CFPB, meanwhile, does not regulate employment status[10] or interpret the tax code.
But there are other critical things to consider. Again, talk to a qualified lawyer for specific guidance on any particular situation[11], but, in addition to state licensing, at a minimum, folks should also consider (i) IRS and state rules and regulations on employees vs. independent contractors, (ii) RESPA Sections 8 (a) and 8 (b), (iii) State and federal wage/hour and employment laws, (iv) GSE, HUD, and Investor representations and warranties (repurchase risk) around TPOs and of course, (vii) TILA’s Loan Originator Compensation Rule.
The IRS “duck” test
The Internal Revenue Service has a test it uses to analyze the complex[12] question of whetheran independent contractor is really an employee (and thus the employer must pay and deduct employment taxes from wages among other things). Basically, the test looks beyond any written description of the parties about the relationship to factors such as how much control the employer exercises over the contractor, what equipment they use, is it an exclusive relationship and similar indicia of being an employee. In other words, the IRS uses the time-honored “duck test”[13] to distinguish employees from independent contractors. But, don’t take it from me because I am not a tax expert.[14] Rather, since Artificial Intelligence is going to replace lawyers,[15] I just asked ChatGPT for the answer. Here’s how it[16] replied,
“It’s important to note that classification as an employee or independent contractor is not solely determined by what the company and the originator agree upon. The Internal Revenue Service (IRS) and state laws have specific guidelines and tests to determine proper classification. Misclassifying employees as independent contractors can lead to legal and tax issues for the employer.
If you’re a mortgage originator or considering becoming one and are unsure about your employment status or tax implications, it’s essential to consult with a tax professional or legal expert to ensure you understand your specific situation and obligations accurately. Additionally, tax laws and regulations may have changed since my[17]last update, so it’s always a good idea to verify with up-to-date sources.
ChatGPT basically is telling you, “It depends” and “seek counsel”, but I imagine many of you are unsatisfied with that answer and still want a more definitive explanation even though I don’t provide legal advice in this blog. Besides, you don’t even know when my last update was.[18]
Regardless, without offering any legal opinions on particular fact patterns, considering the factors used by the IRS, it’s hard to see how most originators working in typical arrangements for mortgage bankers and brokers are anything but quacking employee ducks.[19] Given the kinds of penalties typically found with income tax violations, mortgage companies should hesitate to jump into claiming mortgage originators are “1099 Employees” without other changes to the typical relationship.
Wage/hour and state laws
Exactly who is an independent contractor under applicable state law is in a bit of flux with, for example, California whipsawing over Uber drivers and other gig economy jobs. So, I’m not going to say too much about state law characterization of employment since there is too much specific state law to consider. Still, it is important to remember that if an independent contractor relationship is recharacterized as an employment relationship under applicable state law, the employer is also potentially responsible for compliance with wage/hour rules, including minimum wage and overtime requirements, opening up the risk of class action type damages for those kinds of claims.[20]
RESPA
Meanwhile, I think it’s fair to say I am more knowledgeable about RESPA than tax or employment law.[21] Back in the late 1990s mortgage brokering was challenged as being an illegal kickback violation of RESPA Section 8 (a), but HUD issued its 1999 Policy Statement[22] sanitizing mortgage brokerage as a valid exercise of the RESPA 8 (c)(2) services rendered exception.[23]Accordingly, most TPO arrangements, including those involving originators set up as independent contractors should be able to comply with RESPA’s 8 (a) prohibition against payments for referrals of settlement services.
While almost everyone[24] has heard of RESPA Section 8 (a) and its prohibition on illegal kickbacks, less well known is RESPA’s 8 (b) prohibition on unearned fee splits. Per the CFPB’s RESPA FAQs,
“RESPA Section 8(b) prohibits unearned fee arrangements in connection with federally related mortgage loans. RESPA Section 8(b) prohibits the giving and accepting of any portion, split, or percentage of charges made or received for real estate settlement service business, unless for services actually performed. 12 USC § 2607(b).”
Consider a mortgage broker who is thinking about hiring independent contractor originators. Employees can be paid under the 8 (c) (2) exception when the broker is paid by wholesalers for services as a mortgage broker under the HUD Policy Statement view of 8 (c) (2) noted in the previous paragraph. But if the brokerage firm uses independent contractors as originators, it would seem there could be an 8 (b) problem. Does the mortgage broker shop perform any additional (compensable) services than its independent contractor originator? In other words, if the originator is really an independent contractor, there would be two parties (the brokerage firm and the individual originator) who could be seen as splitting a fee for the same work in violation of 8 (b).[25]
Perhaps it’s possible to argue that one is an employee for RESPA purposes but not for taxation and wage/hour laws, but that’s going to be a tough row to hoe. Even though RESPA doesn’t have its own definition of employee, in the past when HUD regulated RESPA, they looked to the IRS “duck” test in entering into a 2003 Consent Order where there was a questionable employment relationship being used to get around RESPA.[26]CFPB, which now has RESPA interpretation and enforcement in its control, likely won’t tie its own hands in terms of interpreting what a “bona fide employee” is under RESPA based on what HUD did. In fact, if I was the CFPB,[27]the totally unhelpful thing I would have to say about RESPA and employment would be something like,“RESPA’s (8) (c) (2) exemption for compensation to bona fide employees does not extend to people who are independent contractors.”
Investor risk and LO Comp
I’m guessing I have worn out even the most ardent supporters of the independent contractor originator approach, but if you are still a fan, be sure to also take a careful look at the representations and warranties in your loan sale agreements and seller guides relative to TPO origination and use of non-employees to do certain functions to avoid repurchase exposure to your investors and/or risk to agency approvals (bank regulations may also be implicated by use of independent contractors to originate loans). Similarly, one must still take the LO Comp Rule into account when determining how any independent contractor will be paid. There’s no escaping that misguided rule regardless of employment status.
Brokered loan compensation
Speaking of LO Comp and brokered loans, those of you who think ignorance is bliss and safety in numbers might want to reconsider blindly compensating your originators differently for brokered loans after the most recent CFPB Supervisory Highlights seemed to make that a clear violation. I have some thoughts on ways around the broad general application of that, but, if I wasn’t clear before, I’m definitely not providing that or any other legal advice in this blog[28].
[1] Not this intrepid compliance pro. As noted in previous Musings, I just tell those folks they need a hug from the Dr. Rick of mortgage compliance.
[2]The person saying, “tell me why I can’t…” should be able to articulate the benefits of their proposal.
[3] As I discuss below, use of the term “employ” begs the entire question.
[4] Note that this is a separate, but related, issue from the conflict of interest questions arising from dual roles in a transaction or legal liability for cross selling.
[5]What a great adverb!
[7] If you are wholesale rep telling brokers they can have “1099 employees” please pay careful attention to the section below on RESPA 8 (b) and let your brokers know what state(s) you are licensed to practice law. Don’t be another cause for pause for a beleaguered wholesale legal department. (Check out that rhyme and alliteration!)
[8]Seek qualified legal counsel in your state for individualized guidance.
[9] See footnote 7 above.
[10]Neither does the FTC, but that didn’t stop them from issuing a proposed rule about non-compete agreements last winter.
[11]Why do I keep annoyingly repeating this admonition? Ask a legal ethics expert about that. I also recognize that the fiction of you not taking this as legal advice is hard to believe, so I want to make sure I am on the right side of that equation even if you aren’t.
[12] Also see what the National Association of Realtors had to say about in in their FAQs on the topic.
[13]If it looks like a duck and quacks like a duck, it probably is a duck.
[14]And this is not legal advice.
[15]This is my sarcastic way of showing that particular doomsday AI threat is still a ways off.
[16]Please note that I also asked ChatGPT, “what’s your preferred pronoun” and it advised me that while it doesn’t have personal preferences or consciousness, “it” or “the AI” were acceptable.
[17] Seeing the first person used by a computer-generated response reminds me of HAL in 2001: A Space Odyssey saying, “I’m sorry Dave”.
[18] So, I think I’m safe from AI taking my job for a while, but I’ve got my eye on it.
[19]Considering factors such as control over work hours and methods, inability to deliver loans to other companies (exclusivity), software and equipment that must be used, etc..
[20] I can recommend some good counsel if you are sued.
[21]I’ll be leading an opening discussion on RESPA at MBA’s Compliance and Risk Management Conference in Washington DC on September 10 with Severson’s Mike Flynn.
[22] Requiring at least 5 out 12 services be provided-including taking the application.
[23]No need to revisit that wholesale/broker issue in this edition as I have discussed it at length many times, See e.g., https://mortgagemusings.com/f/edition-2-respa-is-a-wholesale-lot-of-trouble
[24]Almost everyone who reads these Musings, that is. If you haven’t heard of RESPA (or Rob Chrisman for that matter) I’m wondering why you even read this far.
[25] Many wholesalers (as well as correspondent investors) prohibit a “sub-broker” relationship (a TPO from a TPO). Could permitting a sub-broker arrangement be another way to limit competition for the wholesaler?
[26]See https://archives.hud.gov/content/focus/2003-09-30.cfm
[27] “Yeah, and if a frog had wings, he wouldn’t bump his ass a-hopping.” Nathan Huffhinds-Raising Arizona.
[28] I can, however, provide legal advice for a fee with an engagement agreement.