In today’s economy, more and more employers are utilizing independent contractors to reduce costs and minimize risks in the event of terminations or layoffs. However, the federal government has recently given the Department of Labor (“DOL”) extra funding for its “Middle Class Task Force,” whose mission is to investigate and identify misclassified workers, including those workers characterized as independent contractors instead of employees. The DOL estimates that up to 30 percent of companies misclassify employees, and the federal budget assumes that a federal crackdown will yield at least $7 billion in tax revenues in ten years. Moreover, the DOL and the IRS recently signed a memorandum of understanding to improve the agencies’ coordination on employee misclassification compliance and education. In light of this aggressive enforcement by federal agencies, employers should carefully consider the benefits and risks to using independent contractors, and take steps to ensure that they have not misclassified any employees.
What are the risks of using independent contractors?
There are a number of cost and practical benefits to using independent contractors, such as not having to pay unemployment or workers’ compensation premiums or being able to utilize individuals with specialized expertise who do not require training, but using independent contractors is not without risk. A significant risk is exerting too much control over the contractor such that he or she is found to be an employee. This “misclassification” can have some costly consequences.
• Misclassification Risks – Back Taxes, Penalties and Interest
– An employer can owe unpaid income taxes, payroll taxes (FICA, FUTA, unemployment) and penalties for failing to fulfill the duty to withhold, remit and report (W-2 and W-4).
• Misclassification Risks – Liability to Workers
– An employer could owe back pay liability under wage and hour laws for any unpaid overtime or rest/meal violations, face double damages, claims for benefits (health insurance, retirement, paid time off, equity compensation, etc.), potential class action treatment or attorneys’ fees for successful plaintiffs.
• Misclassification Risks – FLSA/ERISA
– An employer could be liable for penalties for failing to maintain the required records under the Fair Labor Standards Act (“FLSA”). In the absence of time records, employees generally are permitted to reconstruct the hours for which they should be compensated. A willful violation of the FLSA can result in a penalty of up to $10,000. Violations can also result in imprisonment for up to six months.
– ERISA claims are often tacked on to FLSA claims. There is a risk of disqualification of retirement plans for either covering workers who are not employees or not covering employees. This could result in loss of favorable tax treatment for cafeteria plans, health care reform penalties for not providing health care coverage to full-time employees, and/or significant excise tax providing discriminatory coverage. Moreover, health care coverage is only non-taxable for employees.
• What are best practices for an employer using independent contractors?
On a practical level, the question of independent contract versus employee comes to the surface when the IRS or DOL audits an employer to determine whether the employer has misclassified its employees. These federal agencies use a variety of tests to determine when a worker is an employee versus independent contractor (e.g. the IRS uses a 20-factor test, while the DOL uses an “economic realities test”), but the common theme in the tests is the right-to-control—that is, to what extent the employer controls the worker. To minimize the risk of liability, an employer should:
• Audit itself before the IRS does – an employer should carefully review its classifications for compliance and document its conclusions.
• Review industry practice—a defense to misclassification can be reliance on an established industry standard.
• Be consistent across worker classifications and time.
• Consider Voluntary Classification Settlement Program through the IRS.
• Review all plan documents.
• Obtain professional advice.
• Run through an Independent Contractor v. Employee Checklist.
– Although by no means an exhaustive list, below are examples of some questions to consider—the greater the number of “yes” answers, the greater the probability that the relationship between the person and the company can be characterized as an independent contractor relationship, and not an employer-employee relationship.
1. Is the person free to decide the details of how to do the work?
2. Does the person set his or her own work hours?
3. Does the person supply his or her own tools and equipment?
4. Does the person make his or her services available to the public and in fact work for other entities?
5. Is there a written agreement expressing the understanding and agreement of the company and the person that the relationship is one of an independent contractor and not employer-employee? Although not determinative, the existence of such an agreement can help employers prove their intent behind the classification of a worker.
While there can be some very strong advantages to having work performed by independent contractors and other contingent workers, there are great risks in misclassifying workers to achieve some perceived advantage. Notwithstanding these risks, the use of independent contractors remains a promising benefit to employers who are careful to abide by the guidelines described above.
Laura Salerno Owens is an attorney with the Employment, Labor & Benefits firm of Barran Liebman LLP. She provides compliance advice to employers and she represents employers in single plaintiff and class action litigation. Questions about this article can be sent to lsalerno@barran.com.
