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Calling An Employee By Any Other Name Has Consequences

There has been a recent and growing trend of employers misclassifying employees as “independent contractors,” particularly in the construction industry. Contractors historically have relied on armies of skilled subcontractors to supplement their core work forces, often project by project.

Independent contractors are preferred for the monetary benefits they confer on employers, in the form of eliminated payroll and social security taxes, workers’ compensation and unemployment insurance, and minimized wage, overtime and union restrictions. But sometimes, these “independent contractors” are not “independent” in the eyes of federal and state government agencies.

Wary of the financial incentives driving the practice of employee misclassification, the U.S. Department of Labor has in the past several years stepped up its review of independent contractor relationships. In addition, the Internal Revenue Service has expanded its efforts to audit employer-employee relationships, and the private sector has experienced a proliferation of private lawsuits challenging independent contractor classifications.

At the state enforcement level, several states have created new laws defining and regulating the independent contractor classification and are aggressively investigating and conducting audits of potential offenders — particularly construction contractors. Such audits may include issuing stop-work orders.

Faced with these increased enforcement efforts, businesses must carefully re-examine and re-evaluate their worker classification practices to avoid the potentially significant financial, legal and administrative penalties and sanctions that may result from improper misclassifications.

The DOL has made it a top priority to review independent contractor-classified relationships and identify violations. Although the DOL has targeted the construction industry, particularly in northeastern states like Connecticut and Rhode Island, specific trades and categories such as drywall, electrical, landscaping and property management are the focus of their enforcement efforts, which include a written agreement between the DOL and IRS to share information from their respective investigations to further dissuade and reduce incidence of fraud.

This coordinated interagency effort greatly increases the costs and risks for businesses, which potentially face both monetary sanctions from the DOL and substantial tax penalties and liability from the IRS when either agency detects a misclassification error.

Adding further pressure to employers, states like Massachusetts and Connecticut have increased their policing of independent contractor relationships and have agreed to exchange information with the DOL and IRS, exposing employers to scrutiny from state employee benefits security administrations, the Occupational Safety and Health Administration, and the Office of Federal Contractor Compliance when compliance violations are detected.

Several states also have narrowed their statutory definitions of “independent contractors.” New York has enacted legislation directed at the construction industry that creates a rebuttable presumption that all construction workers are “employees” unless the employer proves otherwise.

Enforcement actions by government agencies are not the only liability that employers potentially face. Worker misclassification also leaves employers vulnerable to private lawsuits, including class actions by their own work forces, as was the case recently when a Massachusetts court found Federal Express liable for misclassifying workers as independent contractors under the Massachusetts Independent Contractor Act.

These types of claims expose companies to stiff penalties in the form of back wages, potential tax liability and attorneys’ fees.

It is increasingly important for contractors and other employers to carefully evaluate the status of individuals they have classified as independent contractors. However, determining whether a worker is an employee or independent contractor depends upon several factors, all of which are relevant, and none of which is independently controlling.

This ambiguity is further muddled by the inconsistency among states in what criteria they use to establish “independent contractor” status, which means that a worker may be an independent contractor in one jurisdiction but a statutory employee in another.

Notwithstanding the inherent ambiguity in worker classification criteria, there are general guidelines employers should follow. These guidelines focus on the concept of “control.”

Generally an individual is an independent contractor if the “employer” has the right to control or direct only the result of the work, but not the actual work or the method by which the work will be conducted.

The IRS has divided this definition of control into two parts: “behavior” control and “financial” control. Under this bifurcated analysis, employers should consider “behavioral control” factors such as:

  • How the worker’s hours are set, including timing and frequency of the worker’s activities;
  • Whether the employer provides training for how to perform the work or whether means and methods are left to the worker’s discretion; and
  • Whether the employer or worker has discretion over the means and methods of the work.

Regarding “financial control,” employers should consider the following factors related to the administrative aspects of the worker’s relationship:

  • Whether the employer controls the business or administrative aspects of the worker’s job, which is more consistent with an employee relationship;
  • Whether the individual is compensated with a flat fee, which is more typical of independent contractors, or with an hourly or salary-type arrangement, which is more typical of employees;
  • Whether the worker has a substantial investment in his facilities and equipment, which is typically true for independent contractors, or they belong to the company hiring the worker, which is typical for employees;
  • Whether the individual seeks other work from other businesses, which is consistent with independent contractor status; and
  • Whether the individual realizes a substantial profit or loss from the work he or she performs, which is also consistent with independent contractor status.

Besides the “control” test, employers must examine the type of relationship they are creating with a worker. This examination will be aided by considering issues such as:

  • Whether the work relationship is permanent and ongoing, which is more likely to resemble an employer-employee relationship, or sporadic over defined project periods;
  • Whether there is a written agreement defining the relationship and establishing employee-type benefits, like vacation time, insurance or sick pay. A contract alone is not controlling, even if both parties call their relationship “independent;” if the worker requests independent 1099-type status, it will not necessarily control how government agencies will view the relationship;
  • Whether the individuals pay for their own costs of the work, including equipment, insurance and administrative expenses, which more follows an independent contractor relationship;
  • Whether the services performed are a key aspect of the employer’s business, because the more the work is central to the employer’s core business, the less likely it is to be deemed “independent”; and
  • Whether the individuals exercise independent judgment and skill to perform the work, in which case they are more likely to be independent contractors.

These are only some of the factors to consider when determining the proper classification of workers. An accurate assessment requires a case-by-case application of controlling law established by judicial opinion and administrative regulation to several factors that must be weighed individually and as a whole to determine a total picture of the relationship.

Although this analysis may be time-consuming and complicated, it could help avoid the costly consequences of worker misclassification in an environment of heightened public and private scrutiny. For contractors who omit such precautions, calling a worker by any other name may prove to be a sour experience.