Misclassification of Independent Contractors: The Crackdown, Its Costs, and How to Minimize or Avoid Its Risks

This article was published as a comprehensive three-part series in the Employment and Class Action sections of Law360 on July 7–9, 2015 as “The Costs of Worker Misclassification.” © Copyright 2015, Portfolio Media, Inc., publisher of Law360.  This article is based on the 2015 Update to my White Paper. 

Introduction

Over the last half-dozen years, employers have seen a crackdown on the misclassification of employees as independent contractors. Part I of this article will first address how this form of misclassification has arisen and what its consequences are for companies caught in the crackdown. Part II will next detail how regulators, legislators, plaintiffs’ class action lawyers and union organizers have sought to counter businesses that are believed to engage in independent contractor misclassification. Finally, Part III will discuss how businesses can minimize or avoid the risks of this type of misclassification.

First, let’s briefly discuss an actual class action so that the issue of independent contractor misclassification can be viewed from a real-world perspective, including the circumstances that lead a company to classify workers as independent contractors. In a district court case, a company that was sued for misclassification made a motion for summary judgment after extensive discovery. The company argued that, as a matter of law, the undisputed facts showed that the class of workers in question were independent contractors. The court examined the evidence in the light most favorable to the plaintiffs, as it must do on a motion for summary judgment. It then granted summary judgment in favor of the company, concluding as follows:

“[T]he only reasonable inference is that [the company] hasn’t retained the right to direct the manner in which [the workers] perform their work. [The company] … offers numerous suggestions and best practices for performance of assigned tasks, but the evidence doesn’t suggest that [the company] has the authority under the [Independent Contractor] Agreement to require compliance with its suggestions. Further, other factors strongly weigh in favor of independent contractor status; in particular, the parties intended to create an independent contractor arrangement, the [workers] have the ability to hire helpers and replacement[s], they are responsible for acquiring [the tools of their trade] and can use the [tools] for other commercial purposes, they can sell their [contractual rights purchased from the company] to other qualified [contractors], and [the company] doesn’t have the right to terminate contracts at-will. Although some facts weigh in favor of employee status, after considering all the relevant factors, the court finds that the plaintiffs are independent contractors as a matter of [state] law.” (Emphasis added.)

An appellate court, looking at the same facts, reached the opposite conclusion. It held that, as a matter of law, the workers were employees, not independent contractors. The appellate court examined 20 separate factors and concluded as follows:

“Viewing the factors as a whole leads to the conclusion that [the company] has established an employment relationship with its [workers] but dressed that relationship in independent contractor clothing. Even where the factors should point us toward finding that the [workers] are independent businesspersons, [the company’s] control and micromanaging undermine the benefit that a [worker] should be able to reap from that arrangement.”

Those who are familiar with the subject of independent contractor misclassification will recognize that this case involved FedEx Ground. The lower court decision was issued by the U.S. District Court for the Northern District of Indiana, which was assigned to handle dozens of FedEx Ground cases from around the country. The appellate court is the Kansas Supreme Court, which was asked by the Seventh Circuit to rule on this case under Kansas law. I will use FedEx as a case study for each of the three parts of this series.

Second, I will identify the industries affected by independent contractor misclassification. I have been studying reported cases for the last five years and have described hundreds in monthly updates on independent contractor compliance and misclassification. Although businesses in virtually all industries use independent contractors, my study reveals that businesses in more than 40 industries have been specifically targeted by federal or state agencies or been the subject of class action lawsuits.

Those industries in the cross-hairs of the crackdown include: amateur and professional athletics; aerospace and defense; automotive; banking; cable television and Internet services; car services, limousines and taxis; charities; cleaning and janitorial services; colleges, universities and other educational services; computer programming and technical consulting; construction; cosmetics/beauty products; courier services; crowdsourcing; deliveries and logistics; direct selling; entertainment; environmental services; fashion/design; financial services; food and beverage; government contracting; health care; heavy industry/manufacturing; hospitality, hotels and lodging; home products installation; insurance; landscaping; life sciences; marketing; media; mergers and acquisitions; music and video; professional services, including consulting; publishing/editing; retail and Internet sales; security; staffing; technology; telemarketing; television, radio and movie production; and trucking and transportation services.

I.  How Independent Contractor Misclassification Has Arisen and its Costly Consequences

     A. Economic and Business Advantages to Using Independent Contractors

The use and misuse of independent contractors has increased dramatically since the mid-1990s. According to a 2006 report by the Government Accountability Office, the number of independent contractors in the U.S. workforce increased by 24.5 percent from 1995 to 2005.¹ This was due, in large part, to a combination of two factors: (1) economic and other business advantages derived from the use of independent contractors and (2) lax regulatory enforcement — a classic risk-reward calculus.

Many of the reasons for using independent contractors are well-understood by most businesses. They include the following:

• Businesses are not required to withhold taxes, make Social Security and Medicare contributions on the fees paid to independent contractors, pay unemployment taxes or provide coverage for workers’ compensation insurance.
• Independent contractors are not required to be paid the minimum wage or overtime pay.
• Employee benefit plans only cover employees, not independent contractors.
• Federal labor laws do not afford independent contractors the right to be represented by a labor union.
• Businesses can more easily expand or contract their workforces to accommodate workload fluctuations.
• The custom and practice in particular industries is to use independent contractors.
• Even in industries where there is no historical custom and practice of using independent contractors, some companies acquire business units that have historically used an independent contractor model and wish to continue to use that model to better compete in the marketplace.
• A company that needs to supplement its workforce may have either an internal hiring “freeze” in place, or managers may be discouraged by their superiors from increasing headcount or payroll costs.
• Workers who have specialized talents or technical expertise, and hence are in demand, may insist or indicate a strong preference that they be retained on an independent contractor basis.

These considerable economic and business reasons have led many companies to classify a host of workers as independent contractors, even those workers who may fall within one or more of the definitions of “employee” under the labor, tax and/or benefit laws.

In the FedEx Ground case discussed above, it is common knowledge that FedEx acquired its ground division in 1985 from a company that operated that business on an independent contractor model. The appellate court noted that FedEx’s lawyer “acknowledged at oral argument [that] the company carefully structured its drivers’ operating agreements so that it could label the drivers as independent contractors in order to gain a competitive advantage” (i.e., to avoid the additional costs associated with employees). “In other words,” the appellate court noted, “this is a close case by design, not happenstance.”

     B. Decades of Lax Enforcement and Different Legal Tests

Lax enforcement of independent contractor laws by governmental revenue and workforce agencies prevailed throughout the 1990s and well into the latter part of the 2000s. Government inattention to the issue of proper worker classification also contributed to a demonstrable lack of understanding of the legal distinctions between independent contractors and employees.

Although some businesses knowingly have misclassified employees as independent contractors, most businesses that misclassify employees have paid insufficient attention to the legal requirements or simply do not understand the laws in this area, either because they have mistaken conceptions of the laws or because they are confused by the array of different laws at the federal and state levels.

This is not the least bit surprising. Even many legal “treatises” and articles by lawyers that purport to list the various independent contractor laws fail to take into account that the tests for independent contractor status are varied. Further, the same language found in an independent contractor statute in one state is often interpreted differently by the courts and administrative agencies in another state. The 2006 GAO report addressing employee misclassification reached the conclusion 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.”² As varied as the tests are under federal law, some state laws are even more complex and far more varied — a veritable crazy quilt of state laws.

There is, however, one overriding constant factor in almost all of the federal and state tests for independent contractor versus employee status: whether a business has the “right to control the manner and means” by which a worker accomplishes the end product of his or her services. In determining whether a business has such a right to control, some federal and state agencies consider more than two dozen factors that may indicate whether or not the business has retained or used such control.

For example, while the IRS has articulated a three-part test, it essentially considers about 20 factors in determining independent contractor status under the “common law” test it follows. Yet, as noted in its online guide, the IRS states that “all information that provides evidence of the degree of control and the degree of independence must be considered.”

Similarly, the U.S. Department of Labor considers six main factors in its so-called economic realities test, but likewise states in its online guide that “all facts relevant to the relationship between the worker and the employer must be considered.” Dr. David Weil, administrator of the wage and hour division, has recently stated publicly that the Department of Labor will issue further guidance in the next few months on determining independent contractor status, but such guidance is not expected to deviate much from the current standards as articulated on the department’s website.

About half the states have statutory tests for independent contractor status in their laws covering unemployment, workers’ compensation, overtime and minimum wage and/or wage payments and deductions. Many of those statutory laws are referred to as “ABC” tests and require a business to affirmatively prove all three prongs of the test to establish independent contractor status. These types of statutory tests are often more worker-friendly than the judge-made tests under the federal tax, wage and labor laws.

A 2009 review of the factors used by the courts and by various state and federal agencies revealed that, collectively, far more than 48 factors were being used by different decision-making bodies in determining independent contractor status — and, in the years since, dozens of additional factors have been considered. Although some commentators have called on legislatures to standardize the test for independent contractor status, it is highly unlikely that state legislative bodies and Congress will coordinate among themselves to pass a unified bill with a common definition of an independent contractor.

     C. Rise in Intentional and Unintentional Misclassification

Businesses engage independent contractors for a variety of reasons. Many businesses utilize them to carry out an essential function of the business, such as delivering or installing goods or providing a specialized service. Another common usage is when a business connects a customer seeking a service with an individual who provides the service. This latter utilization has been the centerpiece of the on-demand or sharing economy, where independent contractors supply the services sought by customers of companies like Uber Technologies Inc., Lyft Inc., Homejoy Inc., TaskRabbit Inc., BloomThat Inc., Washio Inc. and Spoonrocket Inc.

Since mid-2007, federal and state regulators have been cracking down on independent contractor misclassification. A variety of reasons have been articulated for the crackdown, but the three main justifications that have been articulated by those favoring the crackdown are:

• to capture lost tax revenues occasioned by the failure to withhold taxes on the compensation paid to workers misclassified as independent contractors or paid in cash;
• to ensure that workers who should be legally classified as employees are protected by the full array of laws intended to safeguard them and are paid in accordance with wage laws; and
• to foster fair competition so that those companies who “play by the rules” and pay wages to workers in accord with the law are not disadvantaged by those who are misclassifying employees as independent contractors.

These reasons would resonate with any law-abiding corporate citizen when it comes to companies that knowingly misclassify workers as independent contractors or pay them cash under the table. These reasons, however, do not address one of the more prevalent types of independent contractor misclassification — the unintentional form, where legitimate companies use individuals whom they regard as legitimate independent contractors, but fail to structure, document and implement the independent contractor relationship in a manner that complies with a myriad of federal and state laws.

As stated publicly earlier this year by the Department of Labor’s wage and hour administrator, although an independent contractor relationship may not be used to evade compliance with federal labor law, “[T]he use of independent contractors [is] not inherently illegal … [and] legitimate independent contractors are an important part of our economy.”³

So, where does FedEx Ground fall in the unintentional or intentional misclassification realm? At least one federal appellate court has ruled in favor of FedEx on the independent contractor issue,⁴ and another has stated that FedEx presents a “close case.”⁵ So, it is hard to place them in the category of having intentionally misclassified employees as independent contractors.

FedEx is not unlike many other businesses that have failed to properly structure, document and implement an independent contractor relationship that can survive legal scrutiny. In addition, companies that have not utilized customized solutions and opted for a one-size-fits-all or other “standardized” compliance approach are likely to find that they are usually ill-fitting, unsustainable or impractical. In any event, what may work for one company is unlikely to serve the business needs of another and might not even meaningfully enhance the company’s state of independent contractor compliance.⁶

What are the concerns for a company whose independent contractor relationships are not properly structured, documented and implemented? Those businesses, like FedEx Ground, are at risk for a host of costly misclassification consequences — even when the misclassification is unintentional.

     D. Costly Consequences of Misclassification

Independent contractor misclassification liability can be devastating to many for-profit and nonprofit organizations and those governmental entities that rely on the use of 1099 contractors, regardless of whether the employees have been mistakenly or intentionally misclassified.

Risks include years of exposure to some of the most common forms of independent contractor misclassification liability, such as:

1. unpaid federal, state and local income tax withholdings and Social Security and Medicare contributions;
2. unpaid unemployment insurance taxes, both to the federal government and to state governments;
3. unpaid workers’ compensation premiums;
4. unpaid overtime compensation and/or minimum wages;
5. unpaid work-related expenses; and
6. unpaid sick and vacation pay.

These types of liabilities usually also include interest and/or penalties for noncompliance.

How much can these liabilities add up to? I discuss 18 administrative and judicial cases in part two of this series, and the recoveries range from the hundreds of thousands of dollars to more than $10 million, with the recent FedEx Ground settlement topping the list at $228 million for its California drivers.

Another costly liability risk arises if misclassified employees, who are otherwise entitled to coverage under Employee Retirement Income Security Act employee benefit plans, have not been provided with group health, disability and life insurance coverage, as well as contributions to a 401(k) plan or other pension and profit-sharing plan. The Microsoft Corp. case in the 1990s demonstrates how costly misclassification can be, no matter how unintended, when workers classified as independent contractors are recharacterized 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 temporary workers, who were not afforded coverage under Microsoft’s stock purchase plan, plus millions more in legal fees for the workers’ class action lawyers.⁷

The Affordable Care Act gives rise to yet another form of independent contractor misclassification liability. If an employer (including all employees in the employer’s controlled group) has fewer than 50 full-time equivalent employees, but would equal or exceed that number if independent contractors were recharacterized as employees by the IRS or a court, the ACA would require that company to provide qualifying medical coverage to its employees (which includes misclassified independent contractors). Employment status is also relevant in determining whether a “large employer” is subject to the excise tax when a particular worker receives subsidized health insurance coverage offered through a state or federal exchange. A large employer is required to offer minimal essential coverage that is affordable and provides minimum value to at least 95 percent of its full-time employees (including those who are misclassified) and their dependents.

II.  The Four Prongs of the Crackdown on Independent Contractor Misclassification

The crackdown on independent contractor misclassification has transpired on four fronts: enforcement actions by federal and state regulators, including the U.S. Department of Labor, the IRS and state workforce agencies; legislative bodies that have enacted laws seeking to curtail the use of independent contractors or make their misclassification more costly; class action lawyers that represent workers who claim they and other similarly situated individuals have been misclassified as independent contractors; and unions that are seeking to represent workers whom the unions claim are employees under federal labor laws. Each of those four prongs of the crackdown are discussed below.

     A.  Federal and State Regulatory Enforcement Initiatives

            1. U.S. Department of Labor

With funds authorized by the Obama administration in each of its budgets released since 2011, the DOL has embarked on a multifaceted enforcement approach. First, it has been hiring more investigators to “detect and deter” independent contractor misclassification. Second, it has been prosecuting more companies that fail to pay overtime or minimum wages to employees whom the DOL believes are being misclassified as independent contractors. Third, the DOL has made grants to state workforce agencies to identify misclassification and recover unpaid unemployment taxes.

To finance these enforcement activities, the last three budgets submitted to Congress by the president all included $10 million for the DOL to distribute to state workforce agencies to increase their enforcement efforts, as well as almost $4 million to hire and retain additional federal personnel to investigate and prosecute misclassification.⁸ In 2014, a total of $10.2 million was awarded to 19 states to help finance their crackdown on independent contractor misclassification, with four states receiving “high-performance bonuses” due to improved detection of worker misclassification.⁹

The DOL has also commenced a “Misclassification Initiative,” in which it has entered into memoranda of understanding with an increasing number of state workforce agencies from coast to coast. The dual objectives of these federal-state partnerships are to coordinate enforcement efforts and to share information between the state and federal agencies about noncompliant companies. By the end of 2014, the DOL had announced that it had entered into such agreements with agencies in 18 states.¹⁰ In January 2015, the DOL announced that two more states had signed memoranda of agreement,¹¹ and, in May 2015, it announced 21 states had signed one.¹²

The DOL has itself successfully investigated and prosecuted hundreds of businesses that it concluded were misclassifying employees as independent contractors. These include both small and large enforcement actions, some resulting in seven-figure settlements. Among the more notable cases in the last three years were:

• A $1.075 million consent judgment against a cable company for allegedly misclassifying its cable installers and failing to pay them overtime.
• A $1.3 million consent judgment against a text message and Internet information provider for misclassifying its “special agents” who answered text messages from website users and failing to pay them minimum wage.
• A $560,000 consent judgment against a telemarketing company for misclassifying telemarketers and failing to pay them minimum wage and overtime compensation.
• A $1.5 million judgment in a federal lawsuit brought against a cable installation company providing installations for Time Warner by the DOL on behalf of 250 former cable installers, who were found to have been misclassified as independent contractors and denied overtime compensation.
• Back wages totaling $687,000 collected from a drilling rig company for misclassifying roughnecks and crane operators and failing to pay them overtime compensation.
• A $395,000 consent judgment against a construction contractor for misclassifying carpenters, electricians, masons, laborers, painters and drywall hangers and failing to pay them overtime compensation.
• A $277,000 assessment against a janitorial service subcontractor and its payroll services company found to be a joint employer of 233 low-wage custodians misclassified as independent contractors.

            2.  Internal Revenue Service

The IRS has also been active in seeking to restore what it estimates are billions of dollars in lost tax revenue due to the misclassification of independent contractors. As far back as November 2007, the IRS announced that it had entered into agreements with nearly 30 state revenue commissioners and workforce agencies as part of its Questionable Employment Tax Practices (“QETP”) program to share information and enforcement techniques about employers suspected of misclassifying employees.¹³ That QETP program remains a priority of the IRS, and at least 37 state workforce and revenue agencies have signed a QETP memorandum of agreement with the IRS.¹⁴

In February 2010, the IRS announced that it was commencing a three-year employment tax national research project to conduct line-by-line audits of 6,000 businesses, focusing on, among other things, employee misclassification.¹⁵

In September 2011, the IRS unveiled a new program, the Voluntary Classification Settlement Program (“VCSP”), to permit taxpayers to voluntarily reclassify independent contractors as employees for federal employment tax purposes. The VCSP was modified in December 2012 and updated in 2014. 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 a company’s reclassification as a tacit admission of past wrongdoing.¹⁶

In early 2014, the IRS launched an enhanced effort to promote its SS-8 program, which allows individual workers to file a Form SS-8 to initiate a review of their independent contractor status if they feel they have been misclassified.¹⁷ More recently, the IRS announced in June 2014 that it is increasing its corporate audits of S corporations because it has found that many are misclassifying their workers as independent contractors.¹⁸

In addition, the IRS has entered into a memorandum of agreement with the DOL. That agreement seeks to reduce incidences of misclassification of employees as independent contractors by providing for the sharing of information and collaboration by the tax and labor agencies, as well as employment tax examinations of questionable taxpayers brought to the attention of the IRS by the DOL.

In addition to the above initiatives, the IRS continues, of course, to use its regular audit processes to examine the classification of independent contractors. In 2007, the IRS assessed FedEx Corp. a $319 million penalty in an employment tax audit, taking the position that FedEx had failed to comply with the employment tax laws with respect to its ground division drivers. That assessment for unpaid taxes was just for 2002. But, in 2008, the IRS withdrew that assessment.¹⁹ Although there was no announcement regarding why the assessment was withdrawn, it is likely that FedEx was able to successfully use the “safe harbor” provisions of the Revenue Act of 1978 to shield itself from that assessment.²⁰

            3.  State Workforce Agencies

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 among various state agencies. To date, at least 21 states have created task forces designed to identify and remediate independent contractor misclassification.²¹

Many state workforce agencies have been as aggressive as the DOL. For example, the most recent figures from the New York Labor Department show that, in 2014, it completed more than 12,000 audits and investigations. Through these audits, the department found 133,000 misclassified workers and assessed more than $40 million in unpaid unemployment contributions.²² Similarly, Massachusetts reportedly audited more than 18,000 businesses in 2013 and recovered $15.6 million from companies found to have misclassified independent contractors.²³ Likewise, Illinois audited more than 3,500 employers in 2013 and recovered $5.1 million in unreported unemployment contributions attributable to wages of employees found to have been misclassified.²⁴

California has also been diligent in pursuing businesses that are believed to have misclassified employees as independent contractors. In March 2014, the California labor commissioner’s Division of Labor Standards Enforcement ordered a large logistics company to pay $2.2 million in back pay, attorneys’ fees and interest for having allegedly misclassified seven short-haul drivers.²⁵ In May 2014, the commissioner issued citations of more than $1.5 million to two janitorial companies for allegedly misclassifying 52 workers as independent contractors.²⁶

An even more effective 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 who are receiving compensation on a 1099 basis. Many workers who regard themselves as independent contractors are nonetheless applying for unemployment benefits — and more claims examiners are finding that such workers have been misclassified and are entitled to unemployment benefits as “employees.”

When a business has not paid unemployment contributions to a state fund on behalf of a 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 has 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. Thus, prudent employers treat even a simple claim for unemployment benefits as having the potential for resulting in a regulatory “miniclass action.” Further, some businesses that have become the objects of class actions can trace the genesis of their litigations to a successful claim for unemployment benefits by a single employee found to be misclassified as an independent contractor.²⁷

State attorneys general have also taken an active role in regulatory enforcement in the area of independent contractor misclassification. Companies that have failed to remit unemployment taxes and/or withhold state income tax have been forced to resolve such claims with various state attorneys general. FedEx is one example. It agreed with the attorney general of Montana to pay $2.3 million to settle an unemployment tax proceeding and agreed with the attorney general of Massachusetts to pay $3 million to settle claims that it failed to pay state unemployment and workers’ compensation taxes.²⁸ Other state attorneys general were also reported to have filed claims against FedEx, including those from New York and Kentucky, relating to unpaid state taxes and violations of other state labor laws.²⁹

     B.  Legislative Initiatives

            1.  State Laws Designed to Curtail Misclassification

Since July 2007, at least 26 states have enacted legislation intended to curtail misclassification of employees as independent contractors.³⁰ Some states have passed multiple misclassification bills. Most of these new independent contractor laws provide for civil and criminal penalties, debarment from state contracts, presumptions in favor of employee status and/or private rights to bring individual or class actions for misclassification of employees. Some of the state laws create the misclassification task forces described earlier.

The majority of state laws enacted since July 2007 apply generally to all industries, such as the California Independent Contractor Law, which became effective on Jan. 1, 2012. It prohibits “willful misclassification” by businesses; adds hefty penalties for violations, especially those pursuant to a “pattern or practice”; and imposes joint liability on any outside nonlegal consultant or other person who “knowingly advises an employer to treat an individual as an independent contractor to avoid employee status” if the individual is found not to be an independent contractor.³¹

A number of the new laws, however, have targeted specific industries where misclassification is regarded by legislators as more prevalent. One such industry is construction, which has been the subject of new laws in Delaware, Illinois, Maine, Maryland, New Jersey, New York and Pennsylvania. Similarly, Maryland has passed a law that specifically addresses the use of independent contractors in the landscaping industry.

In 2013, New York enacted a law seeking to curtail the use of independent contractors in the commercial goods transportation industry.³² That bill went into effect in 2014, and similar bills are likely to be introduced in the legislative chambers of other states.

In September 2014, California passed a law that imposes liability on businesses that use staffing companies and other “labor contractors.” Under that law, client companies “share with a labor contractor all civil legal responsibility and liability for all workers supplied by that labor contractor for … the payment of wages and failure to secure workers’ compensation coverage …”³³ Thus, companies using staffing firms have more reason than ever to ensure that their staffing companies have an enhanced understanding of independent contractor compliance.

Notably, although more than two dozen states have enacted laws pertaining to independent contractors since July 2007, all of those statutes permit the continued use of properly classified independent contractors. Thus, the key under virtually all of these new laws is whether an independent contractor relationship is structured, documented and implemented in a compliant manner or, where a new law has changed its test for independent contractor status, whether the relationship needs to be restructured, re-documented and re-implemented in a manner that complies with a new statutory scheme.  I discuss this issue further below.

            2.  Federal Bills Aimed at Misclassification

Congress has tried to follow suit, but none of its initiatives in this area have become law. In 2008, the Employee Misclassification Prevention Act (“EMPA”) was introduced in both houses of Congress. It was reintroduced in both the House of Representatives and Senate in a different form in 2010 and again in 2011. If passed, the bill would have, for the first time, made misclassification of employees as independent contractors a federal labor law violation, imposed substantial record keeping and notice obligations on businesses (even those that properly classify their independent contractors), and subjected businesses to hefty penalties for noncompliance with the proposed new law.³⁴

In 2011, and again in 2013 and 2014, Congress introduced the Payroll Fraud Prevention Act. This was a trimmed-down version of the earlier EMPA and, like EMPA, would have made independent contractor misclassification a federal offense.³⁵

Another misclassification bill, the Fair Playing Field Act, was first introduced in September 2010 and reintroduced in March 2012, and reintroduced yet again in November 2013. This bill would have eliminated a long-standing “safe harbor” found in Section 530 of the Revenue Act of 1978 that many businesses have relied on for continuing to classify certain workers as independent contractors.³⁶ As noted above, it is likely that FedEx used the safe harbor to escape a $319 million back tax assessment by the IRS related to its classification of drivers in its ground division as independent contractors.

None of the federal bills, if passed, would have foreclosed the use of independent contractors that are properly classified as such.

     C.  Class Actions

Businesses that either use independent contractors to supplement their workforces or that operate on the basis of independent contractor business models have also been targeted increasingly by plaintiffs’ class action lawyers. Independent contractor misclassification lawsuits have mushroomed against both large and small businesses. Almost no industry is free from these types of lawsuits, although some industries have been harder hit and others are particularly vulnerable.

Among the businesses that are particularly vulnerable to misclassification class actions are Silicon Valley startups and other on-demand companies in the sharing economy that use hundreds or thousands of low-wage independent contractors that are often indistinguishable from low-wage employees.³⁷

A representative sampling of class actions that were resolved in the last few years in favor of workers who claimed they were misclassified as independent contractors include the following:

• A nationwide courier services company — FedEx — that settled a misclassification class action by drivers for its ground and home delivery divisions for $228 million.
• A newspaper publisher that lost a class action brought by its newspaper carriers, who were awarded $11 million by a state court in California, and another newspaper that settled a misclassification lawsuit for $3.2 million.
• A home improvement retailer that settled with its installers for $6.5 million.
• A New York adult entertainment club that settled with exotic dancers for $8 million.
• A cleaning and janitorial services company that paid $10 million to settle a class action in Massachusetts brought by more than 100 custodians, who alleged that they were misclassified as “franchisees” instead of employees.
• A nationwide food distribution company that paid $3.5 million in allegedly unpaid employee benefits to settle one of a number of class actions brought by bakery food drivers who made deliveries in Connecticut and Massachusetts.
• A nationwide workforce management-staffing company supplying “outsourcing and contact center services” for the financial services, retail, technology, e-commerce, telecommunications, travel and hospitality industries that paid $1.25 million in settlement to more than 200 customer and technical support service workers in California.
• A car service company that paid $3.5 million to 489 drivers and their lawyers.
• An oil and gas company that settled for $2 million with oil field workers that monitored oil and gas wells.
• A nationwide logistics and last-mile delivery company that settled class actions filed by drivers in Oregon and Washington for $2.25 million.
• An airport shuttle company that settled with more than 3,000 drivers for $11.9 million in damages and legal fees.

These examples highlight the value of independent contractor misclassification cases to plaintiffs’ class action lawyers, who typically receive between 25 to 33 percent of the settlement as an attorneys’ fee award, or the full amount of their legal fees if higher, when they secure a settlement or judgment in favor of their class member clients. In addition, companies beset by these types of lawsuits incur “hidden costs,” including their own legal fees and the distraction of key management personnel that are needed to defend class actions of this nature.

     D.  Impact of Labor Organizations and Potential for Unionization

Under federal labor law, only employees can be unionized; independent contractors are not covered by the National Labor Relations Act and have no right to organize. Recognizing that independent contractors are beyond the reach of labor organizations, unions have been at the forefront of the regulatory and legislative efforts to curtail the use of independent contractors.

Labor organizations have actively supported state legislative initiatives resulting in new laws, such as those referenced above, which seek to curtail the use of independent contractors in two heavily unionized industries: construction and the courier delivery-transportation business. Following the passage of state laws that set forth stringent requirements for construction employers to classify workers as independent contractors, union membership in the construction industry has undoubtedly risen in those states that have passed such laws since 2007, including New Jersey, Pennsylvania, Illinois and New York, among other states.

After years of effort by the Teamsters Union, the National Labor Relations Board in 2014 certified a Teamsters local union as the collective bargaining representative of drivers in Connecticut for FedEx Home Delivery, following the NLRB’s finding that such drivers were employees and not independent contractors or separate business entities, as argued by FedEx.³⁸

Similarly, years of efforts by the Teamsters to organize drivers who had been classified as independent contractors by drayage companies operating at the ports of Los Angeles and Long Beach, California, have recently succeeded. As of January 2015, a number of those drayage companies that previously classified drivers as independent contractors converted to employee business models and have begun to bargain with a Teamsters local union for an initial collective bargaining agreement.³⁹

III.  Alternatives to Minimize or Avoid Future Misclassification Exposure

Despite the media attention that has been focused on the issue of independent contractor misclassification in recent years, including articles in newspapers and trade publications, most companies have yet to diagnose their state of compliance or determine their potential exposure for independent contractor misclassification liability. Fewer still have enhanced or updated their workforce models in a manner sufficient to meaningfully minimize or eliminate the risks of costly government regulatory and enforcement actions and class action litigation.

For companies that would like to continue their current workforce strategies, instead of being required to reclassify every independent contractor 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 redistribute contingent workers currently treated as independent contractors.

Virtually all newly enacted state laws, as well as proposed federal legislation, permit the continued use of independent contractors, provided the workers are properly classified. Nonetheless, some lawyers and legal commentators routinely advise businesses to cease using independent contractors or to reclassify them as employees to avoid the potential for misclassification liability. There are, however, a number of proven alternatives that permit companies to maintain their use of independent contractors while minimizing or avoiding future misclassification liability.

Those alternatives include restructuring, re-documenting and re-implementing the independent contractor relationship; reclassifying independent contractors (either voluntarily or through a government program); and/or redistributing independent contractors through a workforce management or staffing company.

     A.  Bona Fide Restructuring and Re-Documentation

Businesses that are concerned about the potential for misclassification liability often recognize that, at best, their independent contractors probably fall within a legal gray area, where some facts favor contractor status while others indicate employee status. As noted above, it is a basic precept of independent contractor law that the tests used to determine whether a worker is an independent contractor or an employee differ from law to law.

The first step that is typically recommended by most lawyers and consultants to companies concerned about misclassification liability is to diagnose whether the company’s independent contractors are properly classified. That step, however, is wholly unnecessary for any business that wishes to consider a bona fide restructuring of its independent contractor relationships.

Once a company has determined that it wishes to consider the restructuring alternative, it may then be beneficial to perform a comprehensive analysis on the company’s anticipated level of compliance after restructuring. Some businesses have conducted that review and assessment using a process such as IC Diagnostics, a process that examines whether the position would likely pass the applicable independent contractor tests under governing state and federal laws. All of the factors used by courts and administrative agencies — far more than 48 — are examined to determine worker status, with each of the factors weighted to reflect its relative importance in assessing compliance with applicable laws.

A compliance analysis should then measure the company’s anticipated compliance with each of the applicable independent contractor laws. For example, the IC Diagnostics process uses a scale that is calibrated to provide assessments of alternative ways to minimize misclassification liability. Even for businesses that operate in those states that have strict tests for determining independent contractor status, this process can provide an assessment of how much restructuring is needed and, once implemented, how each alternative will minimize or eliminate future misclassification liability.

Where bona fide restructuring is considered a sound alternative, the business can proceed to the next step in the process: re-documenting the restructured independent contractor relationship. This should be a comprehensive undertaking; it should embody the entire relationship between the independent contractors in question and the business. Re-documentation should also be accomplished in a manner designed to further enhance independent contractor compliance, consistent with applicable laws. Practice tools can be used to ensure that the re-documentation of the independent contractor relationship is thorough and state of the art.

Many independent contractors work without an agreement or, worse, work under agreements that do not reflect the true relationship between the contractor and company. A contract that misstates the true relationship between the parties, such as one that states that a worker is not subject to the supervision of the company even though he or she is regularly supervised by a superior at the company or given regular evaluations, is generally of little or no benefit.

Similarly, a contract that recites that a worker is an independent contractor offers no protection if the factors used by a court or government agency to determine the worker’s status demonstrate sufficient direction and control to create an employment relationship. Even agreements drafted for companies by otherwise talented lawyers include language that a plaintiffs’ class action lawyer may use to support his or her argument that the business has retained a right to direct and control the manner and means by which the worker performs the agreed-upon services. That is exactly what transpired in the recent FedEx Ground decisions by the Ninth Circuit and Kansas Supreme Court.

After the restructured relationship is memorialized in a written independent contractor agreement, the final step is implementing the restructured relationship. Companies must ensure that what is set forth in the contractor agreement will be implemented in the field and that it does not include empty recitals or misstatements of the relationship. Equally important, businesses must avoid exercising direction and control, which is often unintended yet has the potential to undermine an otherwise enhanced state of independent contractor compliance.

Other aspects of the re-implementation process may include reviewing and revising company operating manuals and procedures, documenting the implementation of certain provisions in the updated contractor agreement and putting safeguards in place to ensure conformity with the restructured independent contractor relationship.

The Ninth Circuit and the Kansas Supreme Court both commented in their 2014 FedEx Ground decisions that the company did not implement its independent contractor relationships in a manner that complied with applicable laws.

There are no “quick and dirty” ways to enhance independent contractor compliance. The use of form or model independent contractor agreements, sometimes called templates, tends to cause businesses to overlook the need to restructure and to implement a sustainable independent contractor model that will withstand legal scrutiny and serve a company’s unique business model.

On the other hand, bona fide restructuring, re-documentation and re-implementation need not be a prohibitive undertaking and, once completed within a reasonably short period of time, can place a business in an enhanced and sustained state of compliance. That itself may substantially minimize the likelihood that a regulator or class action lawyer will seek to challenge a company’s compliance with independent contractor laws.

Many companies assume that if they experience an adverse legal determination, they have no choice but to reclassify the affected workers and make them employees. However, restructuring and re-documentation is also a valuable means for companies that are subject to legal challenge to revamp their independent contractor relationships in order to maximize compliance and minimize future misclassification liability.

There are, of course, some situations where a business is unable to attain compliance with independent contractor laws. There are at least two alternatives to restructuring that such businesses may wish to consider: reclassification and redistribution. These alternatives may also be used by companies that have properly classified a group of workers if the business nonetheless wishes to minimize or cease its use of independent contractors in the future.

     B.  Reclassification: Government Program or Voluntary Action

Businesses that are at greater risk for misclassification liability are more likely to have to defend their classification of workers as independent contractors. More companies are receiving notices from state unemployment agencies that question whether a former worker classified as an independent contractor should be reclassified as an employee, thereby exposing the company to the risk of liability for any prior misclassification. Some businesses also have received notices from state labor commissioners and workers’ compensation agencies inquiring whether an entire group of workers are independent contractors or employees, and some have received tax audit notices — even companies whose compliance with independent contractor laws should be beyond dispute.

Regardless of whether a company may survive a legal challenge to its independent contractor relationships, it may wish to consider reclassification. This step is likely to be far less painful and costly than being compelled by a government agency to reclassify and 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, if there is a finding of misclassification in the future.

The costs of compelled and voluntary reclassification are often weighed against the savings derived from continuing a business structured, in whole or in part, on an independent contractor model. This is a business decision that is premised on a host of competing considerations — far too many to mention here.

Reclassification can be undertaken in one of two ways: (1) under a government-sponsored reclassification program; or (2) voluntarily, without government involvement.

As noted above, in September 2011, the IRS announced its Voluntary Classification Settlement Program (“VCSP”), which allows a business to voluntarily reclassify workers who currently receive Forms 1099 from the company by making what is referred to by the IRS as a “minimal payment covering past payroll tax obligations.”⁴⁰ 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.⁴¹

Although the VCSP appears to be an attractive form of “amnesty,” there have been only a scant number of 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 laws, as well as federal wage-and-hour laws. Second, although the program evidently contains a provision that there is no admission that the taxpayer erroneously classified its workers as independent contractors, 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 independent contractors correctly.⁴²

For these and other reasons, businesses interested in reclassification are more likely to do so voluntarily without entering the VCSP. Voluntary reclassification, however, should be implemented in a manner that does not create unfair inferences of past noncompliance. On one hand, some workers that have been paid on a 1099 basis might welcome their reclassification but may also fail to understand why they were not treated as employees from the beginning of their relationship with the company. On the other hand, other workers who are accustomed to being compensated on a 1099 basis may object strenuously to becoming an employee and losing the tax advantages of self-employment, including tax deductions for legitimate business expenses. In addition, reclassification of workers from 1099 to W-2 status may require some businesses to engage in an array of administrative changes to comply with federal and state tax, employee benefits and labor laws. The timing of those changes can be important.

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 Employee Retirement Income Security Act rules or any rules associated with the Affordable Care Act.

     C.  Redistribution of Independent Contractors

Where voluntary reclassification is not a practical or viable alternative, another choice is to use a knowledgeable and reputable workforce management or staffing company. This alternative cannot completely eliminate all potential liability for misclassification, but using a responsible workforce organization may 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.⁴³

Workforce management and staffing organizations are not payroll companies; when they hire or retain some or all of a company’s independent contractors, they may either treat them as 1099 contractors or as W-2 employees.

If the talent is treated as independent contractors, 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. 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 independent contractors, including health insurance under a plan maintained by the staffing or workforce management company. If the workforce solutions firm treats the workers as independent contractors, it is imperative to select a firm that is knowledgeable about independent contractor compliance issues, otherwise the workforce solutions or outsourcing company can offer little or no protection from misclassification liability.⁴⁴

Although using a knowledgeable and experienced outsourcing company may 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 independent contractors or employees it has retained or hired in the company’s benefit plan language and discrimination testing.

Conclusion

The use of independent contractors is still a viable means to supplement a company’s workforce or to structure a business model in almost all states. Further, no bill introduced in Congress has proposed a prohibition on the use of independent contractors. All a business is required to do is classify independent contractors correctly or, conversely, not misclassify employees as independent contractors. Even companies in industries beset by multimillion-dollar independent contractor misclassification judgments, such as the adult entertainment and cable installation industries, can take steps to enhance independent contractor compliance and effectively avoid or defend against class actions.⁴⁵

Lax enforcement of labor and tax laws in the past, as they apply to independent contractors, has placed most businesses in a 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 discussed above. Some companies, in fact, may choose to use not just one, but perhaps two or even all three of these alternatives for different groups of independent contractors. In view of the current and pending legislative, regulatory and judicial landscape, there is only one undesirable alternative: inaction.

Written by Richard Reibstein.

For information about the author, see the About the Publisher page of this legal blog. 

Endnotes