Independent Contractor Misclassification
Updated: Sep 15
The internet and mobile applications have completely revolutionized the way companies do business. In turn, a new and increasingly popular business model has emerged – the gig economy, also known as, the on-demand economy. This business model allows business owners the opportunity to avoid all of the red-tape that comes with hiring employees. Instead, the business owners rely on independent contractors as the primary service provider. By utilizing this model, companies are able to avoid significant tax and other liabilities every year. While this is an extremely smart business model that may yield savings for a company, improper classification may result in a compliance nightmare and have detrimental legal consequences for the business owner. The cost of worker misclassification can be detrimental to your business and result in steep penalties.
It is a misconception that simply referring to a worker as an independent contractor in a written agreement will protect a business from a legal challenge regarding the status of their workers. Further, a worker is not properly classified as an independent contractor just because the work is part-time, seasonal, or for a trial period. Over the last several years, federal and state enforcement efforts have resulted in a steady increase in agency audits and class and collective action lawsuits. So, it has become increasingly more important for businesses to understand the laws that determine a worker’s status.
This post will provide you with a fundamental understanding of the tests that various courts and government agencies use to determine whether the contractor is correctly classified as an independent contractor so that you may assess whether your current working arrangement qualifies.
RIGHT TO CONTROL TEST: Internal Revenue Service
There are several tests used to determine whether independent contractors are properly classified. The IRS and some courts utilize, the right to control test which focuses on the degree of control the company has over the worker performing the service. In an employment relationship, the employer controls the manner and means by which employees perform their work. In an independent contractor relationship, the contractor controls the work. The company controls the result, not how the work is performed. The right to control is the primary focus of this inquiry, not whether the company actually exercises that control. Some examples of control over the manner and means of the work include: Although no one factor is determinative, the IRS’s test considers several factors grouped into three general categories:
Behavioral Control - The behavioral control factor takes into consideration how much control a hiring entity has over the assignment to be completed as well as the manner in which the assignment is done. In general, if a worker is provided strict guidance on how, when, and where to complete the assigned task, then the worker is generally considered to be an employee. Whereas, if the worker does not require training or guidance and completes the work in accordance with their own standards and set their own schedule, they are typically considered an independent contractor.
Financial Control - Financial control considers whether a hiring entity has the right to control or direct the business and financial aspects of the worker’s job. For instance, typically, an independent contractor will incur unreimbursed expenses. In addition, independent contractors will generally provide their own tools or equipment. But, employees will rely on their employer to provide anything additional. Another factor considered is how payment occurs. Employees are paid a regular wage in exchange for working for a specific time period, while contractors are generally paid a flat fee for the duration a project. Also, independent contractors are free to market their services to other businesses and will incur a profit or loss.
Relationship of the Parties - A contractual agreement which defines the relationship between the hiring entity and the worker and details the project or task to be completed will generally help to determine the relationship of a business with a contractor. Conversely, if a worker has been hired or engaged for an indefinite period of time, provided with benefits such as overtime pay, vacation, and health insurance, then the worker is more likely an employee. In addition, an examination of whether the services provided are key aspects of the business can provide some insight into the relationship. If the worker’s services are a key aspect, then it is more likely that the worker is an employee of the hiring entity rather than an independent contractor.
These factors are not to be considered in isolation and no one factor is determinative. It is the broader picture or the totality of the circumstances that determine the relationship between the parties.
THE ECONOMIC REALITIES TEST: THE DEPARTMENT OF LABOR’S STANDARD
The Department of Labor’s (“DOL”) Fair Labor Standards Act (“FLSA”) defines employee as "any individual employed by an employer" who is "suffered or permitted" to work. Unfortunately, this vague statutory definition is useless. With little guidance from the statute, the DOL and the courts have developed the economic realities test to determine whether an employment relationship exists under the FLSA. The primary focus of this test is whether the economic realities of the parties' relationship are such that the worker is economically dependent on the hiring entity or is in business for themselves.
Contractual language, the worker's title or label, and common law factors evaluated in isolation do not define the relationship. Courts analyze the totality of the parties' relationship and nearly all use a balancing test to evaluate various factors, including the following six factors:
The DOL states that a number of nonexclusive and non-determinative factors are helpful guides, including:
1. The extent to which the work performed is integral to the hiring entity's business. If so, it is more likely the worker is economically dependent on the hiring entity and is an employee. The DOL’s position is that a true independent contractor's work is unlikely to be integral to the hiring entity's business.
2. Whether the worker's managerial skill affects their opportunity for profit or loss. A worker that is in the business for themselves has the ability to incur a profit or a loss. The worker's ability or decision to work more jobs or more hours it not considered to be a managerial skill and is therefore not considered in this analysis. To be properly classified as an independent contractor, the worker's managerial skills must include their decisions concerning:
managing time schedules
purchasing equipment and materials
3. The worker's relative investment in tools and facilities compared to that of the hiring entity. In order for a worker to be properly classified as an independent contractor, they must make some investment (and undertake a risk of loss). The investment must compare favorably to the investment of the hiring entity.
4. The special skill and initiative required to complete the job. An independent contractor’s skill must indicate that they exercise independent judgment or initiative. Technical skills alone are not sufficient to constitute independence or business initiative.
5. Whether the working relationship is permanent or indefinite. If indefinite, the DOL is likely to find an employment relationship. However, simply because the relationship lacks permanency or is of a specified duration, the worker is not necessarily an independent contractor. The key factor is whether the length of the relationship is the worker’s choice or the standard of that particular industry. If the length of the relationship is determined by the worker, this is an indicator that the worker may be an independent contractor. If the length of the relationship is determined by the industry, this indicates that the worker may be an employee.
6. The nature and degree of the hiring entity's control over the worker. Generally, courts (and historically the DOL) distinguish between control only over the outcome of the work (supporting an independent contractor relationship) and control over how the work is performed (supporting an employment relationship). Control factors may include:
fixing working hours and the rate of pay;
determining how the work is performed; and
freedom to work for others and hire assistants.
THE STATES: ABC TEST & HYBRID TEST
In an effort to prevent misclassification, the “ABC Test,” is used by many states. The ABC Test requires three factors to be satisfied for a worker to qualify as an independent contractor. While the ABC Test is subject to interpretation and clarification which varies from state-to-state, it typically consists of the following factors:
The worker must be free from the hiring entity’s control or direction over the assignment,
The services provided by the contractor must be performed outside of the hiring entity’s place of business and/or usual course of business; and
The contractor must be customarily engaged in an independently established trade, business, profession, or occupation of the same nature as the service performed.
Tests for independent contractor status can also vary under state employment statutes. State independent contractor tests may impose a more narrow definition than the federal equivalent.
THE “HYBRID” TEST
Some courts and administrative bodies apply the “hybrid” test to determine employment status. This test is a combination of the right to control and economic realities tests. The issue of control is predominant.
CONSEQUENCES OF IMPROPER CLASSIFICATION
Although the benefits of properly classifying a worker as an independent contractor are significant, the financial costs and penalties of misclassification can be serious. Classification lawsuits are costly to defend and may potentially disrupt or destroy a company's business that is reliant on the use of independent contractors. Misclassification suits often result in settlement payments in the millions of dollars. Just ask UBER, Lyft, at FedEx. Since contractors can avoid many of the tax and other employment law requirements of an employment relationship, the IRS, state government agencies, and courts construe independent contractor status narrowly and impose large penalties for improper classification.
The IRS typically requires a company to reclassify the worker as an employee, making the company liable for any financial and litigation liability concerning that employee, including:
Retroactive wage payments and overtime pay
Tax and insurance obligations
Employment law compliance
Employee benefits, including stock options, retirement benefits, and health plan
Civil monetary penalties
Disability payments and workers’ compensation
Protecting Your Company
Independent contractor misclassification carries serious consequences, risks, and penalties. In order to protect your company, it is essential that your company create classification policies and processes for hiring and managing independent contractors.
For now independent contractor classification remains a complicated issue. To minimize your company’s exposure to misclassification liability, your company should follow state and federal guidelines as closely as possible, use a written contract in all independent contractor engagements, and keep documentation on file to support your classification decisions. Boyd, Cooper & Associates can assist you in evaluating and engaging independents as well as developing policies and establishing the appropriate program for proper management of your independent contractors. These preventative measures will help you to minimize or eliminate compliance risks and ensure that your workers are properly classified.
For more information on contractor misclassification and compliance, contact Cooper Legal today.
This blawg is provided by the firm for informational purposes only and may not be relied on as legal advice. If you have any questions related to your specific business needs, schedule a legal consultation today.
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