Why You Should Re-Evaluate Your Independent Contractor Designations

Why You Should Re-Evaluate Your Independent Contractor Designations

In an uncertain economy, companies are often reluctant to commit to permanent hires and instead choose to rely upon independent contractors to meet their staffing needs. But what might seem like an optimal staffing strategy can pose significant risks to companies. The U.S. government is cracking down on companies that treat workers as contractors when those workers really function as employees. The cost of misclassification is high: back wages, taxes, benefits and penalties can overwhelm small and large companies alike. If your company uses independent contractors, you should carefully consider their classification in 2012.

Detecting misclassification is a priority for the U.S. federal government.

Misclassification is not a new issue. So why raise it again now? The U.S. Internal Revenue Service (IRS) and the Department of Labor (DOL) have identified misclassification as a priority for 2012. Moreover, legislative efforts to raise the stakes for employers are gaining traction.

In September 2011, the IRS and the DOL executed a memorandum of understanding (“MOU”) intended to improve the agencies’ coordination on misclassification issues. In addition, the DOL has now signed similar MOUs with 11 separate states (Colorado, Connecticut, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Missouri, Montana, Utah, and Washington). The partnerships enable the agencies to share information regarding worker misclassification and to coordinate enforcement efforts. California enacted SB 459 in October 2011, increasing penalties and raising the specter of individual liability for willful misclassification.

Is the U.S. government likely to follow through on increased enforcement? The answer appears to be yes. In 2011, the Wage and Hour Division of the DOL collected nearly $5 million in back wages for minimum wage and overtime violations that were a result of employees being misclassified as independent contractors, reflecting an increase of 500 percent from fiscal year 2008. With a full year of the IRS and the DOL working together, federal/state coordination, legislative action on the horizon, and the full support of the Obama Administration, we can expect this number to continue to rise. With that in mind, if you have not already evaluated your independent contractor relationships, now is the time to do so.

It’s complicated.

Whether a worker qualifies as an independent contractor is a complicated issue. There is no single, uniform test, let alone a single factor, that can be used to determine who qualifies. Indeed, the IRS and the DOL both have their own separate tests which do include common themes, but which also differ significantly. And in some cases, states are choosing to be even more restrictive than the federal government.

The main factors to keep in mind are:

a) Behavioral control.

If a company has the right to control how a worker does the tasks for which he or she was hired, then that worker is likely to be classified as an employee. Facts that show whether the business has a right to direct and control a worker include the type and degree of instructions the business gives the worker, including, for example:

• when and where to do the work;

• what tools or equipment to use;

• which workers to hire or get to assist with the work;

• where to purchase supplies and services;

• what work must be performed by a specific individual; and

• what order or sequence to follow.

The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.

The training an employer provides to a worker also may be indicative of employee or independent contractor relationship. An employee may be trained by an employer to perform services in a particular manner. Independent contractors ordinarily use their own methods.

(b) Financial Control.

In determining whether a worker is an employee or an independent contractor, U.S. courts often look to whether the company has a right to control the business aspects of the worker’s job. The following factors are considered in this determination:

• The extent to which the worker has unreimbursed business expenses: Independent contractors are more likely to have unreimbursed expenses than are employees. While employees also may incur unreimbursed expenses in connection with the services they perform for the company, it is the extent of these expenses that is significant. Fixed ongoing costs that are incurred regardless of whether work is currently being performed weigh strongly in favor of an independent contractor determination.

• The extent of the worker’s investment: An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independent contractor status.

• The extent to which the worker makes his or her services available to the relevant market: An independent contractor is generally free to seek out business opportunities beyond the company for which it is performing work. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

• How the company pays the worker: An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid by a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors on an hourly basis.

• The extent to which the worker can realize a profit or loss: An independent contractor can make a profit or loss. The company incurs the profit or loss if the worker is an employee.

(c) Type of Relationship.

U.S. courts also look to the type of relationship between the company and the worker in determining whether a worker is an employee or an independent contractor. Facts that show the parties’ type of relationship include the following:

• The permanency of the relationship: If a company engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.

• The extent to which services performed by the worker are a key aspect of company’s regular business: If a worker provides services that are a key aspect of a company’s regular business activity, it is more likely that the company will have the right to direct and control the worker’s activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney’s work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.

• Written contracts: Written contracts describing the relationship of the parties may be evidence that the parties intended to create an employee or independent contractor relationship.

• Benefits: If the company provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay, it is likely that the relationship is employer-employee.

Misclassification will cost you.

Often the issue of misclassification arises when a laid off contractor files for unemployment insurance. It is not uncommon for the relevant tax authority to issue a statement as to the employee status of similarly situated workers, thereby exposing a company to potential class liability as well. Potential costs to the employer include:

• Payment of back pay and overtime compensation going back for a period of two years or more, as well as penalties equaling the amount of back and overtime pay;

• Payment of the full amount of the employee’s income tax which should have been withheld, both the employer and the employee’s portions of the FICA tax, plus penalties;

• Damages for failing to provide certain benefits made available to similarly situated employees; and,

• Liability for attorneys’ fees, criminal sanctions, and other penalties against the employer and, if the employer is an entity, against its corporate officers personally.

In closing, given the complexity of determining employment status in any particular case, and the potential risk of retroactive liability, employers should consult with legal counsel before assuming that an individual will qualify as an independent contractor under U.S. federal and individual state laws for all purposes. Generally, none of the aforementioned factors, standing alone, will determine the status of the employment relationship. Each situation will be determined on its own facts. As a general proposition, the most important factor is whether the individual is subject to the will and control of the employer as to the tasks the individual performs. Independent contractors can remain a viable staffing option when properly classified.

For more information on the U.S. government’s efforts to police misclassification by employers, see http://www.dol.gov/whd/workers/misclassification/.

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