New Scrutiny Focused on Independent Contractors

Kegler Brown E-mployment Alert

We all know the federal and state governments need money. Where to find it? A number of states and the federal government have recently recognized that immense payroll tax receipts are lost by misclassification of workers as “independent contractors.” Even a decade ago, the Labor Department estimated that 10 30% of employers misclassified workers as independent contractors. In 2006, the Government Accounting Office estimated that worker misclassification resulted in an underpayment of $2.72 billion in Social Security taxes, unemployment insurance and income taxes, per year. As a result, the IRS and at least thirty-seven states are cracking down on independent contractor misclassification. President Obama’s job creation budget for 2011 contains significant programs that target the misclassification of independent contractors, including a joint proposal for the Departments of Labor and Treasury to eliminate incentives for misclassification, and to add $25 million to target misclassification with 100 additional enforcement personnel.

In Ohio, the Attorney General characterized the misclassification of independent contractors as a “black market” to defeat government regulation and taxation. He estimated that the lost revenues to State workers’ compensation, unemployment compensation and income tax revenues are up to $800 million per year. Ohio has accordingly created a special task force to crack down on misclassifications.

Recent years have seen a surge in companies turning to “independent contractors” to perform work. The benefits of a contractor relationship are significant - since the worker is not an employee, no taxes or other withholdings need be made, no FICA/FUTA contributions need be made, no workers’ compensation or unemployment compensation contributions are required, overtime and hours of work are not an issue, and contractors usually cannot file discrimination or wrongful discharge claims. By designating workers as “independent contractors,” a business can generally save as much as 30% on payroll costs.

However, the risks of misclassifying an employee as an independent contractor are both varied and serious. First, the issue can arise in the context of a suit under the Fair Labor Standards Act, in either an individual suit or a collective action on behalf of many workers, usually based on the failure to pay overtime wages. In addition, if the IRS finds a worker has been misclassified, the employer may be required to pay back withholding taxes, interest and penalties (even if the workers have paid their taxes). Beyond that, employees that have been improperly classified can obtain benefits (such as retirement, health, stock options, etc.) they should have received as employees. Liability also arises in misclassification cases for lack of coverage for workers’ compensation (unpaid premiums, as well as wage and medical payments) and unemployment compensation.

Unfortunately, there is no bright-line test to determine who is an employee and who is an independent contractor. The common law test - easy to state but impossible to apply with predictability - is whether the engaging company retains the right to control the “means and manner” of how the work is performed. What complicates the issue is that the IRS, the Department of Labor, the National Labor Relations Board, and various state agencies all utilize different sets of rules to make the determination, each within the context of their own purposes and social objectives. As a result, virtually every independent contractor - employee adjudication is made on its own case by case basis and its own individualized factual mosaic.

With increased focus on misclassifications, if your business utilizes independent contractors, it may be a good time to reexamine whether or not the workers are actually contractors.