The misclassification of an employee as an independent contractor can have several serious consequences. The employer may be liable for years of unpaid federal, state and local income tax withholdings and Social Security and Medicare contributions, unpaid workers’ compensation and unemployment insurance premiums, and even unpaid work-related expenses and overtime compensation. These liabilities, plus interest and penalties, can potentially be huge for businesses that make substantial use of independent contractors. Another liability risk arises if misclassified employees who are otherwise entitled to coverage under employee benefit plans have not been provided with health, pension, and other employee benefits. This could lead to litigation, possibly including class action litigation, brought by or on behalf of misclassified employees who were deprived of benefits to which they claim they were entitled. Finally, the determination of whether an employer is required to provide health insurance coverage under Obamacare depends on whether the employer has over 50 full-time equivalent (FTE) employees. If an employer does have over 50 FTE employees and does not provide heath care insurance, the employer must pay a per-month “Employer Shared Responsibility Payment” on its federal tax return beginning with the return for 2014. While the federal government has not expressly so stated, it is reasonable to assume that independent contractors who are determined to have been misclassified employees will be added into a new calculation of the 50 FTE threshold. In years to come, some employers may find that they are liable for retroactive “Employer Shared Responsibility Payments”.
There are different routes to a state or federal determination that an employee has been misclassified as an independent contractor. One way in which regulatory agencies discover independent contractor misclassification is through the unemployment and workers’ compensation claims process. Local claims offices are more frequently issuing initial determinations of “employee” status in benefit claims filed by workers, including individuals who have signed independent contractor agreements or are receiving compensation on a 1099 basis. As a result of the prolonged recession, many workers who previously regarded themselves as independent contractors are nonetheless applying for unemployment benefits – and more claims examiners are finding that such workers have been misclassified and are entitled to unemployment benefits as “employees.” If a business has not paid unemployment contributions to a state fund on behalf of that worker, the initial determination that the worker had been misclassified as an independent contractor, if upheld by an administrative law judge or referee, can have the same effect as an adverse audit. And once a single worker is found to have been misclassified, the business is then often charged for unpaid contributions for “all similarly situated” workers, along with costly penalties and interest.
Twenty-one states have adopted legislation designed to discourage employee misclassification, and most of these state laws include significant penalties. Eighteen other states have proposed bills intended to limit the use of independent contractors or make misclassification more costly. In addition, the U.S. Department of Labor has hired several investigators to “detect and deter” companies from misclassifying employees as independent contractors and failing to properly pay overtime or afford statutory benefits to workers. The DOL has also initiated a “Misclassification Initiative” in which it has entered into memorandums of understanding with 13 states to coordinate enforcement efforts and share information between the state and federal agencies about non‑compliant companies.
Another way the issue can be raised is through IRS Form SS-8. Individuals paid as independent contractors or businesses may file Form SS-8 to obtain an IRS determination of their status as an employee. If the IRS finds that the individual was misclassified as an independent contractor, it can issue an agreement that would state the individual is responsible for paying only the employee’s part of employment taxes. This would entitle the individual to a refund, assuming the individual has paid taxes on the basis that he or she was self-employed, and the employer would then be responsible for the employer’s portion of the taxes (and possibly interest and penalties). It is not hard to see why an independent contractor, if his or her contract was coming to an end, would file a Form SS-8 to obtain a determination of status as an employee in order to, among other things, recover the employer portion of the FICA/Medicare/Social Security tax. If reclassified as an employee, the individual might then also seek unemployment benefits and sue the company for unpaid employment benefits.
Last but not least, the issue of employee misclassification can also arise during an IRS audit.
So when is an independent contractor actually an employee? That question is often very difficult to answer. Even the GAO, in a 2006 report, said, “the tests used to determine whether a worker is an independent contractor or an employee are complex, subjective, and differ from law to law.” (GAO Report- Employment Arrangements)
Two things are clear, however. First, many state laws that address misclassification of employees as independent contractors create a presumption that an individual is an employee unless the business paying the individual establishes that he or she is not an employee. And second, the determination of employee misclassification is often made by an administrative agency, which makes it more difficult to challenge the decision because courts often give governmental agencies wide latitude in interpreting their regulations. With that background, court cases and state laws offer some guidance, but the issue of employee classification remains very subjective. The U.S. Supreme Court has identified certain factors that should be considered in determining whether a worker is an employee or an independent contractor under the Fair Labor Standards Act (FLSA), which, among other things, establishes a Federal minimum wage and requires that certain employees receive overtime pay at 1-1/2 times the regular wage for hours in excess of 40 in a work week. In general, the Supreme Court held that a worker who meets the FLSA definition of employee is one who is economically dependent on the business he or she serves. In contrast, an independent contractor is one who is engaged in a business of his or her own. Many state laws describe employment status as a situation where the hiring party has the “right to control the manner and means” by which the worker accomplishes the end product of his or her work. While these standards are FLSA or state law specific, they do give a point of reference. The question, then, is what specific factors will a court look at to economic dependency or employer control? The IRS has stated that it will consider “all information that provides evidence of the degree of control and the degree of independence.” (IRS Form 15-A- Employer’s Supplemental Tax Guide) Here are some factors to consider:
Length of Contract. A contract with an independent contractor typically has a fixed term or it terminates upon completion of a specified project. An open-ended contract (or no written contract) suggests employment. Moreover, a contract with an independent contractor, even if it has a fixed term, can suggest employment status if it is renewed many times, thereby creating a long-term relationship with expectations of an indefinite number of contract renewals in the future.
Nature of Work. An independent contractor typically performs tasks that the company needs to have performed only at certain times or for a special reason, not tasks that are performed by employees of the company as part of the company’s core business. Moreover, a contractor’s performance objectives are usually described in detail in a written agreement, whereas a vague scope of work, such as “responsibilities as assigned” suggests an employment contract.
Supervising Employees. Independent contractors typically do not supervise employees. Such supervision, whether required by the contract or de facto, would suggest employee status.
Hours worked. Who decides what hours the individual works? An independent contractor typically sets his or her own hours, even if paid by the hour. In contrast, an employee must be “at work” during specified periods on specified days.
Exclusivity. Can the individual do work for other companies? If not, this would suggest employment, although prohibiting an independent contractor from working for competitors during the term of the contract would not be unusual if trade secrets or technology are involved.
Marketing. If the individual is an independent contractor, then one would expect the individual to be marketing his or her services so that new work can be found to provide other sources of income when the current contract ends? Does the individual have a website, business cards and marketing materials? Has the individual received other requests for work and how has he or she responded?
Expenses. Does the individual have insurance, at his or her expense, to protect the employer against errors or malfeasance? Does he or she pay for professional training, conferences and membership in professional organizations? Who pays for equipment such as laptops, cell phones, tablets, and storage devices that are used off the company’s premises? An independent contractor would typically pay all or most of these expenses whereas an employee would not.
Reports. What reports does the individual file? An independent contractor will typically file periodic progress reports describing tasks performed or progress achieved. Employees are not usually required to file such reports because they are more closely supervised and their accomplishments are known to their supervisor.
Other. Can the individual engage subcontractors? If the individual unilaterally terminates the contract before the end of the term, must the individual pay a penalty to cover the cost to the company of finding another contractor to complete the work? If the work performed is not satisfactory to the company, must the individual do the work again without additional compensation? Are there incentives for early completion and penalties for late completion? Each of these questions, if answered “yes”, would be indicative of independent contractor status.
These are only some of the factors an administrative agency or court might consider and, unfortunately, there is no way to predict how many factors, and the weight given to each, will tip the balance one way or the other. Suffice it to say that the written contract between the individual and the company is a very important part of the analysis. If doubt exists as to whether a contract with an independent contractor will survive scrutiny, companies should contact an attorney with a view to possibly amending the contract to add provisions, or clarify existing provisions, in order to reduce the risk of reclassification of the individual as an employee.