Worker Misclassification Under Fire

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Corporate America isn't the only place where there's pressure to improve the bottom line. Debt burdened governments, both federal and state, are searching for new sources of revenue, too. And they are seizing on lost tax dollars from employers who misclassify workers as independent contractors as one way to replenish their coffers.

President Obama, for example, believes the federal government can capture $7 billion in lost employment tax revenue over the next 10 years just by reducing employers' misuse of independent contractor status. And his administration is moving on several fronts to achieve that goal.

Following a 2009 GAO report critical of misclassification enforcement efforts by the Internal Revenue Service (IRS) and the Department of Labor (DOL) and urging more interagency cooperation, the IRS in February launched an effort to conduct 6,000 audits focused on employment tax issues over the next three years. The IRS also is signing information-sharing agreements with state agencies to exchange results of misclassification audits. The DOL's Wage and Hour Division (WHD) is adding 90 investigators to the task of rooting out misclassification, and is offering $12 million in grants to the states to bring their own enforcement actions.

The WHD is also expected to announce new recordkeeping rules next month. Among the rules under consideration is one that would require employers to conduct a classification analysis of all independent contractors, show the analysis to the workers and retain the analysis for any WHD employee who requests it.

Meanwhile, several states have passed laws restricting employers, particularly in the construction industry, from classifying workers as independent contractors, and raising penalties for violators. Some three dozen states have initiatives underway to root out misclassification.

Clearly, government has put employers on notice that they'd better make sure workers are correctly classified. But that can be easier said than done.

"All the talk about independent contractorship right now obscures the fact that there is a whole host of situations where it just isn't that clear [whether someone is misclassified]," says John Thompson, a partner at Fisher & Phillips. He points out that the IRS rules, the Fair Labor Standards Act, and state tax and wage and hour laws all have different criteria.

"The analysis is different, depending on the law," Thompson says. "It's a morass."

Competitive Advantage

That legal morass is confronting growing numbers of companies in industries ranging from health care to transportation to landscaping to sales. Strapped for help after the layoffs of the past two years, many have seized on hiring independent contractors as a way to close the labor gap without taking on the cost and liability of hiring permanent employees.

"In the last couple of years with the down economy, corporate on high would dictate a hiring freeze," says James Coleman, a partner at Constangy Brooks & Smith. "Because managers couldn't get around the hiring freeze, they figured out the back door way was to bring workers in as independent contractors."

As the economy picks up, some experts predict wary employers will use additional independent contractors as a temporary measure until they feel confident the economy is on firmer footing.

In addition to giving the employer more flexibility to add and cut workers as economic conditions dictate, there are other practical motivations for classifying workers as independent contractors.

Employers avoid burdensome federal and state employment laws, and ensuing liability, because independent contractors aren't covered under Title VII, the Family and Medical Leave Act (FMLA) and other worker-protection laws. They also realize significant cost savings because they avoid paying Social Security and Medicare taxes, don't have to contribute to workers compensation and unemployment funds, and don't have to pay minimum wage or overtime. They also don't have to withhold state and federal income taxes from contractors' pay.

Deep Dilemma

In some industries where use of independent contractors is common, the cost advantage of using independent contractors can put the employer on the horns of a dilemma, says Paul DeCamp, a partner at Jackson Lewis.

"If you call a person an employee, you are safer on the compliance front, but you may be at real risk on the competitive front. Your competitor may call the same worker an independent contractor," realizing cost advantages, he says.

The dilemma deepens when the employer tries to determine whether his workers are correctly classified.

"Lots and lots of positions fall into a gray area where some factors point to the person being an employee and others point to him being an independent contractor," DeCamp says.

In general, if the employer directs how the worker does his work and supervises that process, the worker is probably an employee. In contrast, if the worker is asked to produce an outcome without specific instruction or supervision, the worker is probably an independent contractor. Independent contractors generally can set their own schedules and accept work from other companies.

Other factors that play into the analysis include the expected duration of the relationship, how the person is paid--for hours or results--and whether he performs services nearly identical to those performed by employees.

"It is very fact specific and very difficult to generalize because of the variations between statutes," Coleman says.

Risk Assessment

Even though the analysis is difficult, employment law experts are urging employers to take a close look at their independent contractor relationships.

"If this isn't on your radar screen, it ought to be," Coleman says.

While certain industries such as construction are clearly in the enforcement spotlight, potential liability cuts across a wide swath of the economy.

"The real worry is that lots of industries use independent contractors without much thought," DeCamp says. "Sometimes they use them as substitute for temporary help, sometimes they use them as part of an ongoing business model. It may be correct or it may be incorrect, but no one has done the analysis to figure out where the risks are."

Management has to start by determining how many independent contractors the company has, Coleman adds. "Then analyze the relationships: Who are they reporting to? Are we paying them for time or results?"

Thompson agrees that in this enforcement climate, employers should start assessing their liability.

"If organizations are using independent contractors now, they had better take a hard and candid look at whether, under the various laws, that status is likely to be confirmed," he says. "If they are considering this for the first time, they should do everything they can to structure the arrangement in a way that increases the chances it will be confirmed, because the risk is greater than it has ever been."

Senior Editor

Mary Swanton

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