Perhaps nothing causes more consternation among small and mid-sized business owners than the employee versus independent contractor problem. Generally, the issue surfaces when an audit notice from the State Department of Labor arrives in the mail, as the result of an individual applying for unemployment benefits. The company’s position is that the person in question is not entitled to any benefits since they were not employed by the business. Rather, the company maintains, the individual provided services in their capacity as an independent contractor. Take care, business owners, you are about to enter the “Twilight Zone.”
Defining the Issue
Misclassification of workers has serious implications for the federal and state governments. A report by the Government Accountability Office estimated that in 2006 alone, the federal government lost out on $2.72 billion in Social Security, Medicare and unemployment taxes due to such misclassification. Moreover, a study on misclassification in Illinois demonstrated that the state lost almost $125 million of income tax revenue during the 2001-2005 period because of the issue. Further, a task force in New York found that in 2008 the state lost $4.8 million in unemployment taxes alone with respect to misclassification.
Quite frankly, it is inherently beneficial for companies to label workers as independent contractors rather than employees. Income tax withholding and payroll taxes are avoided, as are state employee discrimination laws. In addition, company-provided benefits (e.g., medical, dental, retirement, etc.) are also by-passed.
Conversely, governments (both federal and state) have a vested interest in having workers classified as employees. They want workers to be covered by the applicable laws, to receive company benefits (cutting down on potential government costs), to be covered by workmen’s compensation, and to be subject to the withholding and payroll tax requirements.
Considering this clash of objectives, it’s not surprising that conflicts arise. Notwithstanding a company’s belief that it is on strong footing regarding the issue upon entering an audit, it is important to recognize that the burden of proving independent contractor status falls on the business. Thus, given the government’s inherent employee status bias at both the state and federal levels, employee classification should be expected, unless strong counter-vailing evidence is presented by the company.
An important consideration to note is that the various states often have information sharing agreements with other states, as well as with the federal government. Thus, what may start as a single audit by a single government entity may expand in scope to include several. Moreover, although unemployment taxes may be the genesis of an audit, it is likely to expand rapidly to include a variety of other taxes (e.g, income tax withholding).
States and the federal government have historically looked to multiple factors in evaluating whether a person should be considered an employee. Generally, the factors center around the degree of control exercised by the business over the purported independent contractor. Rather than place undue importance on any one particular factor, determinations are usually based on the “totality of the circumstances.” Among the typical elements focused on are the following:
- Who chooses when, where and how the person performs their services?
- Is the person directly supervised by personnel from the company?
- Is the person required to work exclusively for the company?
- Does the company set the person’s working schedule?
- Does the company set the pay rate?
- Does the company have the right to review and approve the person’s work product?
- Who assumes the risk of loss and benefits from any profit?
- Does the person carry liability insurance?
- Does the person keep a place of business, and invest in facilities, equipment and supplies?
Independent contractors are generally free from supervision, as well as direction and control with respect to their services. They are in business for themselves, offer their services to the general public, and bear the benefits and burdens of their operations.
On July 15, 2015, the United States Department of Labor (“DOL”) issued an interpretive memorandum (Administrator’s Interpretation No. 2015-1) in which it expressed its belief that most workers classified as independent contractors are actually employees under the standards set forth in the Fair Labor Standards Act. In so doing, the DOL adopted the “economic realities” test for evaluating whether an independent contractor should really be classified as an employee within the broad definition of “employ” articulated in the statute, that being to “suffer or permit to work.”
The DOL interprets the factors to be considered under the economic realities test as follows:
- Is the work performed by the individual an “integral part of the employer’s business?” If the worker provides the same services that the business provides, the individual is more likely to be considered an employee.
- Does the individual’s “managerial skill” affect their opportunity for profit or loss? If a worker merely has to work more hours to increase their compensation, no managerial skill is demonstrated, and employee status is reflected. Whereas, a worker who has the ability to hire others and purchase equipment and materials to increase profit is more likely to be deemed a true independent contractor.
- How does the worker’s investment compare to that of the company? An independent contractor should make a significant investment in his or her business if they are in business for themselves.
- Does the work performed require a special skill and initiative? An independent contractor possesses “business skills,” judgement, and initiative in addition to technical skills. Demonstrating technical skills alone is not sufficient.
- Is the relationship between the worker and the company permanent or indefinite? A long-term relationship suggests the worker is an employee.
- What is the nature and degree of the employer’s control? An independent contractor exercises meaningful control over the work at issue, such that it is possible to view them as a person conducting their own business. The DOL noted that the control factor should not play a dominant role in the entire employee/independent contractor analysis.
While the memorandum is not the law, it does signal the DOL’s intention to focus on the entire area, and a turn away from a strict control based analysis. Further, it demonstrates the importance the federal government is placing on the issue, and its bias toward finding employee status.
Several state legislatures have recently enacted legislation specifically targeting the employee/independent contractor misclassification issue. For example, under the California statute, penalties include fines of between $5,000 and $15,000 per violation of the law. If it is determined that the employer is engaged in a pattern of violations, the fines are increased to between $10,000 and $25,000 per violation. It should be noted that these fines are in addition to any others that are permitted under existing law.
Further, since employers are acting on behalf of the government with respect to the withholding of income taxes and payroll taxes, in addition to being subject to fines and penalties in misclassification situations, as “responsible parties” they can be held liable by the government for such taxes (including possible personal liability).
Clearly, the employee/independent contractor issue continues to be a hotspot for both the states and the federal government. Companies should take care when it comes to the classification process. The water here is deep and murky, and failure to read the relevant signs can put businesses in significant trouble. Business owners must beware, as the risk is not worth the reward.
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