Beware of Traps with Independent Contractor Business Models

Companies are increasingly moving away from the traditional employee model and implementing independent contractor models for some aspects of their business to reduce their direct labor costs without sacrificing market share, productivity, or efficiency. However, implementing an independent contractor model is not without risk and, given the current economic and political climate, independent contractor relationships have been facing and continue to face increased scrutiny.

Risks

The risks of implementing an independent contractor model may include misclassification litigation and federal or state investigative initiatives. For example:

  1. Federal and state Department of Labor (DOL) wage and hour investigations seeking unpaid overtime compensation if employee status is found to exist;
  2. Private individual and collective lawsuits under the Fair Labor Standards Act (FLSA) and state wage and hour laws seeking recovery of unpaid overtime, liquidated damages, treble damages (under some state laws), and attorneys’ fees;
  3. Investigations and assessments/fines by federal and state taxing authorities, including the Internal Revenue Service (IRS), federal and state DOLs, and other entities for assessments including unpaid payroll taxes, unemployment compensation contributions, and fines and potentially leading to a full IRS audit of all independent contractors engaged by the employer over a three-year period;  and
  4. Class action or individual lawsuits under other employment laws, such as Title VII of the Civil Rights Act, the Age Discrimination in Employment Act (ADEA), the Americans with Disabilities Act (ADA), the Family and Medical Leave Act (FMLA), the Employee Retirement Income Security Act (ERISA), etc., seeking retroactive entitlement to the benefits and protections typically afforded to employees.

Legislative and Enforcement Initiatives

  • The DOL budget for FY 2013 specifically allocates $14 million to be used to combat misclassification, including $10 million for grants to states to identify misclassification of employees as independent contractors and $3.8 million for enforcement by the Wage and Hour Division of the DOL. Under the DOL’s five-year initiative, which was launched in 2010 to “identify and deter employee misclassification,” the DOL has committed to working closely with the U.S. Department of Treasury to conduct targeted wage and hour investigations in industries with the “most substantial” independent contractor abuses.
  • The Wage and Hour Division has opened 13 new enforcement offices and expanded six of its existing offices nationwide to help increase enforcement.
  • Since at least 2007, there have been several federal legislative efforts to pass legislation aimed at curbing independent contractor misclassification. The federal bills have focused primarily on: (1) eliminating the current safe harbor provision in the Internal Revenue Code for companies that have a reasonable basis for classifying individuals as independent contractors; and (2) making independent contractor misclassification an independent violation of the FLSA by imposing various additional record-keeping requirements, among others. (None of the bills have been passed to date. However, independent contractor misclassification issues continue to be a primary legislative initiative.)
  • Numerous states, including California, New York, North Carolina, Ohio, Pennsylvania, and Virginia have either passed misclassification legislation or have introduced such legislation, mostly targeting key industries known to use independent contractors (e.g., the construction industry and the trucking/transportation industries).
  • The DOL has formed inter-agency initiatives with the IRS and state Attorneys General to share information and conduct joint investigations to combat misclassification.

A Well-Crafted Agreement Shapes and Memorializes the Structure of the Independent Contractor Relationship

There is no single test used for determining independent contractor status. A court may use the common law test, the IRS test, the economic realities test, or a hybrid, depending on where the work is being performed and the laws that are being enforced (e.g., the FLSA, Title VII, the ADA, the National Labor Relations Act, the ADEA, income tax withholding, and state unemployment or workers’ compensation laws.)

As illustrated in a March 2012 decision in favor of Jeffry Knight, Inc., a cable installation and repair company, certain factors may weigh more heavily in favor of independent contractor status than employee status, or vice versa. The court will consider all of the circumstances to make the ultimate determination on independent contractor status.

Whatever factors are utilized for making the independent contractor determination, it is wise to have in place a carefully drafted independent contractor agreement and separate policies and procedures for independent contractors than for those governing employees. Avoid company “control” terminology and make the contractor responsible for “tools of the trade” and benefits. A well-trained management staff also helps to avoid misunderstandings about the nature of the relationship. It is important, for example, to use the correct terminology in communications with independent contractors:

  • Refer to individuals as independent contractors, not employees.
  • Advise, do not supervise.
  • Make reference to a breach of contract, not discipline.
  • Retain or engage, do not hire or employ.
  • Terminate contracts, do not fire or discharge.

Minimizing Risks of Liability

While it is impossible to determine with certainty how any court or agency may rule when assessing the enforceability or defensibility of any one independent contractor model, employers should work closely with legal counsel to build key factors and business considerations that will minimize the risks of misclassification liability into their independent contractor agreements.

William E. Grob is a shareholder in the Tampa office of Ogletree Deakins. Guilène F. Theodore is Of Counsel in the Tampa office of Ogletree Deakins.