Classification of Independent Contractors, Quirky Question # 130

Quirky Question # 130:

We’ve heard that classification of workers as “independent contractors” instead of “employees” has been coming under increased scrutiny by courts and regulators.  Since our company works with a number of independent contractors, we wonder if we should be concerned.  Do you have any guidance?

Dorsey’s Analysis:

The short answer is: yes, the issue is getting increased attention, and there indeed may be  cause for concern.

In truth, whether workers are appropriately classified as “independent contractors,” or should, instead, have been deemed “employees” by the companies for whom they work is an issue that has been the subject of considerable litigation for years.  But in this economic climate, “misclassification” of workers has become a hot button issue, in large part because federal and state governments stand to lose considerable income via mandatory tax withholdings where workers are inappropriately classified as independent contractors.  In fact, Senator John Kerry of Massachusetts introduced legislation in mid-December 2009 that would amend the Internal Revenue Code in an effort to reduce the “misclassification” of workers for federal tax purposes.  Similar legislation was introduced in July 2009 by Senator Jim McDermott of Washington.  In August 2009 the United States Government Accountability Office (“GAO”) issued a report on misclassification of workers, in which the GAO offered a number of suggestions for reducing the incidence of “misclassification” of workers.

What is the difference between an “independent contractor” and an “employee”?

Although courts and federal and state agencies approach the question of whether a worker is an “independent contractor” or an “employee” somewhat differently depending upon the applicable law at issue, the crux of the inquiry is generally the same: how much control does the purported “employer” have over the worker in question?  The more “control” an entity exerts over the worker, the more likely the worker will be deemed an “employee” under the relevant law.   In assessing whether an entity has sufficient “control” over an individual to render that individual an “employee” under the applicable law, courts and agencies employ slightly varied, multi-factored, fact-specific inquiries.

A.         Determination of Worker Status Under Federal Income Tax Principles

Under federal income tax principles, a worker constitutes an “employee” when the party for whom services are performed has “the right to control and direct” the worker “not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.”  Rev. Rul. 87-41, 1987-1 C.B. 269 (quoting language from Treas. Reg. §§ 31.3121(d)-1(c); 31.3306(i)-1, and 31.3401(c)-1).  For purposes of this test, the employer need not “actually direct or control the manner in which the services are performed,” provided that the employer “has the right to do so.”  Id.  If a worker constitutes an employee under the test, the description or designation of the relationship by the parties as anything other than that of employer and employee is immaterial.  Id.

In 1987, the Internal Revenue Service (“IRS”) issued Revenue Ruling 87-41, which identified 20 factors that help to indicate whether “sufficient control is present to establish an employer employee relationship.”  It cautioned that the 20 factors were not equally-weighted criteria to be assessed in a quantitative manner, but offered little guidance in applying the factors.  Subsequently, however, the IRS released training materials for its examiners that helpfully organize and condense the factors from Revenue Ruling 87-41.  See Internal Revenue Service, Independent Contractor or Employee?  Training Materials, Training 3320-102 (Oct. 1996) (“IRS Memo”). The IRS Memo incorporated the latest court decisions and authorities in arranging the factors and discussing the weight and significance of each factor.  Based on the IRS Memo, the determination of employee status turns on three main considerations: behavioral control, economic control and the relationship of the parties.

1.         Behavioral Control Factors (indicating Employee status).  Behavioral control of how the work is performed is the central element of the employee status test.

·          Instructions on when, where and how to perform the work.

·          Training with respect to the methods or procedures of the work.

2.         Financial Control Factors (indicating Independent Contract status).  Control over the means and details of the business aspects of how the worker performs services can be as important as express control over work processes.

·          Significant Investment.

·          Business/Travel Expenses.

·          Services Available to Market.

·          Method of Reimbursement.

·          Realization of Profit or Loss.

3.         Relationship of the Parties.  The following factors indicate the intent of the parties regarding control of the worker, which is less important than the behavioral control and economic control factors, but can be important in close situations.

·          Intent of the Parties Shown in Written Contract, Tax Reporting, Employee Benefits.

·          Discharge/Termination Rights.

·          Permanency of the Relationship.

·          Regular Business Activity.

B.         Determination of Worker Status Under Certain Case Law.

A number of federal civil rights statutes, such as Title VII of the Civil Rights Act of 1964, as amended (“Title VII”), the Age Discrimination in Employment Act (“ADEA”), the Americans with Disabilities Act (“ADA”), and the Fair Labor Standards Act (“FLSA”) protect only employees.  To determine whether an individual is an employee protected by such anti-discrimination laws, some courts have looked to the IRS’s 20-Factor Test set forth above.  Other courts have applied the common-law agency test set forth by the United States Supreme Court in Nationwide Mutual Insurance Company v. Darden, 503 U.S. 318, 112 S. Ct. 1344 (1992).  See, e.g., Wortham v. American Family Ins., 385 F.3d 1139, 1140-41 (8th Cir. 2004) (applying the Darden test); Weary v. Cochran, 377 F.3d 522, 525 (6th Cir. 2004) (same); Barnhart v. N.Y. Life Ins. Co., 141 F.3d 1310, 1313 (9th Cir. 1998) (same). In Darden, the Supreme Court was examining certain individuals’ claims that they were employees protected by Employee Retirement in Security Act (“ERISA”).  The Court held that, absent a more specific definition, the term “employee” in federal employment statutes should be defined in accordance with the common law “right to control” test.  As such, in Darden the Supreme Court considered the following twelve factors to determine whether an individual qualifies as a common law employee:

(1)        The alleged employer’s right to control manner and means by which the individual’s work is accomplished;

(2)        The skill required to perform the individual’s duties;

(3)        The source of tools and instrumentalities needed to perform the duties;

(4)        The location where work is performed;

(5)        The duration of relationship of parties – a shorter relationship indicating lack of an employer/employee relationship;

(6)        The alleged employer’s right (or lack thereof) to assign additional projects;

(7)        The individual’s discretion over when and how long to work;

(8)        The method of payment;

(9)        The individual’s role in hiring and paying assistants;

(10)      Whether the work is part of alleged employer’s regular business;

(11)      Whether “employee benefits” are provided; and

(12)      The tax treatment of the individual.

Darden, 503 U.S. 318, 323-24, 112 S. Ct. 1344.  As with the IRS’s 20 Factor Test, described above, the crux of the question is whether the purported employer exerts sufficient control over the manner and means by which the alleged employee performs his or her duties for the Company; the more control exerted, the more likely it is that a court will find the existence of an employer/employee relationship.

Another, similar test used by courts to determine whether an individual is an employee subject to the protections of various employment laws, is the “common law hybrid employment test,” which combines the economic realities of the working situation and the common law agency test set forth in Darden.  See, e.g., Wilde v. County of Kandioohi, 15 F.3d 103, 105 (8th Cir. 1994); Cobb v. Sun Papers, 673 F.2d 337, 339 (11th Cir.), cert. denied, 459 U.S. 874 (1982).  In these cases, courts again consider, and place a good deal of importance upon, the extent of the employer’s right to control the means and manner of the worker’s performance.  However, the courts also place emphasis on the economic realities of the situation, and consider other factors such as: (1) whether the alleged employer or the worker furnishes equipment used and place of work; (2) length of time during which the individual has worked; (3) the method of payment; and (4) whether the work is an integral part of the alleged employer’s business.  See, e.g., Lopez v. Johnson, 333 F.3d 959 (9th Cir. 2003); Trainor v. Apollo Metal Specialities, Inc., 318 F.3d 976 (10th Cir. 2002).

What are the risks if my workers are deemed to have been “misclassified” as independent contractors?

To put this issue in its proper perspective, set forth below are some examples of the negative consequences that may result in the event that a company’s “independent contractors” are deemed “employees” by a court or agency.

Federal Tax Consequences: If an employer has misclassified employees as independent contractors, it can be held liable for the total amount of employment taxes that should have been withheld from wages paid to the workers.  This includes the total amount of federal income tax that should have been withheld (and state income tax, if applicable) and both the employer and employee shares of FICA (which are equal to 15.3% of wages up to the FICA wage base, which is currently $106,800).  An employer can be relieved of liability for federal income tax withholding to the extent that it can show that the worker actually reported the income and paid the income tax attributable to it.

At present, there is some comfort on this last point – but that comfort may be short-lived.  Under Section 530 of the Revenue Act of 1978, employers who misclassify employees as independent contractors may be relieved of liability (and may continue for future periods to treat such workers as independent contractors without liability) if they meet certain requirements.  The basic requirements for Section 530 relief are: (1) the employer must have filed all federal tax returns on a basis consistent with the treatment of the worker as not being an employee (normally, this means that the employer must have filed Forms 1099), (2) the employer must have treated individuals in substantially similar positions to that of the worker as independent contractors, and (3) the employer must have a “reasonable basis” for having treated the worker as other than an employee.  “Reasonable basis” is defined as including (but not limited to) one of the following: (1) legal authority such as a judicial precedent, a published tax ruling, or a private letter ruling addressed to the employer; (2) a past audit by the Internal Revenue Service in which no assessment was made attributable to the treatment (for employment tax purposes) of individuals holding positions substantially similar to the position held by the workers in question; (3) a long-standing recognized practice of a significant segment of the industry in which the worker is engaged.  The employer is also free to try to establish another “reasonable basis” for its classification.  Section 530 relief does not apply in the case of a worker who provides services as “an engineer, designer, drafter, computer programmer, systems analyst, or other similarly skilled worker engaged in a similar line of work.”

However, one of the proposals identified by the GAO for a means to address “misclassification” of workers as independent contractors is to revise Section 530 to permit fewer positions to qualify for the exception, and Senator Kerry of Massachusetts introduced a Bill in December of last year that would do just that.  The proposed legislation, entitled “The Taxpayer Responsibility, Accountability, and Consistency Act of 2009” (S 2882.IS), revises Section 530 such that the definition of “reasonable basis” is more limited, and as such, the “530 safe harbor” would be available in fewer circumstances.  Time will tell the fate of the proposed legislation.

Vulnerability to Discrimination and Related Claims Under Various Employment Statutes: As explained above, many federal civil rights statutes, such as Title VII, the ADEA the ADA, and the FMLA apply only to employees.  Thus, if an individual who is not an employee brings a cause of action against an employer under any one of these statutes, that cause of action can be addressed by a motion to dismiss or motion for summary judgment based upon an argument that he or she is not an “employee,” and therefore, is not subject to the protections of the relevant statute.  If, on the other hand, the individual is an employee (or even has a good argument that he or she is an employee), the company will be forced to delve much further into the underlying facts surrounding the individual’s claim.  It is worth noting that some state analogues to the federal antidiscrimination statutes have a looser definition of “employee,” such that companies may be seen as the employer just because it pays the individual for providing services.

Vulnerability to Claims of Violation of the FLSA: Likewise, the FLSA protects only employees.  If individuals are held to be the company’s employees under the FLSA, they will be able to maintain claims against the company for violation of the FLSA for, for example, failure to pay requisite overtime or meet standard minimum wage requirements.  In addition, the GAO has proposed that a separate provision be added to the FLSA, making the misclassification of workers its own, separate violation of the Act.

Possibility that Individuals will be Held to be Entitled to Benefits: If an individual is held to be an employee, he or she may be entitled to benefits conferred by the company upon its employees.  For example, if the company has any incentive compensation plans that apply to particular “employees,” an independent contractor held to be a “common law employee” may be able to argue that he or she is entitled to the benefits conferred under that incentive compensation plan, depending upon the language of the plan at issue.

What do I do now?

Given the current legislative and economic climate, now is a perfect time to re-examine the status of those workers your company has classified as “independent contractors.”  The factors used by the IRS as well as the common law tests employed by courts, described above, should help guide your analysis.  Pay particular attention to the requirements you impose upon your independent contractors and delve deeply to assess whether those requirements are necessary and appropriate.