The Many Pitfalls of Worker Misclassification

Worker classification is an area of major concern for domestic and international employers of all sizes. Our Labor and Employment Group recently alerted you to significant regulatory action by the US Department of Labor relating to classification of workers as employees versus independent contractors.[i] Those regulations, along with continuing action by the National Labor Relations Board and the IRS in this area, highlight that worker classification issues are being closely scrutinized today. These issues will continue to present employers with the difficult task of managing service relationships to meet their business needs while ensuring proper classification of their workers under the various legal regimes that apply.

The effects of misclassification can reverberate throughout an employer's Human Resources and employee benefit plan functions. To ensure a comprehensive approach to maintaining compliance, an employer must identify and tackle all of the many issues that arise from misclassification. Below is a list of misclassification issues for year-end review:

  • back pay (e.g., minimum wage and overtime pay);
  • failure to withhold and underpayment of Federal and state/local income and employment taxes;
  • failure to provide proper wage statements, such as Forms W-2;
  • failure to provide employee benefit coverage and appropriate remedial action;
  • failure to make employer and employee contributions to retirement and other employee benefit plans;
  • failure to provide required benefit plan disclosure and administrative notices;
  • excise taxes under the Affordable Care Act (the "ACA") for failure to provide required health plan coverage;
  • civil tort liability to a misclassified worker as well as third parties who are injured as a result of a misclassified worker's negligent acts; and
  • violations of state, federal and/or foreign labor laws, which may include civil penalties and/or notice requirements imposed by the government agency.

In the remainder of this Alert, we focus on the impact of the ACA and other misclassification risks that arise in the context of managing employer health and welfare plans and highlight certain global considerations. We conclude with our recommendations on preemptive steps to avoid worker misclassification issues.

Impact of the Affordable Care Act

Many aspects of the ACA, including employer coverage responsibilities and the calculation of penalties for failure to provide compliant health coverage, depend on whether an individual is properly classified as an "employee," significantly increasing the adverse consequences of misclassification. To make matters worse, one misclassification may trigger the assessment of ACA excise tax penalties based on the employer's entire full-time workforce.

Furthermore, the ACA has resulted in many employers struggling with "joint employment" and "co-employment" issues with their staffing or other service providers. Abundant caution is necessary with worker classification in this area because a mistake could result in both ACA non-compliance as well as liability for misclassification as listed above.

One step employers should take now is to review existing contracts with staffing or other service providers to reduce their potential legal exposure. Employers should require that service providers provide ACA-compliant coverage to their full-time employees and acknowledge sole responsibility for the classification of those employees.

Service provider contracts also should address potential co-employment issues by stating that the provider's workers are solely its common law employees and that the provider exclusively manages all employee issues regarding compensation, performance issues, time off, and any other HR-related issues that typically are the responsibility of an employer.

Finally, the contract should contain indemnities specifically targeted to require the provider to indemnify employers for misclassification errors of their employees and any ACA penalties.

Other Misclassification Risks for Health Plans

Treatment of Misclassified Employees Under Plan Document

In light of the ACA, most health plans (both insured and self funded) exclude independent contractors from coverage. Without an express provision to the contrary, an independent contractor that is reclassified as an employee may become eligible for coverage under a health plan – including retroactive coverage. Some employers address this issue by including express language in their health plans that excludes reclassified workers from coverage. This type of provision can protect an employer from claims for retroactive coverage and enable the employer to exclude reclassified workers from future coverage.

Often health insurance policies do not contain the appropriate language to exclude reclassified workers from coverage because insurers will not entertain changes to their standard format. We recommend that employers determine whether their insurance policies contain appropriate language to exclude reclassified workers because, without it, the insurance company could disavow financial responsibility for claims of reclassified workers, leaving the employer with that liability.

Misclassification also can impact the amount of an employer's health insurance premiums. Insurance companies underwrite their policies based on the number and claims experience of an employer's "employees." If that population changes due to reclassification, the cost of health coverage also could change.

Nondiscrimination Testing

The data that an employer uses to perform nondiscrimination testing for self-funded health plans and cafeteria plans does not include independent contractors. Depending on the size and attributes of the misclassified group, it is possible that the testing results could change. Thus, as part of its overall response to misclassification, an employer should assess and possibly re-run prior plan testing

Legally-Required Notices for Employees

Employers are responsible for providing various types of health plan notices to their employees at different stages of the employment cycle. An employer whose independent contractors are reclassified as employees must evaluate not only which notices should have been provided, but also how to address the prior lack of notice. For example, an employer must consider the extent to which COBRA notices or a Summary of Benefits Coverage required under the ACA should have been provided, and the impact of failure to provide those notices at the required time.

Other General Misclassification Issues

Worker misclassification not only involves improperly classifying someone as an independent contractor instead of an employee, but also improperly classifying an employee as being exempt from overtime pay and meals and rest breaks. Both of these worker misclassification issues are especially present at the early stages of a company and, if left unaddressed, the company may be faced with a much larger problem in the future, such as a class action lawsuit.

In some instances, a single employee filing a wage claim with the state may be enough to prompt an audit of the company by the state employment department/division. These audits can be extremely burdensome on the company's time and resources and could include a review of all of the company's "independent contractors" and pay practices. In addition, the IRS may, in turn, conduct a similar audit leading to a requirement to pay back wages along with various tax penalties as discussed above.

Global Considerations

In most countries outside of the U.S., misclassification risks are equally an issue.  Independent contractors, agency workers, and even vendor employees are potentially at risk of reclassification. The big risks are:

  • claims for equity compensation, especially for companies that grant broad equity compensation awards;
  • claims for discretionary leave benefits, such as generous parental leave benefits;
  • the "domino effect" among employee classes and individual employees. Although class action is generally not available outside of the U.S., this area is closely followed by workers, regulators and employee representative bodies in most countries and a successful claim will likely lead to audits and further claims; and
  • equal treatment claims from agency workers. Even if agency workers are not reclassified as direct employees of the end user, there is a risk, especially in the European Union, that they will be able to claim a right to a wide range of discretionary benefit programs under "equal treatment" rights concepts.

Recommendations on Preemptive Steps to Avoid Misclassification

Employers should consider taking preemptive steps to avoid worker misclassification issues. One preemptive measure is to conduct a privileged examination of the work force to determine whether contractors are properly classified and, if necessary, take remedial action. Employers should also consider setting up strict requirements for hiring contractors and be vigilant in meeting those requirements. Employers may also choose to engage a third party to screen and hire its contractors, though the contract with the third party should include a strong indemnification clause to provide protection for the employer in the case of alleged misclassification.

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.

© Orrick - Global Employment Law Group | Attorney Advertising

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Updated: May 25, 2018:

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Privacy Officer
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