Homejoy’s Shutdown, Due to Misclassification Lawsuits, Likely to Propel Tech Start-Ups to Enhance Their Independent Contractor Compliance

by Pepper Hamilton LLP
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Earlier Friday, Carmel DeAmicis of Re/code reported that Homejoy, the home cleaning start-up that uses independent contractors as their home cleaners, was closing down its operations due to four misclassification lawsuits filed against it.  This is not the first company in the sharing economy using on-demand contract workers to alter its business model or shut down operations – and it will not be the last.  According to the Re/code article, Homejoy was unable to continue to raise money because “the on-demand space has become a riskier bet for investors in a short amount of time.” This news is likely to propel many other tech start-ups using independent contractors as service providers to reexamine their use of 1099ers and consider ways to enhance their independent contractor compliance.

Evidently, Homejoy spent more time on the operations and revenues side and less time on the compliance side of its business.  That approach can cause investors to think twice about pouring financial resources into a tech start-up – and apparently that is what occurred today with this home cleaning firm.

Despite the current crackdown on the misuse of independent contractors and the recent Interpretation issued by the Administrator of the Wage and Hour Division of the U.S. Department of Labor, the use of independent contractors is still a viable means to supplement a company’s workforce or to structure a business model. Only one state essentially prohibits the use of independent contractors, and no bill introduced in Congress has proposed a prohibition on the use of independent contractors. All a business is required to do is classify independent contractors correctly or, conversely, not misclassify employees as independent contractors. In other words, compliance is the key to sustained success when a company’s operations are humming and revenues are favorable.

Even businesses in industries beset by multimillion-dollar independent contractor misclassification judgments (such as the adult entertainment, cable installation, and courier industries) or in the midst of lawsuits alleging misclassification (such as the ride sharing industry and firms like Uber and Lyft), can take steps to enhance independent contractor compliance and effectively avoid or defend against class actions.

How can companies minimize their independent contractor misclassification risk? As we discussed in our 2015 White Paper on the subject, there are three alternatives:  restructuring; reclassification; and redistribution, as described below.

There is also a fourth option – doing nothing – and simply hoping no lawsuit will be served or no regulatory agency will send an audit notice.  This option is most often a result of corporate paralysis.  In today’s legal landscape, doing nothing to enhance compliance with independent contractor laws may expose such companies to misclassification liability or lead investors to shy away from sinking funds into tech start-ups and other companies that rely on contractors – or both, as in the case of Homejoy.

1.  Restructuring

For companies that would like to continue their current workforce strategies using independent contractors, there is every incentive to restructure, re-document and re-implement their business models. Virtually all newly enacted state laws, as well as proposed federal legislation, permit the continued use of independent contractors, provided the workers are properly classified. While many lawyers and legal commentators routinely advise businesses to cease using independent contractors or to reclassify them as employees to avoid the potential for misclassification liability, there are alternatives that permit companies to maintain their use of independent contractors while minimizing or avoiding future misclassification liability.

Businesses that are concerned about the potential for misclassification liability often recognize that, at best, their independent contractors probably fall within a legal gray area, where some facts favor contractor status while others indicate employee status. As noted above, it is a basic precept of independent contractor law that the tests used to determine whether a worker is an independent contractor or an employee differ from law to law.

Once a company has determined that it wishes to consider the restructuring alternative, it may then be beneficial to perform a comprehensive analysis on the company’s anticipated level of compliance after restructuring. Some businesses have conducted that review and assessment using IC Diagnostics™, a process that examines whether the position would likely pass the applicable independent contractor tests under governing state and federal laws. All of the factors used by courts and administrative agencies – and there are dozens – are examined to determine worker status, with each of the factors weighted to reflect its relative importance in assessing compliance with applicable laws.

Where bona fide restructuring is considered a sound alternative, the business can proceed to the next step in the process: re-documenting the restructured independent contractor relationship. This should be a comprehensive undertaking; it should embody the entire relationship between the independent contractors in question and the business. Re-documentation should also be accomplished in a manner designed to further enhance independent contractor compliance, consistent with applicable laws. Proprietary practice tools can be used to ensure that the re-documentation of the independent contractor relationship is thorough and state of the art.

Many independent contractors work without an agreement or, worse, work under agreements that do not reflect the true relationship between the contractor and company. A contract that misstates the true relationship between the parties, such as one that states that a worker is not subject to the supervision of the company even though he or she is regularly supervised by a superior at the company or given regular evaluations, is generally of little or no benefit.

Similarly, a contract that recites that a worker is an independent contractor offers no protection if the factors used by a court or government agency to determine the worker’s status demonstrate sufficient direction and control to create an employment relationship. Even agreements drafted for companies by otherwise talented lawyers include language that a plaintiffs’ class action lawyer may use to support his or her argument that the business has retained a right to direct and control the manner and means by which the worker performs the agreed-upon services. That is exactly what transpired in the recent FedEx Ground decisions by the Ninth Circuit and Kansas Supreme Court.

After the restructured relationship is memorialized in a written independent contractor agreement, the final step is implementing the restructured relationship. Companies must ensure that what is set forth in the contractor agreement will be implemented in the field and that it does not include empty recitals or misstatements of the relationship. Equally important, businesses must avoid exercising direction and control, which is often unintended yet has the potential to undermine an otherwise enhanced state of independent contractor compliance.

Other aspects of the re-implementation process may include reviewing and revising company operating manuals and procedures, documenting the implementation of certain provisions in the updated contractor agreement and putting safeguards in place to ensure conformity with the restructured independent contractor relationship.

The U.S. Court of Appeals for the Ninth Circuit and the Kansas Supreme Court both commented in their 2014 FedEx Ground decisions that that company did not document and implement its independent contractor relationships in a manner that complied with applicable laws.

There are no “quick and dirty” ways to enhance independent contractor compliance. The use of form or model independent contractor agreements, sometimes called templates, tends to cause businesses to overlook the need to restructure and to implement a sustainable independent contractor model that will withstand legal scrutiny and serve a company’s unique business model.

On the other hand, bona fide restructuring, re-documentation and re-implementation need not be a prohibitive undertaking and, once completed within a reasonably short period of time, can place a business in an enhanced and sustained state of compliance. That itself may substantially minimize the likelihood that a regulator or class action lawyer will seek to challenge a company’s compliance with independent contractor laws.

Many companies assume that if they experience an adverse legal determination, they have no choice but to reclassify the affected workers and make them employees. However, restructuring and re-documentation is also a valuable means for companies that are subject to legal challenge to revamp their independent contractor relationships in order to maximize compliance and minimize future misclassification liability.

There are, of course, some situations where a business may not be able to attain compliance with independent contractor laws even in with restructuring. There are at least two alternatives that such businesses may wish to consider: reclassification and redistribution. These alternatives may also be used by companies that have properly classified a group of workers if the business nonetheless wishes to minimize or cease its use of independent contractors in the future.

2.  Reclassification

Recently, tech start-up Shyp reclassified its shoppers from 1099 status to employee status – although it left its couriers (delivery drivers) in the 1099 classification.

Reclassification can be undertaken in one of two ways: (1) under a government-sponsored reclassification program; or (2) voluntarily, without government involvement.

In September 2011, the IRS announced its Voluntary Classification Settlement Program (“VCSP”), which allows a business to voluntarily reclassify workers who currently receive Forms 1099 from the company by making what is referred to by the IRS as a “minimal payment covering past payroll tax obligations.” That payment to the IRS would be “10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Section 3509 of the Internal Revenue Code,” according to the IRS announcement. Participation in the VCSP would also eliminate interest and penalties on the liability and, most importantly, exempt companies from an employment tax audit for worker misclassification in prior years.

Although the VCSP appears to be an attractive form of “amnesty,” there have been only a scant number of participants, for obvious reasons. First, it does not provide any form of reduced penalties or interest with respect to the array of other federal and state laws that are implicated by reclassification, including state tax, unemployment and workers’ compensation laws, as well as federal wage-and-hour laws. Second, although the program evidently contains a provision that there is no admission that the taxpayer erroneously classified its workers as independent contractors, the likely takeaway by the workers themselves, their lawyers (if any) and other federal and state agencies that may become involved is that the company would not have entered the program if it had been classifying its independent contractors correctly.

For these and other reasons, businesses interested in reclassification are more likely to do so voluntarily without entering the VCSP. Voluntary reclassification, however, should be implemented in a manner that does not create unfair inferences of past noncompliance. On one hand, some workers that have been paid on a 1099 basis might welcome their reclassification but may also fail to understand why they were not treated as employees from the beginning of their relationship with the company. On the other hand, other workers who are accustomed to being compensated on a 1099 basis may object strenuously to becoming an employee and losing the tax advantages of self-employment, including tax deductions for legitimate business expenses. In addition, reclassification of workers from 1099 to W-2 status may require some businesses to engage in an array of administrative changes to comply with federal and state tax, employee benefits and labor laws. The timing of those changes can be important.

Reclassification does not require that all workers previously excluded from an employee benefit plan be included in the future. Exclusion would be permissible if the governing documentation for the company’s plans is drafted properly and the exclusion does not violate applicable tax or Employee Retirement Income Security Act rules or any rules associated with the Affordable Care Act.

3.  Redistribution

Where voluntary reclassification is not a practical or viable alternative, another choice is to use a knowledgeable and reputable workforce management or staffing company. This alternative cannot completely eliminate all potential liability for misclassification, but using a responsible workforce organization may dramatically reduce the risk of such liability, as well as the likelihood of a lawsuit challenging the classification of a group of workers paid on a 1099 basis.

Workforce management and staffing organizations are not payroll companies; when they hire or retain some or all of a company’s independent contractors, they may either treat them as 1099 contractors or as W-2 employees.

If the talent is treated as independent contractors, a knowledgeable workforce solutions company will take its own steps to maximize compliance with state and federal workforce, tax and benefit laws while facilitating the engagement of a company’s valuable contingent workforce. If a staffing company instead treats the workers as employees, the staffing company will withhold income taxes, make Medicare and Social Security contributions, pay workers’ compensation and unemployment insurance premiums, and can provide an array of benefits to the former independent contractors, including health insurance under a plan maintained by the staffing or workforce management company. If the workforce solutions firm treats the workers as independent contractors, it is imperative to select a firm that is knowledgeable about independent contractor compliance issues, otherwise the workforce solutions or outsourcing company can offer little or no protection from misclassification liability.

Although using a knowledgeable and experienced outsourcing company may substantially lessen the risk of future misclassification liability, it is not a panacea. For example, a business that contracts with a leasing workforce management organization may still have to account for the independent contractors or employees it has retained or hired in the company’s benefit plan language and discrimination testing.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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