WHITE PAPER: Independent Contractor Misclassification Update 2012 – How Companies Can Minimize the Risks

This White Paper is a 2012 update to the 2010 White Paper of the same title first published by Pepper Hamilton LLP on April 26, 2010.

“Misclassification of employees as independent contractors” is now a common phrase uttered by state and federal legislators and regulators. State task forces have been formed to crack down on businesses that do not pay unemployment insurance and workers’ compensation premiums or withhold taxes for workers whom the states believe are employees and not independent contractors (ICs). Class action lawyers have been targeting some of those same types of companies, seeking unpaid employee benefits and overtime for workers who are not treated as employees.

This White Paper first examines the risks posed to private businesses and governmental entities that have business models reliant upon the use of ICs and other contingent workers. We then address how those risks typically arise and the costly consequences those risks may pose to companies and organizations using ICs. Finally, this White Paper discusses the steps businesses can take to avoid or minimize IC misclassification liability, including re-structuring, re-documenting, and re-implementing their business models, voluntary or government-sponsored reclassification, or redistribution of ICs through the use of a knowledgeable workforce management or staffing firm.

Federal and State Regulatory Initiatives

With funds authorized by the Obama administration in its budget released in January 2012, the U.S. Department of Labor is hiring more investigators to “detect and deter” companies from misclassifying employees as independent contractors and failing to properly pay overtime or afford statutory benefits to workers. The federal budget for Fiscal Year 2013 also finances inter-agency cooperation: $14 million was budgeted in the coming year for grants to states to assist them in identifying misclassification and recovering unpaid taxes.[1]

The U.S. Department of Labor has also initiated a “Misclassification Initiative” in which it has entered into memorandums of understanding with 13 states from coast to coast to coordinate enforcement efforts and share information between the state and federal agencies about non‑compliant companies.[2]

The Internal Revenue Service (IRS) has also been active in seeking to restore what it estimates are billions of dollars in lost tax revenues due to misclassification of ICs. In November 2007, the IRS announced that it had entered into agreements with a number of state revenue commissioners and workforce agencies to share information and enforcement techniques about employers suspected of misclassifying employees.[3] At last count, the IRS has entered into agreements with 34 states to share information and enforcement techniques.

In February 2010, the IRS announced that it was commencing an Employment Tax National Research Project to conduct line-by-line audits of 6,000 businesses focusing on, among other things, employee misclassification.[4] Later in September 2011, the IRS also announced a new program to permit taxpayers to voluntarily reclassify ICs as employees for federal employment tax purposes.[5] Enrollment in the voluntary program has been relatively scant, as companies recognize that this form of “amnesty” may be an invitation to state and federal workplace agencies and plaintiffs’ class action lawyers to treat the reclassification as a tacit admission of past wrongdoing.[6]

State workforce agencies have been equally vigorous in their regulatory and enforcement efforts. Most state workforce and tax agencies have substantially increased the number of random and targeted audits they conduct each year. Some states have done so as part of a coordinated enforcement effort. To date, more than a dozen states have created misclassification task forces.[7]

Another way in which regulatory agencies are focusing on independent contractor misclassification is through the unemployment and workers’ compensation claims process. Local claims offices are more frequently issuing initial determinations of “employee” status in benefit claims filed by workers, including individuals who have signed independent contractor agreements or are receiving compensation on a 1099 basis. As a result of the prolonged recession, many workers who regard themselves as ICs are nonetheless applying for unemployment benefits – and more e claims examiners are finding that such workers have been misclassified and are entitled to unemployment benefits as “employees.” If a business has not paid unemployment contributions to a state fund on behalf of that worker, the initial determination can have the same effect as an adverse audit, if an administrative law judge or referee upholds the determination that the worker had been misclassified as an independent contractor. Once a single worker is found to have been misclassified, the business is then normally charged for unpaid contributions for “all similarly situated” workers, along with costly penalties and fines.[8]

State and Federal Legislative Initiatives

In addition to regulatory enforcement actions, state legislatures have begun to dramatically change the landscape of independent contractor law. In the past two years alone, 11 states passed laws curtailing the use of ICs or increasing penalties for misclassification: California, Connecticut, Florida, Kansas, Maine, Nebraska, New York, Pennsylvania, Utah, Vermont, and Wisconsin. Ten states had passed laws of a similar nature in the three years prior to 2010, bringing the total number of states to 21 that have targeted independent contractor misclassification. In addition, at least 18 state legislatures have proposed bills intended to limit the use of ICs or make misclassification more costly.[9]

Many of these independent contractor laws provide for civil and criminal penalties, debarment from state contracts, presumptions in favor of employee status, and private rights to bring individual or class action suits for misclassification of employees. Some of the new laws have targeted industries in which misclassification is regarded by legislators as more prevalent, such as construction. Delaware,[10] Maine,[11] New York,[12] New Jersey,[13] and Pennsylvania[14] have passed laws focused on that industry. The laws in other states apply generally to all industries, such as the recently enacted California Independent Contractor Law that became effective January 1, 2012. It prohibits “willful misclassification,” adds hefty penalties for violations, especially those pursuant to a “pattern or practice,” and imposes joint liability on any outside non-legal consultant or other person that “knowingly advises an employer to treat an individual as an independent contractor to avoid employee status” if an individual is found not to be an independent contractor.[15]

Congress has tried to follow suit. In April 2010, the Employee Misclassification Prevention Act was introduced in both houses of Congress, and in October 2011, it was reintroduced in the House and Senate.[16] If passed, it would, for the first time, make misclassification of employees as independent contractors a federal labor law violation and also impose substantial recordkeeping and notice obligations upon businesses – even those that properly classify their ICs – and subject businesses to hefty penalties for non-compliance with the proposed new law.

A second bill, the Fair Playing Field Act of 2010, was first introduced in September 2010 and was reintroduced in the House and Senate in March 2012.[17] This bill would eliminate a longstanding “safe harbor” that many businesses have relied upon for continuing to classify certain workers as independent contractors.

None of the federal bills would foreclose the use of ICs that are properly classified as such. Similarly, among those nearly two dozen state laws, all permit the continued use of properly classified ICs to supplement a company’s workforce, except for one state. Thus, the key under virtually all of these new laws is whether the independent contractor relationship is structured, documented, and implemented in a compliant manner.

Misclassification Liability: How the Risk Typically Arises

Use of ICs has increased dramatically over the past decade in large part due to the economic advantages of using ICs, whose earnings are reported to the IRS on a Form 1099 basis instead of on a Form W-2. Employers are not required to withhold taxes, make Social Security and Medicare contributions, or pay unemployment and workers’ compensation premiums for ICs. Similarly, employee benefit plans including group health insurance and 401(k) plans only cover employees, not ICs. These economic inducements have led many businesses to unwittingly classify many workers as ICs even though they may fall within the definition of employees under the tax and labor laws. Undoubtedly, some businesses knowingly misclassify employees as ICs, but many pay insufficient attention to this subject or have mistaken conceptions of the laws in this area. Lax enforcement by revenue and workforce agencies has contributed greatly to the misclassification of employees as ICs.

Typically, ICs are referred to as freelancers, consultants, per diems, contractors, project workers, temps, specialists and the like. ICs are found in virtually every industry, and often work as information technology professionals, Internet and telecommunications experts, marketing specialists, copywriters, analysts, and workers with specialized technical or professional skills. Other employers treat their delivery or sales force as non-employees. Some companies use temporary employment agencies to supply long-term temps. Other companies use ICs to supplement their workforce, while some businesses, such as transportation companies, often have more ICs than employees.

The U.S. Bureau of Labor Statistics has estimated that more than 10.3 million workers in the United States (7.3 percent of the workforce) are treated by businesses as ICs.[18] A U.S. Department of Labor study in 2000 found that as many as 30 percent of businesses misclassified employees as ICs, and the Government Accountability Office (GAO) recently determined that the number of misclassified workers has expanded by 50 percent in the interim.[19] These statistics indicate that, absent steps to attain compliance, hundreds of thousands of businesses have exposure to considerable financial liability for non-compliance with existing state and federal tax and labor laws and with respect to their employee benefit plans.

The Costly Consequences of Misclassification

The laws permit the use of ICs, provided such workers are not “employees” under existing tax, employee benefit, and labor and employment laws. As long as an IC is correctly classified, he or she is not eligible to participate in an employee benefit plan and may be paid on a Form 1099 basis without any employee tax or FICA withholdings or unemployment or workers’ compensation contributions.

In contrast, employees misclassified as ICs under current laws can be costly, regardless of whether the employees have been mistakenly or intentionally misclassified. For some businesses, particularly those highly reliant on ICs, the potential costs of misclassification could be extremely high. Risks include liability for many years of unpaid federal, state and local income tax withholdings and Social Security and Medicare contributions, unpaid workers’ compensation and unemployment insurance premiums, and even unpaid work-related expenses and overtime compensation. Any one of these types of liabilities (plus interest and penalties for non-compliance) can be potentially devastating for businesses that make substantial use of ICs.

Another costly liability risk arises if misclassified employees who are otherwise entitled to coverage under employee benefit plans have not been provided with health, pension, and other employee benefits. The Microsoft case in the 1990s demonstrates how costly misclassification can be, no matter how unintended, when workers classified as ICs are re-characterized by the courts or regulatory agencies as employees. In addition to satisfying a very substantial payment obligation to the IRS, Microsoft paid $97 million to settle a benefits case brought by its long‑term temps who were not afforded coverage under Microsoft’s stock purchase plan, plus millions more in legal fees for the workers’ class action lawyers.[20]

Finally, unions have urged state and federal government regulators to vigorously prosecute businesses suspected of misclassification of employees as ICs as part of a concerted effort by organized labor to increase the number of employees that they currently represent. Simultaneously, labor unions have strongly lobbied for legislation at the state and federal levels that would limit the use of ICs by businesses and, as a result, expose more workers to union organizing.[21]

Despite media attention that has been focused on this issue in recent years, including articles in newspapers and trade publications,[22] most companies have yet to diagnose their state of compliance or determine their potential liability. Fewer still have enhanced or updated their workforce models to minimize or eliminate the risks of costly government regulatory and class action litigation attacks. For companies that would like to continue their current workforce strategies instead of being required to reclassify every IC as an employee under government or court compulsion, there is every incentive to restructure, re-document, and re-implement their business models, or reclassify or re-distribute their ICs and other contingent workers.

Three Alternatives to Minimize or Avoid Future Misclassification Exposure

All of the newly enacted state laws (as well as the proposed federal legislation) permit the continued use of ICs, provided the workers are properly classified. Nonetheless, some lawyers and legal commentators routinely advise businesses to cease using ICs or to reclassify all of their ICs as employees to avoid the potential for misclassification liability. There are, however, a number of alternatives that permit companies to maintain their use of ICs while minimizing or avoiding future liability. Those alternatives include restructuring and re-documenting of the relationship between a business and its ICs, reclassification, or re-distribution of ICs through a workforce management or staffing company.

1. Bona Fide Restructuring and Re-documentation (and the Use of IC Diagnostics™)

Most businesses concerned with the potential for misclassification liability recognize that, at best, their ICs probably fall within the “gray area,” where some facts favor IC status while other facts indicate employee status. The 2006 GAO Report addressing employee misclassification stated that “the tests used to determine whether a worker is an independent contractor or an employee are complex, subjective, and differ from law to law.”[23]

With the exception of a few state laws, though, most tests are based in whole or large part on whether the hiring party has the “right to control the manner and means” by which the worker accomplishes the end product of his or her work.[24] In determining whether a business has the right to control the worker’s manner and means of performing his or her tasks, some federal and state agencies list as many as two dozen factors that may indicate whether or not the hiring party has such control. Except for a few states with laws that essentially prohibit the use of ICs for businesses operating in some industries, the courts and government agencies have repeatedly stated that no one factor determines whether the worker is an IC or employee. For example, the IRS has stated that it will consider “all information that provides evidence of the degree of control and the degree of independence.”[25] A review of the factors used by the courts and by various state and federal agencies reveals that, collectively, more than 48 factors are used by different decision-making bodies in determining IC status.

The first step that lawyers typically recommend to companies concerned about misclassification liability is to diagnose whether the company’s ICs are properly classified. That step, however, may be premature for any business that wishes to consider a bona fide restructuring of its relationship with its ICs. For companies that are willing to make certain adjustments to their level of control over the manner and means by which their ICs accomplish their work, adjustments can be made to a number of the 48 factors that the courts and regulatory agencies have determined are indicators of IC or employee status. For example, a company may be willing to allow its ICs to set their own hours of work, perform services from home, supervise their own projects, and work for other companies (subject to applicable confidentiality restrictions). If the nature of the work is susceptible to being performed in a meaningful manner with substantially less indicia of control than is currently exercised, such changes can be implemented and memorialized in a written IC agreement.

Many ICs work without an IC agreement, or work under agreements that do not reflect the true relationship between the IC and the company. A contract that misstates the true relationship between the parties (such as one that states that the worker is not subject to the supervision of the company, yet he or she is regularly supervised by a superior at the company and given yearly evaluations) is generally of little or no benefit. Similarly, a contract that recites that the worker is an IC offers no protection if the factors used by the court or government agency to determine the worker’s status demonstrate otherwise. Part of a bona fide restructuring includes a studied review of, and revisions to, the IC agreement. A close review of the agreement also is imperative because many IC agreements, even those drafted by sophisticated corporations, include language that a good plaintiff’s lawyer may use to support his or her argument that the business has a right to control the manner and means by which the worker performs the agreed-upon tasks.[26]

Once a company has determined how it would restructure its relationship with its ICs, it is beneficial to perform IC Diagnostics™. This is a process that examines whether the position would pass the applicable IC tests under governing state and federal laws, using each of the relevant 48 factors indicating IC or employee status, and then measures the company’s compliance with each of the applicable laws on an IC Compliance Scale™. Unless certain states require a strict test for determining IC status, IC Diagnostics™ provide a comprehensive examination of how much the restructuring alternative will minimize or eliminate future misclassification liability.

If IC Diagnostics™ indicate that the bona fide restructuring alternative is a sound choice, the business can proceed with this alternative. The next step is re-documenting the IC relationship. This is a comprehensive step, as it should embody the entire relationship between the ICs and the company. Using a list of the “48 Factors-Plus” assures that the re-documentation of the IC relationship is thorough and state-of-the-art.

The next step is implementing the restructuring. Companies must ensure that what is set forth in the IC agreement will be implemented in the field and does not include empty recitals and misstatements of the relationship, which can provide arguments to class action lawyers and government regulators that the IC agreement is a fraudulent and misleading document.[27] Other steps may include reviewing and revising company operating manuals and procedures, documenting the implementation of certain provisions in the IC agreement, and putting safeguards in place to ensure conformity with the restructured relationship with the ICs.

There are no “quick and dirty” ways to enhance IC compliance, and “one size fits all” solutions are likely to be ill-fitting. The use of form or model IC agreements tend to cause businesses to overlook the need to restructure and to implement a sustainable IC model that will withstand legal scrutiny. On the other hand, bona fide restructuring, re-documentation, and re‑implementation need not be an prohibitive undertaking and, once undertaken and completed in a reasonably short period of time, can place a business in an enviable place: namely, an enhanced state of compliance that can minimize the likelihood that any regulator or class action lawyer will seek to litigate a company’s past.

Even in cases in which IC Diagnostics™ confirms that the workers were properly classified, there are at least two alternatives to restructuring that some businesses may wish to consider: reclassification and redistribution.

2. Reclassification Either by Government Program or Voluntarily

Businesses that are at risk for misclassification liability likely will have to defend their classification of their ICs. More companies are receiving notices from state unemployment agencies that question whether a former worker classified as an IC should be reclassified as an employee, exposing the company to the risk of liability for any prior misclassification. Some businesses also have received notices from state workers’ compensation agencies inquiring whether an entire group of workers are ICs or employees. Others have received tax audit notices. If legislation at the federal level is enacted, companies will be obligated to notify all ICs that they have the right to a governmental determination as to whether they have been properly classified as an IC, and many ICs likely will request an official determination.

Regardless of whether IC Diagnostics™ reveal that a company’s ICs will not pass the governing tests for IC status, businesses may wish to consider reclassification. This step is likely to be far less painful and costly than being forced by a government agency to reclassify and being ordered to make payment of back taxes, unpaid Social Security and Medicare contributions, and unpaid unemployment insurance and workers’ compensation premiums, along with applicable penalties and interest. Further, some businesses that should pass the governing tests for IC status after restructuring may not wish to alter their business plan or the manner in which the subject workers provide services and may wish to consider reclassification in lieu of restructuring.

Reclassification can be undertaken in one of two ways: under a government-sponsored reclassification program; or voluntarily, without government involvement. As noted earlier, in September 2011, the IRS announced its Voluntary Classification Settlement Program (VCSP), allowing businesses to voluntarily reclassify workers who currently receive 1099s from the company by making what is referred to by the IRS as a “minimal payment covering past payroll tax obligations.”[28] 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.[29]

Although the VCSP appears to be an attractive form of “amnesty,” it has attracted only a few hundred 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 as well as the federal wage and hour laws; and second, although the program evidently contains a provision that there is no admission that the taxpayer erroneously classified its workers as ICs, 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 ICs correctly.[30]

For these and other reasons, businesses interested in reclassification are more likely to do so voluntarily without entering the VCSP. However, voluntary reclassification should be implemented in a manner that does not create unfair inferences of past non-compliance. Some types of announcements of the change to workers used to being paid on a 1099 basis are less likely to provoke dismay from those 1099ers who want to remain in that classification (for tax or other valid reasons), or concern on the part of some who welcome the reclassification but fail to understand why they were not treated as employees from the beginning of their tenure with the company. Implementation also requires businesses to consider whether voluntary reclassification requires a different manner of compliance with relevant federal and state tax, employee benefits, and labor laws.

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 ERISA rules.[31]

3. Redistribution of ICs By Use of a Workforce Management or Staffing Company

Where voluntary reclassification is not a practical or viable alternative, another choice is the use of a knowledgeable and reputable workforce management or staffing company. This alternative cannot completely eliminate all potential liability for misclassification, but the use of a responsible workforce organization can 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.[32]

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

If the talent is treated as ICs, 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.[33] 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 ICs, including health insurance under a plan maintained by the leasing company. Regardless of the type of organization used, selecting one that is reputable, knowledgeable, and experienced is fundamental; otherwise, the workforce solutions or outsourcing company can create even greater exposure to misclassification liability.

While the use of a knowledgeable and experienced outsourcing company can 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 ICs or employees it has retained or hired in the company’s benefit plan language and discrimination testing.

Conclusion

The use of ICs is still a viable means to supplement a company’s workforce in almost all states, and Congress has never considered a prohibition on the use of ICs. All a business is required to do is not misclassify employees as ICs. Lax enforcement of the tax and labor laws in the past as they apply to ICs has placed most businesses in the position in which misclassification liability has become a genuine risk – if steps are not undertaken to reduce or eliminate this exposure using any of the alternatives noted above. Some companies, in fact, may choose to use more than one of these alternatives for different groups of ICs it has retained to supplement or constitute its workforce. In view of the current and pending legislative, regulatory, and judicial landscape, there is only one undesirable alternative: inaction.