By Renee Lani
, University of Maryland Francis King Carey School of Law
It is extremely important for an employer to understand the difference between an employee and independent contractor in order to determine a company's tort liability. Nevertheless, an employer that focuses primarily on its liability exposure under tort law may overlook other potential issues. Indeed, tax and labor laws more generally have similarly far reaching and costly effects for companies that incorrectly classify an employee as an independent contractor.
Last year, federal agencies provided guidance to help companies prevent misclassification and the adverse effects that can accompany it, such as loss of tax income for governments and loss of benefits for employees. The growth of the "gig economy1
" is the likely provocation of federal response. As of 2015, 15.8% of our country's economy was composed of workers in alternative employment arrangements, such as independent contractors. Although the federal clarification of what constitutes a statutory employee made waves in the business world for being much broader than previously thought, the agency hoped its action would protect individuals' benefits and help businesses avoid the costly mistake.
Understanding Employment Classification: When an Independent Contractor is Actually an Employee
An employee is typically subject to the control of his or her employer. Furthermore, employees often receive training from employers, and employers reimburse employees for business-related expenses, such as the purchase of an item necessary to complete an assigned task. Briefly stated, an employee is economically dependent on the employer.
Alternatively, an independent contractor tends to be an employee or owner of a separate company. This other company will likely operate under a unique business name, maintain a separate business checking account, service more than one client, provide its own tools, and invoice clients for work completed. In other words, an independent contractor is in business for him or herself and not economically reliant on the employer.
However, the distinction between the two types of workers is not always clear-cut and can require additional analysis. Although using independent contractors can be beneficial to a business by saving labor costs, reducing liability, and providing flexibility in hiring, misclassifying an independent contractor can be a costly mistake.
A. Laws Governing Classification
The Fair Labor Standards Act2
("FLSA" or "the Act") is the controlling law that defines "to employ" as "to suffer or permit work." Although this standard was added to many state laws to help prevent child labor, it is now the controlling standard for all employment classification.
In a 2015 interpretation
, the U.S. Department of Labor's ("DOL") Wage and Hour Division further clarified that a person's employment classification is dependent on the FLSA language, not solely the common law test of control that was the predominant deciding factor before Congress enacted FLSA. Although business leaders claim this new interpretation made independent contractors a fictitious form of employment in some sectors, a Wall Street Journal article3
on the matter presents counter-arguments claiming that the interpretation was necessary to protect all modern-day workers. In response to the new interpretation, Secretary of Labor Thomas Perez "called misclassification a serious problem that not only deprives workers of overtime pay and benefits, such as unemployment insurance and workers' compensation, but also undermines state and federal tax collection."
The Supreme Court and federal Circuit Courts have developed a multi-factor "economic realities test," which helps an employer determine the classification of a worker under the FLSA4. DOL's interpretation of FLSA argues that this test is controlling, as Congress rejected the common law control test when they enacted FLSA. The factors of the economic realities test are varied and no single factor is determinative. DOL insists that all factors must be equally considered to help determine whether a worker is truly in business for him or herself. The factors to consider are as follows:
"The extent to which the work performed is an integral part of the employer's business"
"The worker's opportunity for profit or loss depending on his or her managerial skill"
"The extent of the relative investments of the employer and the worker"
"Whether the work performed requires special skills and initiative"
"The permanency of the relationship"
"The degree of control exercised or retained by the employer"
DOL's interpretation discusses each factor in detail and provides examples to better help businesses analyze the classification of their own workers. Although these factors are now supported by DOL, case law has not always been so straightforward.
Recently, FedEx has been in and out of court
in several states for misclassification lawsuits. In 2014, the National Labor Relations Board
("NLRB") ruled that FedEx drivers in Connecticut were incorrectly classified as independent contractors and that the drivers were actually statutory employees. However, in 2009, the D.C. Circuit heard a similar case
and held that the FedEx drivers in Massachusetts were independent contractors. The NLRB explained that it "do[es] not share the view of the [D.C. Circuit] that, over time, the board has come to treat entrepreneurial opportunity as the decisive factor in its inquiry."
Similarly, National Freight Inc. ("NFI") recently settled an investigation
in which the company will pay approximately $1 million for unpaid overtime to driver dispatchers and yard spotters of the warehouse and distribution company. Before this settlement with DOL, NFI was paying these workers flat weekly rates, even during weeks in which employees worked over 40 hours, a violation of the FLSA.
With its interpretation last year, DOL attempted to end conflicting case law such the above-mentioned FedEx cases and confirm the intentionally broad scope of the tittle "employee" under the FLSA to ensure that companies compensate workers fairly.
B. Problems Arising from Misclassification and How to Avoid Them
Misclassification can and does occur, even in instances where the misclassified individual willingly signed a contract agreeing otherwise. All forms of misclassification can cause headaches not just for a company's legal department, but also for its accounting/tax department.
Federal law mandates that employers provide certain provisions to each employee. In addition to providing employees with minimum wage, employers are required to take certain additional actions
, such as withhold state and federal taxes, offer retirement plans, make Medicare and Social Security contributions, and pay unemployment and workers' compensation premiums.5
Furthermore, the Affordable Care Act requires companies to provide health care coverage to all employees, or else suffer monetary penalties. A company avoids many of these additional costs when it hires an independent contractor instead.
If it is found to have misclassified an individual, a company can be liable for any unpaid wages, such as overtime, promised to employees by FLSA.6 Depending on the culpability of the company7, the company can also be liable for fines up to 100% of the employment tax due to both state and federal governments. These fines are in addition to any federal income tax and Social Security tax not withheld. Furthermore, the company can also be liable for any other benefits that the individual would have received if properly classified. As one would expect, these costs can add up quickly, especially in cases where an entire sector of employees is found to have been misclassified.8
The easiest way for a company to avoid misclassification is to develop standards to evaluate each worker's role
, both at the beginning of employment and periodically after, to ensure that the individual's role has not changed in a way so as to misclassify him or her. A company should utilize DOL's economic realities test and its accompanying factors when reviewing each worker's role and developing its standards. Furthermore, working closely with a tax professional who is proficient on the subject may also alleviate accidental misclassification.
The Department of Labor's Wage and Hour Division is the agency authority that receives complaints from workers and brings enforcement action regarding misclassification. Just this year, the Department revised its wage and hour poster
, required signage in every work place, to include information regarding the misclassification of workers. The intent of these revisions is to educate workers on their labor rights to ensure a fair working compensation. Taken with the Wage and Hour Division's 2015 interpretation of FLSA, these revised signs act as constructive notice to companies, suggesting that DOL intends to get serious about worker misclassification enforcement.
Depending on the trade or business, misclassification of workers can become a complicated and costly problem. If a company is unsure about whether an individual is an independent contractor or employee, the company should take advantage of the IRS's formal determination of worker status
. This voluntary filing helps ensure that a company does not get hit with owing back taxes and fines for misclassification.
Remember, even if a company and worker contractually agree that the worker is classified as an independent worker, it does not mean that the worker is not a statutory employee. 1
"[A] state of work characterized by an abundance of temporary positions filled by independent contractors on a short-term basis." Nowadays, the term often refers to "newer, tech-driven employment for on-demand services." 2
29 U.S.C. 201, et seq. 3
Melanie Trottman, Employees vs. Independent Contractors: U.S. Weighs In on Debate Over How to Classify Workers, Wall Street Journal (July 15, 2015 8:57 PM EST), http://www.wsj.com/amp/articles/labor-department-releases-guidance-on-c…
See, e.g., Tony & Susan Alamo Found. v. Sec'y of Labor, 471 U.S. 290, 301 (1985); Goldberg v. Whitaker House Co-op, Inc., 366 U.S. 28, 33 (1961). 5
See also https://justworks.com/blog/consequences-misclassifying-workers-independ…
See supra NFI example. 7
There are instances where unknowing companies can be penalized less severely. 8
See supra FedEx cases. 9
Form SS-8. The form can be filled out by individuals or businesses. It can take at least six months for the IRS to return a determination.