Many businesses choose to classify certain workers as independent contractors rather than employees. Some of the potential benefits of this classification decision include: avoiding payroll-related administrative costs; avoiding fringe benefit obligations; avoiding a higher headcount; avoiding employment taxes; avoiding worker’s compensation liabilities and costs; avoiding unionization; avoiding paying overtime compensation; and establishing a short-term, readily terminable relationship with workers. However, as many businesses are now experiencing firsthand, independent contractor arrangements are coming under increased scrutiny by state and federal government agencies and are the subject of a growing number of class action lawsuits.
An organization that misclassifies individuals as independent contractors may be exposing itself to substantial liability under various state and federal laws. In addition, some states, including Wisconsin, have altered the test for determining employee status under state law and have imposed new penalties for misclassification of employees.
One frequently overlooked aspect of the employee classification analysis is that there is no one test for determining whether an individual is an employee or an independent contractor. Different tests exist for different laws. For example, a particular worker may be an independent contractor for purposes of income tax laws, but be an employee for purposes of unemployment or worker’s compensation. When making the classification decision, an employer must perform a careful analysis under a variety of laws, including federal and state income tax laws, unemployment compensation benefits/tax laws, worker’s compensation laws, the Fair Labor Standards Act (FLSA), employment discrimination laws, immigration laws, the Employee Retirement Income Security Act (ERISA), and other employment-related laws. The following is a brief summary of the tests used under some of those laws, as well as some other issues employers should consider when classifying a worker as an independent contractor.
Internal Revenue Code
The Internal Revenue Code (IRC) requires businesses to withhold income taxes and withhold and pay Social Security and Medicare taxes on behalf of employees, but not independent contractors. The Internal Revenue Service (IRS) currently utilizes three “common law” rules to determine whether an individual is correctly classified as an employee or an independent contractor1:
- Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial. Are the business aspects of the worker’s job controlled by the payer? (These include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship. Are there written contracts or employee type benefits (e.g., pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
The IRS has advised that businesses must weigh all of these factors in determining whether an individual is an employee or an independent contractor2.
Section 530 of the IRC provides a statutory safe harbor that may allow an employer to avoid retroactive liability, even if the employer previously misclassified its employees. If the employer: (1) had a “reasonable” basis for not treating the workers as employees; (2) was consistent with its treatment of workers in this category; and (3) filed all required federal tax returns consistent with its treatment of the workers as non-employees, the employer may be able to take advantage of the safe harbor provision.
The IRS has also developed a Voluntary Classification Settlement Program (VCSP) that permits employers to voluntarily reclassify their workers as employees for future tax periods with limited liability for past misclassification. Businesses may want to consider taking advantage of this program if they have groups of workers who are clearly misclassified.
Federal Fair Labor Standards Act
The U.S. Department of Labor (DOL) has recently intensified its efforts to investigate employers who improperly classify employees as independent contractors for purposes of the FLSA. This has been a publicized point of emphasis under the Obama Administration. The DOL and the courts generally have applied a six-factor test, which is commonly referred to as the “economic reality” test, to determine whether a worker is an employee or an independent contractor for purposes of the FLSA3.
The potential danger for employers under the FLSA was highlighted in the recent Secretary of Labor v. Cascom case, decided by the Federal District Court of the Southern District of Ohio4. In the Cascom case, the court applied the economic reality test in an expansive manner and ruled that the employer had incorrectly classified its cable installers as independent contractors and owed its workers overtime pay in excess of $800,000.
Employers can expect additional inquiries and investigations by the DOL into worker classification. In that regard, the DOL has recently entered into a memorandum of understanding with the IRS to collaborate in the investigation and enforcement of independent contractor classification issues.
The definition of “independent contractor” for purposes of unemployment compensation under Wisconsin law has changed. As of January 1, 2011, there is a two-part test for determining eligibility for unemployment compensation benefits (i.e., whether an individual is an employee or independent contractor). See Wis. Stat. § 108.02(12)(bm). A worker is not covered for purposes of the statute if the services of the individual are performed free from control or direction by the employer5 and the individual satisfies six or more specific conditions6. The test must be satisfied “by contract and in fact.”7
Like the DOL, the Wisconsin Department of Workforce Development (the state agency responsible for enforcing Wisconsin’s employment-related laws) has committed additional resources and attention to investigating alleged violations of employee misclassification8.
The test for excluding a worker from coverage for purposes of the Wisconsin worker’s compensation law is notoriously difficult to satisfy. Many workers who may correctly be classified as independent contractors for other purposes do not meet the worker’s compensation standard.
The general rule, as set forth in Wis. Stat. § 102.07(8), is that every worker is an employee of any employer for whom he or she is performing service in the course of the trade, business, profession or occupation of such employer at the time of the injury unless the worker satisfies all nine specific statutory conditions set forth in the law9.
Some businesses classify workers as independent contractors to avoid providing those workers fringe benefits such as medical insurance coverage or retirement benefits. Before doing so, however, a business should carefully review the terms of its employee benefit plans to ensure that language in the plans actually excludes such workers. The seminal case on this issue involved Microsoft Corporation10. Microsoft had excluded numerous workers from coverage under various employee benefit programs on the basis that they were independent contractors. However, the Microsoft plans provided that each “employee” was eligible to participate and defined “employee” to include “any common law employee.” The Ninth Circuit Court of Appeals held that individuals deemed by Microsoft to be independent contractors actually met the test for common law employees, and were therefore eligible for coverage. Since the Microsoft case, a number of class action lawsuits have been filed that relate to misclassification and employee benefit plans. A business should consider revising the terms of its employee benefit plans11 to clearly exclude workers who are treated as independent contractors.
In sum, worker classification can be a complicated analysis involving the application of various laws and legal tests. State and federal authorities are increasing their efforts to investigate and prosecute those businesses which they believe are incorrectly classifying employees as independent contractors. Moreover, plaintiffs’ lawyers are now frequently challenging worker classifications by using class action lawsuits, which are especially costly for businesses to defend against. Accordingly, businesses would be wise to revisit their worker classification decisions to ensure compliance with the current law.
For more information, please contact Erik Eisenmann at (414) 978-5371 or firstname.lastname@example.org, David Hertel at (414) 978-5303 or email@example.com, or another member of the Human Resources Law Team.
This article appears in the Spring 2012 edition of the Workplace Newsletter, presented by the Human Resources Law Team of Whyte Hirschboeck Dudek S.C.
1 Many businesses are familiar with the traditional “20-factor test” that the IRS previously used for determining independent contractor status. While this test is still useful as a guide, it is no longer officially recognized by the IRS.
2 If an employer is unsure whether a worker is an employee or independent contractor for purposes of the IRC, the employer may want to consider filing Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. The IRS will then review the facts and circumstances of the particular situation and issue a determination regarding the worker’s correct legal status. Form SS-8 is available at: www.irs.gov/pub/irs-pdf/fss8.pdf
3 The “economic reality” test generally includes the following factors: (1) the degree of control exercised by the alleged employer; (2) the extent of the relative investments of the putative employee and employer; (3) the degree to which the “employee’s” opportunity for profit or loss is determined by the employer; (4) the skill and initiative required in performing the job; (5) the permanency of the relationship; and (6) whether the services rendered are an integral part of the alleged employer’s business.
4 Solis v. Cascom, Inc., Case No. 3:09-cv-257 (S.D. Ohio, September 21, 2011).
5 To determine whether an individual is “free” from the employer’s control, the Wisconsin Department of Workforce Development considers the following non-exclusive factors: (a) whether the individual is required to comply with instructions concerning how to perform the services; (b) whether the individual receives training from the employing unit with respect to the services provided; (c) whether the individual is required to personally perform the services; (d) whether the services of the individual are required to be performed at times or in a particular order or sequence established by the employing unit; and (e) whether the individual is required to make oral or written reports to the employing unit on a regular basis.
6 The specific conditions set forth in the statute are as follows: (a) the individual advertises or otherwise affirmatively holds himself or herself out as being in business; (b) the individual maintains his or her own office or performs most of the services in a facility or location chosen by the individual and uses his or her own equipment or materials in performing the services; (c) the individual operates under multiple contracts with one or more employing units to perform specific services; (d) the individual incurs the main expenses related to the services that he or she performs under the contract; (e) the individual is obligated to redo unsatisfactory work for no additional compensation or is subject to a monetary penalty for unsatisfactory work; (f) the services performed by the individual do not directly relate to the employing unit retaining the services; (g) the individual may realize a profit or suffer a loss under contracts to perform such services; (h) the individual has recurring business liabilities or obligations; and (i) the individual is not economically dependent upon a particular employing unit with respect to the services being performed.
7 There are separate special tests that are applicable to truckers and non-profit organizations. See Wis. Stat. § 108.02 (12)(c).
8 For example, Wisconsin law now includes a penalty of up to $25,000 for employers in the construction industry that “willfully misclassify” employees as independent contractors. See Wis. Stat. § 111.327.
9 The statutory conditions are as follows: (1) maintains a separate business with his or her own office, equipment, materials and other facilities; (2) holds or has applied for a federal employer identification number with the IRS or has filed business or self-employment income tax returns with the IRS based on that work or service in the previous year; (3) operates under contracts to perform specific services or work for specific amounts of money and under which the worker controls the mean of performing the services or work; (4) incurs the main expenses related to the service or work that he or she performs under the contract; (5) is responsible for the satisfactory completion of work or services that he or she contracts to perform and is liable for a failure to complete the work or service; (6) receives compensation for work or service performed under a contract on a commission basis or per job or competitive bid basis and not on any other basis; (7) may realize a profit or suffer a loss under contracts to perform work or service; (8) has continuing or recurring business liabilities or obligations; and (9) the success or failure of the worker’s business depends on the relationship of business receipts to expenditures. An employer must prove the worker meets all nine of the foregoing conditions before the worker will be held to be a non-employee.
10 Vizcaino v. Microsoft, 120 F.3d 1006 (9th Cir. 1997).
11 See, e.g., In re FedEx Ground Package Sys. Inc., 662 F. Supp. 2d 1069 (N.D. Ind. 2009).