The Guessing Game—Are Your Workers Independent Contractors or Employees?

By Kristin Casler, featuring Todd Lebowitz at BakerHostetler

Your company is facing a seemingly innocuous unemployment compensation claim. You might not even bat an eye. But wait! If that worker was misclassified as a contractor, any penalty levied also applies to all similarly situated employees for as far back as the statute of limitations allows. That can add up quickly. Then—get out your calculators—the state unemployment agency folks are sure to notify all of their friends in workers’ compensation, income tax and other state agencies, and then they will share the information with their friends at the U.S. Department of Labor and the IRS.

“All of a sudden you’ve got all of these state and federal agencies on your back, and the molehill has turned into a very large mountain,” said Todd H. Lebowitz, a partner at BakerHostetler and author of a comprehensive 2016 white paper on employee misclassification.

Companies in 2015 saw several major lawsuits and even some nine-figure settlements for independent contractors that the government said were really employees. The continuing lost revenues from such misclassifications have prompted the U.S. Department of Labor to make independent contractor misclassification a priority enforcement area in 2016. Is your company prepared?

Mitigating risk

You can never eliminate 100 percent of the risk, Lebowitz said. There are so many different standards that apply. Standards vary among states and within states and among federal agencies. Sometimes you have to evaluate an employment situation under six or eight different standards, he said.

“The solution here is really about reducing risk,” he said. “Companies don’t want to hear ‘just make everyone an employee,’ so the best they can do is make changes to better support the argument that their independent contractors are properly qualified.”

To that end, Lebowitz provides 10 risk-reducing tips.

1. Take seriously any unemployment claim filed by an independent contractor.

A finding that one contractor is an employee can result in a finding that all similarly situated workers are employees. As mentioned above, there may be substantial assessments for years of unpaid premiums. In the case of the Affordable Care Act, a change in classification could drop the percentage of employees offered health coverage below the required 95 percent. Now you’re looking at a fine based on all of your employees.

2. Avoid rebranding former employees as contractors.

Workers who once performed services as employees are unlikely to be considered legitimate independent contractors. If they are performing the same work, you can’t just call them a contractor. Rebranding often happens when companies seek to transition workers out of the work force or to give them an extended severance package, Lebowitz said.

“Giving the same person a W-2 and a 1099 in the same year is going to raise a red flag,” he said.

3. Avoid retaining contractors to perform the same work in the same location as employees.

When individual contractors and employees work side by side, the likelihood of misclassification is high. An accounting firm will have a tough time legitimately hiring a contract accountant who works the same hours in the same office as the other accountants, Lebowitz said. Even if the contractor is just part-time, she may still be an employee.

4. Avoid directing contractors in how to perform their work.

In a true independent contractor relationship, the hiring entity desires results, but the details about how, when and where to work toward those results are left to the contractor’s discretion. The employer can say, “I need a certain result; I don’t care how you do it.” That’s a legitimate contractor. The more the company intervenes in the process, the more the relationship leans toward employment, he said.

You can have an employee on a short-term basis, he said. “Companies get uncomfortable sometimes that employment can be for a limited or short timespan. There is nothing wrong with hiring an employee for 3 – 6 months and saying that’s it. Some companies improperly call those contractor relationships. The fact that employment isn’t long term doesn’t mean it isn’t employment.”

The same determining factors still apply.

5. Create a well-drafted contractor agreement.

A well-drafted contractor agreement can direct attention to factors that support independent contractor status. But it is insufficient on its own. If the actual facts of employment are inconsistent with the contract, the contract will be of little value, Lebowitz said. If the contract says the worker acts on his own schedule or doesn’t compete with in-house workers, but those statements are false, a court will simply disregard the contract.

6. For companies operating in multiple jurisdictions, be aware that the same relationships may be classified differently in different states.

There are generally three kinds of classification tests that apply. Right-to-control tests have a list of factors that determine classification based on the employer’s control over the worker. Economic realities tests look at whether the worker is economically dependent on the hiring party, such as how much of the worker’s income is from one source and whether the worker serves other clients. These are balancing tests that take into account multiple factors.

The riskiest tests for employers are ABC tests, used in some states, most commonly under unemployment or Workers’ Compensation laws. ABC tests generally require meeting both of the previous tests, plus require that the work is either ancillary to the company’s core business or that all work is performed off-site.

Additionally, some states have industry-specific laws. New York, for example, has different standards for construction workers and commercial drivers than for independent contractors in other fields, Lebowitz said.

7. Be proactive in evaluating current use of independent contractors.

Steps can usually be taken to shift factors in the balancing tests toward independent contractor status. Look at when and where the employee works and the other myriad factors to see if altering the job makes contractor status more likely.

Lebowitz said companies should regularly review their classifications. “Any company that hasn’t scrutinized their independent contractor relationships in the last year or two really should. Doing something a certain way because that’s the way it’s always been done is a recipe for audit, investigation and lawsuits.”

8. Create an internal process that ensures review and approval by a point person before any manager can retain an independent contractor.

At companies where hiring independent contractors is a regular occurrence, managers in the field sometimes establish relationships that human resources never knows about; for example, contractors aren’t processed through payroll and are retained without using employee personnel forms. Independent contractors should never be hired without review and approval by someone who understands independent contractor rules, Lebowitz said. Not knowing about a worker is not a defense to a misclassification claim.

9. Consider using staffing agencies and well-established independent businesses that have many employees rather than retaining individuals.

You can often avoid problems by hiring a vendor who takes care of the taxes and employee benefits. Assuming that this is done properly, of course. Companies should be aware that workers supplied by a vendor will often be deemed joint employees under employment laws, and that the company benefiting from those services may be liable if the primary employer fails to properly pay taxes, withhold deductions, provide unemployment coverage, etc., Lebowitz said. A well-written vendor agreement with carefully drafted representations and indemnity provisions can provide a substantial layer of protection that does not exist when retaining individuals.

10. Check benefit plan language.

Workers who receive health or dental insurance, pension or 401(k) contributions, paid vacation, sick days, or disability insurance are almost certainly employees. Businesses generally do not grant these benefits to independent contractors and, in the case of insurance, often cannot grant such benefits to contractors. The lack of employee benefits, however, does not necessarily mean that the worker is an independent contractor.

Further, plan eligibility can be drafted in a way that renders ineligible individuals who are paid as independent contractors, even if those individuals are later deemed to have been misclassified.

Toe the line before it’s too late

Many companies think that if they haven’t been hit by a misclassification claim, they never will be, Lebowitz said. That’s a foolish way to look at it. The law is the law, and you can’t contract out of legal obligations just by calling an employee a contractor.

Misclassification is really high-profile stuff. It costs a few thousand dollars to fix these problems proactively, but failure to do so can cost you millions.