Employee or Independent Contractor: A Disaster in the Making?
At a recent business association dinner, I introduced myself to the gentleman sitting next to me. He was a retired business executive, now offering his substantial business expertise to new entrepreneurs as a SCORE volunteer. When I told him I was a business lawyer, he asked me: “What is the most common legal issue for new business owners?” Without hesitation, I answered: “New business owners routinely misclassify workers as independent contractors, when those workers should be classified as employees.”
Why do business owners do this? In some cases it is inadvertent – the business owners do not understand the applicable tests or do not properly apply the applicable tests. In many cases, however, it is an intentional decision by the business owner to operate in a “gray area.” There are many reasons why a business owner would prefer to classify a worker as an independent contractor rather than an employee:
- The business is not required to withhold income tax, pay social security and medicare taxes, pay unemployment compensation taxes or provide worker’s compensation insurance for independent contractors
- Independent contractors are not subject to minimum wage or overtime pay requirements
- Independent contractors aren’t eligible to participate in employer sponsored health plans and retirement plans
In my experience, misclassification seems to be more prevalent in certain industries. Other lawyers have observed the same trends. The law firm Pepper Hamilton studied reported cases from 2010 to 2015 and found that businesses in about 40 industries have been specifically targeted by federal or state agencies or have been the subject of class action lawsuits because of worker misclassification. Those industries include amateur and professional athletics, aerospace and defense, automotive, charities, cleaning and janitorial services, computer programming and technical consulting, construction, health care, landscaping, publishing/editing, security, and trucking, among others.
The Unpleasant Consequences of Getting it Wrong
For many years, misclassification was not high on the list of priorities at the IRS or the US Department of Labor (“DOL”). That changed around the mid-2000s, when the IRS, the DOL and state agencies began stepping up their audits of both for-profit businesses and non-profit agencies. In 2004, the IRS audited a non-profit youth soccer league in Fairfield, Connecticut, assessing the league more than $300,000 in back taxes, penalties and interest based upon the league’s misclassification of its coaches as independent contractors instead of employees. The league ultimately settled with the IRS, agreeing to treat its coaches as employees going forward and paying $11,600 in back taxes, thankfully only a fraction of the initial assessment.
Government audits are not the only risk, however. Recently terminated workers and workers injured on the job are likely to retain attorneys and sue for unpaid overtime or for payment of medical expenses on the ground that they should have been classified as employees, not independent contractors. Large companies that use independent contractors to supplement their regular workforce or that operate on an independent contractor business model (such as Uber) are increasingly being targeted in class-action lawsuits brought on behalf of workers who are allegedly misclassified as independent contractors. In two widely reported cases, the federal 9th Circuit Court of Appeals found in 2014 that FedEx Ground drivers in Oregon and California had been misclassified as independent contractors. FedEx lost those cases despite the fact that it had written contracts with all of its drivers in which the drivers agreed that they were independent contractors. That case cost FedEx over $225 million.
The consequences of misclassification can be grave. Besides owing back taxes to the feds, the business will also owe state unemployment taxes and unpaid worker’s compensation premiums, and may owe unpaid overtime or minimum wages, medical expenses and unpaid vacation and sick pay.
A Multiplicity of Tests
If a big company like FedEx can get it wrong, even with the resources to hire the best attorneys to write the best contracts, what’s a small business owner supposed to do? The reason that business owners who want to comply with the law find it so difficult is the multiplicity of tests. Years ago, the IRS used a “twenty-factor common law test.” Around 2010, the IRS issued guidance that it would use a three-part test, emphasizing the degree of control that an employer has over the worker. The DOL’s test, which it uses to enforce the Fair Labor Standards Act’s minimum wage and overtime provisions, is known as the “Economic Realities Test.” The focus of the DOL test is the degree to which the worker is economically dependent upon the employer. Finally, each state uses a test to determine eligibility for worker’s compensation and unemployment benefits. Some state tests mirror either the IRS test or the DOL test, but many do not.
The IRS Test (The 3-Category “Control Test”)
The IRS guidance describes three broad categories of factors that need to be considered in applying the “Control Test”: behavioral control, financial control, and the relationship of the parties.
- Behavioral Control covers facts that show if the business has a right to direct and control what work is accomplished and how the work is done, through instructions, training, or other means.
- Financial Control covers facts that show if the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:
- The extent to which the worker has unreimbursed business expenses
- The extent of the worker’s investment in the facilities or tools used in performing services
- The extent to which the worker makes his or her services available to the relevant market
- How the business pays the worker (by the hour? by the job?), and
- The extent to which the worker can realize a profit or incur a loss
- Relationship of the Parties covers facts that show the type of relationship the parties had. This includes:
- Written contracts describing the relationship the parties intended to create
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay
- The permanency of the relationship, and
- The extent to which services performed by the worker are a key aspect of the regular business of the company
The US DOL Test (6-Factor “Economic Realities” Test)
On July 15, 2015, the Department of Labor issued “Administrator’s Interpretation No. 2015-1,” a 15- page document describing the DOL’s “Economic Realities Test” under the Fair Labor Standards Act. The document briefly describes the history and purposes of the Fair Labor Standards Act and the origins of the Economic Realities Test. The DOL describes the 6 factors that must be considered to determine whether a worker is an independent contractor or an employee under the Economic Realities Test:
- the extent to which the work performed is an integral part of the employer’s business
- the worker’s opportunity for profit or loss depending on his or her managerial skill
- the extent of the relative investments of the employer and the worker
- whether the work performed requires special skills and initiative
- the permanency of the relationship
- the degree of control exercised or retained by the employer
The Administrator’s Interpretation document includes numerous examples of how the test should be applied in different situations. The underlying theme the DOL’s Economic Realities Test is that true independent contractors are in business for themselves, deciding which jobs to take, how much to charge, and when and how to do the work. Whether they succeed or fail in their chosen business is fundamentally within their own control. By contrast, a worker who is economically dependent on the company for whom he or she is working is not really in business for him or herself, but is an employee.
About a third of the 50 states use the “A-B-C Test” to determine whether a worker is an independent contractor: (A) the worker must be free from direction and control in connection with the performance of the service; (B) the worker’s service must be performed either outside the usual course of business of the employer and outside the employer’s places of business (some states only require one of these); and (C) the worker must be customarily engaged in an independently established trade, occupation, profession, or business of the same nature as the service performed.
Florida uses a “right of control” test, which is very similar to the IRS Control Test. Florida courts have adopted a number of criteria to determine whether the employer has a right of control, including
- The extent of the right of control by the employer over the details of the work
- Whether the person employed is engaged in a distinct occupation or business
- The kind of occupation involved, and whether the work is done under the direction of the employer or by a specialist without supervision
- The skill required in the particular occupation
- Whether the employer supplies the instrumentalities, tools, and the place of work
- The length of time the person is employed
- Whether the work is a part of the regular business of the employer
Many states have entered into agreements with the IRS, the DOL or both, to share information and to cooperate in enforcement activities. An audit by the state worker’s compensation agency can thus spark an IRS or DOL audit and vice-versa.
Tests like the IRS’s Control Test and the DOL’s Economic Realities Test are called “balancing tests” by lawyers and judges, because all facts and circumstances need to be taken into account and no one factor predominates. All of the factors must be weighed and a conclusion drawn based on the preponderance of the factors breaking one way or the other. Ignoring certain facts can skew the tests one way or the other.
An close examination of all of these tests reveals certain common themes. The employer’s degree of control is a factor in all of the tests. The worker’s opportunity to realize a profit or suffer a loss is a factor in both the IRS test and the DOL test, and is implied in part C of the A-B-C Test. The extent to which the worker’s services are integral to the employer’s business is an important factor in both the IRS test and the DOL test and is arguably implied in part C of the A-B-C Test. A thoughtful consideration of the work to be performed and the nature of the relationship will usually lead to the correct result and that result will usually be that the worker is an employee, not an independent contractor.
It is important to emphasize that it doesn’t matter if a business has a written contract with a worker that declares him or her to be an independent contractor. If the applicable test results in that worker being classified as an employee, then that worker is an employee, notwithstanding what the contract says. That being said, in a true independent contractor relationship it is a very good idea to have a written contract delineating the services to be provided, the compensation to be paid, and how the relationship can be terminated, as well as providing for indemnification, insurance requirements of the contractor, etc. We recommend that businesses currently using independent contractors on a regular basis should review those relationships based upon the tests described in this article. If the workers at issue truly are independent contractors and the business does not have written agreements with those independent contractors, the lawyer for the business should draft appropriate contracts. If the business already has written independent contractor agreements, but they were not prepared by an attorney or an attorney has not reviewed them recently, we recommend that you have a qualified business lawyer or employment lawyer review them as soon as possible and modify them as necessary. If a company is not certain about the proper classification of its workers, we at Wetherington Hamilton stand ready to assist with that analysis. The IRS, DOL, and Florida Department of Revenue, as well as the plaintiff’s bar, are all paying attention even if you are not.
 SCORE is a nonprofit organization, supported by the U.S. Small Business Administration, that helps small businesses through education and mentoring. With headquarters in the Washington, D.C. area, SCORE has chapters throughout the U.S. Find out more at www.score.org.
 “The Crackdown and Costs of Independent Contractor Misclassification – And How to Minimize or Avoid Its Risks,” by Richard J. Reibstein, Lisa B. Petkun and Andrew J. Rudolph, Pepper Hamilton, LLP, 7/10/2015.