For years, many employers have tried to reduce their tax burdens by treating persons who perform services for them as individual contractors as opposed to employees and thereby reducing the payroll withholding taxes they must pay. This employer classification of employees as independent contractors – and often misclassification – has recently drawn closer scrutiny from the courts and state governments.
For instance, on August 27, 2014, the Ninth Circuit Court of Appeals issued two decisions finding that FedEx’s drivers are employees, not independent contractors. In Alexander v. FedEx, the court found that under California’s right-to-control test, the drivers were employees where “the drivers must wear FedEx uniforms, drive FedEx-approved vehicles, and groom themselves according to FedEx’s appearance standards. FedEx tells its drivers what packages to deliver, on what days, and at what times.” ___ F.3d ___, ___, 2014 WL 4211107 (9th Cir. 2014). The Ninth Circuit court made the same finding in Slayman v. FedEx under Oregon’s right-to-control and economic realities tests. ___ F.3d ___, ___, 2014 WL 4211422 (9th Cir. 2014). Similar findings were made against FedEx by the Kansas Supreme Court (who issued its decision at the request of the Seventh Circuit Court of Appeals) on October 3, 2014, and the National Labor Relations Board on September 30, 2014.
But the focus is not limited to delivery drivers as some state legislatures are focusing on misclassification issues in other areas. Illinois and New York have enacted laws imposing stiff penalties against construction companies that misclassify individuals as independent contractors. Both states have also created task forces whose purpose is to uncover misclassification in the construction industry. Notably, Illinois’s task force does not have an employer-friendly makeup as it is comprised of representatives from the state’s Attorney General’s Office, the Workers’ Compensation Commission, and the state Department of Labor, among other state agencies. The scrutiny is beginning to spread beyond these industries. For example, the Nevada Supreme Court ruled on October 30 that strippers are employees, not independent contractors.
As referenced above, federal courts use an “economic realities” test to determine whether an individual is an employee or independent contractor under the FLSA. Depending on the state in which a business is located, state courts may use a similar test or a “right-to-control” test to determine whether an individual is an employee or an independent contractor under the applicable state wage and hour law. One way for a company to evaluate whether an individual is classified correctly is to use the framework provided by the IRS to determine whether an individual is an independent contractor or employee. IRS Publication 1779 describes three categories of inquiry to answer this question:
This category of inquiry focuses on the right to control how the work is to be performed. Some of the questions to review with individuals in your company are:
Who has the right to supervise the work?
Who provides the equipment and supplies?
Whether the individual can hire helpers or “subcontract” the work?
Who controls the timing of when the work is to be completed?
One other question relates to whether training on company practices and procedures is required to perform the work. Independent contractors should not need training to perform the services they provide to a company, while employers are expected to provide training to many categories of employees.
This category of inquiry focuses on the financial control in the relationship. Questions here include:
Looking at whether the individual has a significant investment in his or her work, as opposed to just working for a paycheck;
Whether the individual is reimbursed by the employer for business expenses (employees are typically reimbursed while independent contractors treat them as a business cost); and
Whether the individual has an opportunity for profit or loss based upon the quality and/or quantity of work performed.
Relationship of the Parties:
This category of inquiry focuses on other factors in the relationship, such as:
Whether there is a written contract between the individual and the company; or
Whether the individual receives any benefits from the company. Independent contractors should have a written contract with the company and should not receive any benefits other than the consideration set forth in the written contract.
Even if your state has not enacted specific penalties for misclassification of workers, existing financial ramifications for misclassification are severe. If an individual is misclassified as an employee rather than an independent contractor, the employer may be liable for unpaid minimum wages or overtime pay, plus liquidated damages. Difficulties in quantifying the amount owed may be exacerbated because the company does not have records of the number of hours worked, in which case the “records” of the employee (which can be just the employee’s memory) may be relied upon. Other financial ramifications include the requirement to pay the employer’s portion of FICA contributions, past unemployment and/or workers’ compensation contributions or penalties, and the possibility of claims for unpaid fringe benefits.
Companies must ensure individuals who have been designated as independent contractors have been correctly classified. Industries that have traditionally used the independent contractor designation liberally are not immune to attack and should undergo the same analysis to ensure all individuals who perform services for a company are correctly classified. For companies that regularly use independent contractors, we recommend conducting periodic internal audits to review the relationship between the company and the contractor in light of the IRS guidance and the increasing scrutiny on this issue.