Independent Contractor or Employee: Getting It Right Is More Important Now Than Ever Before

In a prior post, we took a look at some of the top mistakes growing companies make in the employment arena. Now let’s take a deeper dive into the issue of misclassifying people as employees vs. independent contractors. It’s an issue that is frequently glossed over by startups, but one that can cause significant risks, both in terms of potential liability, but also with potential investors and acquisition partners.

For far too long, employers have taken a laissez-faire approach to classifying workers as independent contractors in order to help control costs, streamline their organizations, and honor the stated preferences of their workers. However, the cost associated with being undisciplined and incorrect about these classification decisions can be quite expensive, and is likely to get more expensive in the near future given the Department of Labor’s “Misclassification Initiative,” which is designed to identify and reduce employee misclassification. In fact, the Department of Labor has requested a specific $25 million line item in its 2011 budget to hire additional investigators and enforcement personnel, as well as to create competitive grants to encourage state agencies to focus more attention on this issue. This should come as no surprise in these lean tax-revenue years given that the General Accounting Office recently estimated a loss of more than $2.7 billion per year in unpaid Social Security, unemployment and income tax as a result of this type of misclassification.

Misclassification of employees as independent contractors can result in substantial liability and penalties for, among other things, back taxes, overtime pay, workers compensation, employee health benefits, and retirement benefits. Recent verdicts highlight the considerable risk associated with this type of misclassification:

• Labrie v. UPS (California 2009). $12.8 million settlement for misclassification of delivery drivers
• Gardner v. Baby Trend Inc. (California 2009). $8.4 verdict on wrongful discharge claim after jury found commissioned salesperson was an employee rather than an independent contractor
• In re FedEx Employment Practices Litigation (Indiana 2009). Certification of near-nationwide class of delivery drivers claiming misclassification
• Western Company of Texas (Texas 2008). Company agreed to pay nearly $600,000 in settlement to approximately 200 workers for unpaid overtime after the Department of Labor concluded the workers were misclassified.

Moreover, heightened risk of government audits, and the increased risk of litigation that often follows, can be a devastating “one-two punch” to any company’s bottom line. In light of the impending promise of increased federal and state scrutiny of independent contractor classifications, and the significant risks associated with misclassification, now is the time to ensure that your company is in compliance.

While there is a great deal of publicly available information regarding independent contractor classification, it can be difficult to apply that information to an analysis of a particular business. One or more of several tests for independent contractor misclassification may be applied to workers, including tests established by:

• IRS regulations;
• U.S. Department of Labor guidelines;
• state agencies; and
• federal and state case law.

Each test relies on different factors, and different tests place priority on different elements of a worker’s relationship with a company in determining the correct legal status as employee versus independent contractor. Although the analyses will vary depending on the circumstances, several themes permeate multiple tests:

• Workers subject to frequent oversight and instruction from “managers” are more likely employees.
• Workers who receive training from the company are more likely employees.
• Workers that contribute to the company’s core business functions are more likely employees.
• Workers who have open-ended relationships with the company are more likely employees.
• Workers who must devote all or most of their professional time to performance of duties for the company are more likely employees.
• Workers who have set schedules and who must work on the company’s premises and/or using the company’s tools are more likely employees.
• Workers who are compensated at fixed intervals, rather than for designated results, are more likely employees.
• Workers who receive health and/or retirement benefits are more likely employees.
• Workers who have an “at will” relationship with the company are more likely employees.

Fundamentally, the fact that a worker may have an express written agreement to be an independent contractor – or even if the worker has said that he/she wants to be an independent contractor – is not enough. Unless the worker’s status complies with the applicable independent contractor classification test, employers may be at risk of liability for misclassification. So, now is the time to get your “house in order” regarding independent contractor classification. Deferring this critical internal assessment simply increases risk, and, where workers are currently misclassified, creates mounting liability.

Credit to my former partner Gary Gansle for this post.