Inside: ‘If it quacks like a duck…’: The questions that prove employee or contactor

All of the various formulations of answers proceed from two, fundamental questions

A common employer response to the burdens and frustrations of modern employment law is to consider divesting, or to actually attempt to divest, itself of some or all of its employees. Of course, the practical problem becomes how to then carry on the business. Two solutions are equally commonly proposed to address that problem. First is the use of “leased” employees formally employed by another entity which, presumably, will bear the legal responsibility for them. If not done correctly, this approach raises the possibility that both entities will be found to be “joint employers,” a concept beyond the scope of this discussion. Second, is the use of “independent contractors,” who (at least largely) are by definition not “employees” subject to the panoply of federal, state and local employment laws and who are treated very differently than employees for tax, unemployment compensation, workers compensation and other purposes.

Classifying workers as independent contractors has become increasingly common in recent years, to the point where we are now beginning to see the inevitable regulatory push-back. For example, in February 2011, the Construction Workplace Misclassification Act took effect in Pennsylvania, severely limiting the ability to qualify as an independent contractor and enhancing penalties for those who misclassify, or knowingly contract with those who misclassify, construction industry employees as independent contractors. In September 2011, the Internal Revenue Service and U.S. Department of Labor announced a coordinated program of education, audit and enforcement directed at the misclassification of employees as independent contractors under the federal tax and wage & hour laws.

Perhaps obviously, this is an area of the law which requires greater attention than may traditionally have been paid to it.  

Common indicia of independent contractor status

The definitions of “employee” and “independent contractor” can and do differ depending upon who is asking the question and for what purpose. Nevertheless, all of the various formulations proceed from two, fundamental questions. The first is control; that is, both the extent to which the putative employer controls what is to be done by the putative employee and how it is to be done. The second is the economic reality of the relationship; that is, can the individual really be viewed as an independently-established businessperson or is he or she economically dependent principally upon the putative employer? In answering each question, substance will always control over form.

In most circumstances, the analysis begins with the 20 “common law factors” utilized by the IRS, which, consolidated and paraphrased to a certain extent, include whether or not the worker (to use a term which does not put the rabbit in the hat):

  • Offers the same services to the general public and performs services for more than one “customer” simultaneously;
  • Has made a significant investment in facilities or tools and provides his or her own tools and materials to perform the work;
  • Is at financial risk or profit and loss on the work being performed and is compensated on a project or percentage completion basis rather than on a regular weekly or monthly basis;
  • Receives extensive training and instruction from the “customer”;
  • Determines the hours and order or sequence in which his or her own work is performed;
  • Is free to employ assistants and controls their hire, supervision and compensation;
  • May terminate the contract or be terminated by the “customer” without cause or financial penalty.

For IRS purposes, no one of these factors is itself controlling and employment status will be determined based upon the totality of the circumstances. That is not, however, universally the case.

Consistent with the increased regulatory focus on this issue generally, more stringent tests of independent contractor status may apply for specific purposes or in specific jurisdictions. For example, the Pennsylvania Construction Workplace Misclassification Act creates a presumption of employment status, distills the 20 IRS factors into three (one of which contains six subparts) and permits the presumption to be rebutted only where the alleged employer establishes each of the statutory factors.

Consequences of misclassification

The potential consequences of misclassification are quite serious. For unpaid federal withholding, FICA, unemployment and similar taxes, the employer is subject to a minimum three-year “look back,” liability for the employer share and at least some portion of the employee share of FICA and other taxes, interest, penalties and other sanctions. Under the federal and state wage & hour laws, the employer could face liability for unpaid minimum wages and overtime, together with interest, liquidated damages and attorney’s fees. Under ERISA, the employer could face liability for the failure to permit the putative contractor to participate in tax-qualified benefit plans, such as back contributions to a Section 401(k) plan, stock incentive plans and the like. Intentional misclassifications of construction industry employees can result in civil and criminal penalties, apart from any liability to the employees, and to an order literally stopping work on a project if a majority of workers on the site are found to be misclassified.

As in so many other areas of employment law, if it sounds too good to be true, it probably is. Between the increasing regulatory scrutiny and the practical difficulty of surrendering sufficient control over the worker and the time, place and manner in which the work is performed even to bring the situation into the gray area, attempts to classify workers as independent contractors (whether at their own request or in an effort to avoid the legal implications of employment) is seldom a viable option, even for the most risk-tolerant employer. Conversely, the same considerations often provide the clearest path to relief for an improperly-classified employee.

For more on the topic, see Michael A.S. Newman’s take, “Compliance: Making sense of the myriad tests for independent contractor v. employment status

Contributing Author

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James A. Matthews, III

James A. Matthews, III is co-chair of Fox Rothschild’s labor & employment law department. He has more than 25 years experience representing management in all...

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