A Solution to the “Five Degrees of Independent Contractor Misclassification”

“Independent contractor misclassification” is a phrase that is misunderstood, misapplied, and misused – constantly. It is used to cover an array of disparate forms of IC misclassification: unpardonable; uninformed; unprepared; unintentional; and unjust. [1]

The phrase is warranted in situations when companies engage in indefensible and unpardonable conduct, such as when a construction worker, custodian, or restaurant worker is paid in cash under the table or when a company knowingly pays an administrative assistant on a 1099 basis.

But the same term is also applied in a few states with laws that de-legitimize valid IC relationships that are lawful under the laws in almost all other states and under all federal laws governing ICs.  When used in this latter context, such as where ICs have some of their own customers but also choose to supplement their income by using a referral company that sends them additional customers seeking the types of services they provide, the phrase “IC misclassification” is not only unsuitable but also legally unjust to both independent contractors and businesses.

And there are at least three other types of so-called IC misclassification in between unpardonable and unjust.  Thus, the phrase is best understood in the context of a spectrum with at least five degrees of IC misclassification.  While most legislative responses are prompted by and cover the first three types (unpardonable, uninformed, and unprepared), a number also broadly apply to unintentional IC misclassification and a few unjustly prohibit many legitimate IC relationships.

Before describing each type of IC misclassification, we will discuss a common situation involving two similar referral companies: one that refers benefits consultants and the other that refers financial analysts to their customers that need those types of talented service providers to better operate their businesses.  The referral companies specialize in the benefits and financial services areas and have a network of hundreds of consultants and analysts that, when available, provide services to the referral company’s clients through and in the name of the referral company.  Each of the referral companies have dotted their i’s and crossed their t’s to avoid retaining or exercising any direction or control over the manner and means by which the services are performed. The consultants and analysts are all in business for themselves as sole proprietorships or LLCs offering their services to multiple customers and other referral companies, or they have the right to do so, but wish to supplement their business by rendering services to the referral companies’ clients.

Each of these referral companies and consultants would likely satisfy the test for IC status under the federal Fair Labor Standards Act (FLSA) and the Internal Revenue Code, as well as most state laws governing ICs, and would be found to be operating in a legitimate and lawful manner. Yet, they are unlikely to pass a few states’ overly restrictive tests for IC status, such as the one that was recently been enacted in California and the test for IC status in Massachusetts. In those two states, those referral companies might be found to have engaged in “independent contractor misclassification” simply by doing nothing more than referring those consultants, who are in business for themselves, to their corporate customers.

Following the recent passage of a law in California that narrowly defines who is and who is not an independent contractor in most industries, legislators in other states and in Congress have begun to propose an array of laws in an effort to curtail IC misclassification.  Legislative bodies should not plunge into this area of the law, however, without first taking into account whether such laws would prohibit legitimate types of IC relationships, whether they will simplify or make even more complex the laws governing ICs, what negative impacts such laws will have on freelancers seeking to supplement regular employment income, and whether there are more effective alternatives than the type of legislative change that was recently enacted in California.  This commentary will discuss those considerations and propose a solution after defining and briefly explaining the five degrees of IC misclassification:

Unpardonable – when a business knows it has no reasonable basis for classifying workers as ICs but does so anyway (this is indefensible wage theft).

Uninformed – when a business has no reasonable basis for classifying workers as ICs but has not bothered to learn the legal requirements.

Unprepared – when a business understands generally the applicable tests for IC status, but it is unclear whether or not particular workers can be classified as ICs under federal and most state laws, yet the business has chosen to classify the workers as ICs without taking meaningful steps to enhance its level of IC compliance.

Unintentional – when a business tries to understand and satisfy the applicable tests for IC status but, despite good faith efforts, the workers are found to have been misclassified as ICs under federal and most state laws solely because the business may not have dotted all its i’s and crossed all its t’s in structuring, documenting, and implementing its IC relationships.

Unjust – when the workers are properly classified under federal and most state laws but not under one of the few overly restrictive state law tests for IC status or where a state law test is dependent on a single factor that is not clearly defined.

A recent example of unjust IC misclassification

Recently, California enacted new legislation, Assembly Bill 5 (A.B. 5), which was signed into law on September 18, 2019 and becomes effective January 1, 2020.  That law codifies the California Supreme Court’s decision in Dynamex Operations West v. Superior Court, which was issued on April 30, 2018. As we noted in a blog post that day, Dynamex created a so-called ABC test similar to the labor standards test for IC status in Massachusetts.  This type of ABC test requires companies to satisfy each of three strict criteria in order to establish independent contractor status, dramatically changing decades of settled law in California.

Prior to Dynamex, IC status was determined in that state by applying a multi-part test issued almost 30 years earlier by the California Supreme Court in the Borello case, which weighed and balanced a number of factors.  This is similar in nature to the test used under the federal FLSA and most state lawsEssentially, Dynamex instantly turned tens of thousands of California businesses and independent contractors in scores of industries that were operating for years in compliance with settled law into companies that, overnight, might well be operating unlawfully.

The new California A.B. 5 test for IC status and the long-established Massachusetts labor standards test for IC status differ substantially from all other states’ ABC tests.  In every other state that has an ABC test, the “B” prong has two alternatives:  the work performed must either be “outside the usual course of the business for which such service is performed or . . . performed outside of all the places of business of the enterprise for which such service is performed.” (Emphasis added.)  However, the “B” prong of the Massachusetts labor standards test and the California test under Dynamex and A.B. 5 requires that a company prove that the contractor’s work is outside the usual course of business in order to establish IC status.  In other words, for some unexplained reason, the alternative way by which companies can satisfy prong “B” in the ABC tests in all other states was dropped.

Thus, in the earlier illustrations, the benefits consultants and financial analysts would remain ICs if they performed their services from their own home office or rendered their services electronically or in an online manner in all states other than Massachusetts and California. Under the new A.B. 5 statute, though, they would now likely become the referral company’s employees, whether they like it or not.  They would not be lawfully able to maintain their own independent businesses and remain independent contractors if they used those referrals to provide consulting and analyst services in the name of the referral companies.

A.B. 5 began as a legislative effort to codify the Dynamex decision into statutory law.  The legislature, however, soon recognized that the multi-factor Borello test was a fairer and more reasonable test than the stringent Dynamex standard and would have turned legitimate IC relationships into violations of the law.  The legislature therefore carved out over fifty industries from the Dynamex ABC test.  For the businesses and independent contractors in those fifty industries, the legislation now provides that the Borello test should remain the standard for independent contractor status.

Those industries that are covered by an exemption should not assume they will satisfy the exemption requirements.   In a reasoned article entitled “Complexity Is the Cost of California’s Worker Classification Law,” which appeared in Law360 on October 24, 2019, Professor Edward Zelinsky of Cardozo Law School concluded that many of the exemptions in A.B. 5 are “opaque” and “ambiguous.”

For example, Professor Zelinsky notes that the exemption for individuals performing marketing services only applies if they engage in “work [that] is original and creative in character and result of which depends primarily on the invention, imagination, or talent of the [individual].” As noted in the Zelinsky article, at least until a body of case law develops over a number of years, “it will often be unclear whether marketing activity is creative enough or imaginative enough to qualify the marketer as an independent contractor for purposes of this A.B. 5 exemption.”  Professor Zelinsky also examined a few other equally “opaque” and “ambiguous” exemptions, including the professional services exemption where a business must show that the professional service provider “customarily and regularly exercises discretion and independent judgment in the performance of the services.”  He commented that “at least for the short run, and perhaps for the long run, this open-ended standard will entail substantial interpretative ambiguity, leaving the boundaries of the exemption unclear.”

As Professor Zelinsky concluded: “A.B. 5 does not make the law of employee status clearer, simpler or more uniform.  Indeed, A.B. 5 makes the law more complex and less uniform than it was before.”

There are many other deficiencies of A.B. 5 besides those identified by Professor Zelinsky.  For example, the new law covers some professionally licensed therapists, such as licensed psychologists, but overlooks others such as licensed clinical social workers, licensed marriage and family therapists, licensed professional clinical counselors, and licensed educational psychologists.

Another key deficiency of the A.B. 5 exemptions is that each requires that all of up to 10 or 12 specified conditions be met.  For example, referral agencies must meet each and every one of ten specified conditions to qualify for the Borello test, but cannot qualify if the referred professional provides services in the name of the referral company.  Similarly, business-to-business contractors must meet each and every one of twelve specified conditions to qualify for an exemption.  Few business-to-business contractors and few referral agencies, however, can realistically satisfy every single one of the 10 or 12 respective conditions for an exemption from the ABC test.  Thus, the exemptions are essentially unrealistic for most companies in those types of businesses.  The California legislature could have followed the lead of other states that have set forth an equally comprehensive list of factors for IC status, but provided that it is not necessary to meet each and every element to establish IC status. [2]

Thus, A.B. 5 is more actually complex than the Borello test it supplanted, as Professor Zelinsky demonstrates in his article.  It is also under-inclusive in the types of professions and industries it exempts from the ABC test.  Finally, it is overly rigid in terms of requiring businesses and contractors to fit into a fixed, multi-factor business structure if they wish to qualify for an exemption from the ABC test.  In sum, it is hardly a model that should be emulated by other state legislators. Yet there are some such legislators and governors who are headed in that direction instead of focusing on legislative and enforcement initiatives that will curtail unpardonable, uninformed, and unprepared IC misclassification – the intentional or reckless type where companies know or should know that they are violating the law.

Recent efforts at the state and federal levels may create more unjust and unwise IC misclassification

Legislators in other states that wish to adopt an ABC type test or enact other rigid legislative schemes to curtail IC misclassification should recognize that while an A.B. 5 type of bill would deter and eliminate unpardonable IC misclassification (otherwise known as payroll fraud or wage theft) as well as uninformed and unprepared IC misclassification, it would also sweep in all forms of unintentional misclassification and may even unjustly outlaw IC relationships that have for years been legitimate and lawful under almost all state and federal laws.

For example, in New Jersey, a Senate bill (S. 4204) and Assembly bill (A. 5936) are under consideration that would codify the current law in New Jersey by virtue of a decision by the New Jersey Supreme Court issued five years ago and reported in a blog post on January 15, 2015.  (The Senate version of the bill would have created an ABC test with a prong B identical to A.B. 5; that is, the individual would be presumed to be an employee – even if the worker was free from control or direction over his or her performance and was customarily engaged in an independently established business, profession, trade, or occupation – if the service provided was not “outside the usual course of the business for which that service is performed.” Regardless with which bill prevails, these New Jersey legislative initiatives would sweep away many legitimate IC relationships.  Unlike California’s A.B. 5, which exempts more than 50 industries from the strict Dynamex ABC test, the New Jersey bills do not include any exemptions.  Unless the Senate or Assembly slow down their consideration of these bills to consider legitimate exemptions, as their counterparts did in California,, the New Jersey bill will de-legitimatize many IC relationships where virtually all freelancers wish to remain their own bosses and there are no complaints by other companies in that industry about a competitive disadvantage.

An increase in enforcement of existing laws would likely solve the problem

Instead of seeking to change existing law in a manner that would effectively eliminate the overwhelming number of ICs, legislators should instead seek greater enforcement of existing laws including existing tests for IC status.  This is precisely what former Labor Secretary Thomas Perez and former Wage and Hour Administrator David Weil had consistently endorsed when they were carrying out their duties at a national level to accommodate the valid interests of both workers and businesses.

Secretary Perez testified before the House Education and the Workforce Committee on March 18, 2015 that the Labor Department has been “work[ing] very closely with states, and we’ve entered into MOUs [memorandums of understanding] with 20 states. . . . because this problem’s not a red or blue problem, it’s a problem — a national problem that has three sets of victims: the worker him or herself; the employers who play by the rules — they can’t compete for contracts, they can’t compete for businesses because they pay their taxes; and then the tax collector, because when a business is cheating, they’re not paying their workers’ comp taxes, my U.I. taxes go up because the pool has gotten smaller.” Secretary Perez added:  “I believe that there’s an important place for independent contractors, but I also believe that there’s ample evidence that that’s been abused.”

Similarly, Dr. Weil, when he served as the Wage and Hour Administrator at the U.S. Department of Labor, stated that although an independent contractor relationship should not be used to evade compliance with federal labor law, the use of independent contractors [is] not inherently illegal [and] legitimate independent contractors are an important part of our economy.” 

There is little question that an increase in enforcement, as former Labor Secretary Perez called for in 2015, would effectively put a dent in unpardonable IC misclassification and also propel companies that engage in uninformed, unprepared, and unintentional IC misclassification to take steps to ensure they comply with the law.

The U.S. Department of Labor and state counterparts have issued reports over the years that as part of their coordinated enforcement efforts, they have identified or recovered for workers tens of millions of dollars in unpaid unemployment and payroll taxes. [3]  On October 28, 2019, the U.S. Department of Labor announced that it had recovered a record $322 million in wages owed to workers in Fiscal Year 2019, and part of that recovery included amounts paid by companies found to have engaged in IC misclassification.  It is abundantly clear – and a matter of common sense – that every dollar invested in adding enforcement officers to eliminate unpardonable, uninformed, and unprepared IC misclassification will yield far more money in uncollected taxes than would be needed to pay for additional government enforcement officers and their overhead costs.

Increased enforcement efforts at the federal and state level would also serve to level the playing field for those businesses using an employee model that cannot compete against companies whose use of ICs falls into one of the first three types of IC misclassification.

In addition to increased enforcement, class action plaintiffs’ lawyers have recovered even far more than have the federal and state governments by enforcing private rights of action to sue for IC misclassification based on existing laws.  In our monthly review of IC misclassification cases, we have reported on hundreds of multi-million dollar settlements – not only seven-figure payments by companies alleged to have engaged in IC misclassification, but an increasing number of settlements in the tens of millions of dollars and even a $100 million settlement in the past year.

Maintaining existing laws would be welcomed by the overwhelming number of ICs

There is an additional and equally compelling reason why the solution is not to enact stricter tests for IC status that will, as A.B. 5 will do on January 1, 2020, turn thousands of law-abiding businesses into offenders and convert legitimate ICs into employees.  This further reason is that an overwhelming number of ICs would prefer not to be turned into employees but would rather remain ICs, at least according to two independent studies conducted by the federal government.

In 2015, the U.S. Government Accountability Office (GAO), in a 72-page report to Congress, stated on page 24 of its Report entitled “Contingent Workforce: Size, Characteristics, Earnings, and Benefits,” that it had asked an array of workers the question: “Would you prefer a different type of employment?” 85.2% of independent contractors responded “No” to the question. Similarly, when the independent contractors were asked if they were satisfied with their jobs, the responses as reported on page 24 of the Report were that 92% they were satisfied with their jobs, with 56.8% saying they were “very satisfied”. In contrast, only 45.3% of full-time employees reported that they were “very satisfied” with their jobs.

The 2015 GAO Report also asked about benefits: 75.6% of regular full-time workers said “Yes” to the inquiry, “My Fringe Benefits Are Good.”  While one might expect that ICs are displeased with their fringe benefits, the study concluded just the opposite:  61.0% answered “Yes” to the same question “My Fringe Benefits Are Good.”  Thus, even though ICs had a slightly lower satisfaction rate with their fringe benefits than regular full-time employees, ICs were still as or more satisfied with their work arrangements as were full-time employees, even with less benefits. While the study does not ask why, it is likely that many of those ICs would say, “two of the benefits I like most are being my own boss and having more flexibility than if I was working as an employee somewhere.”

In 2018, the Bureau of Labor Statistics (BLS) issued a study entitled “Contingent and Alternative Employment Arrangements.” One question reported on page 15 of the study was whether ICs preferred their alternative work arrangement or would prefer a traditional work arrangement.  Of those independent contractors who had an opinion, 89.9% said they preferred their alternative work arrangements, while only 10.1% said they would prefer traditional employment.  This is a critical factor that many legislators, commentators, and those in academia seem to overlook or minimize.

Many freelancers in California are worried that A.B. 5 will eliminate their ability to earn a living. As CNBC reported on December 11, 2019 in an article entitled “California’s New Employment Law Has Boomeranged and Is Starting to Crush Freelancers,” the new A.B. 5 law will not take effect until January 1, 2020, but “freelancers are already feeling the squeeze with a decline in business and income.”

A very recent Gallup poll, as reported in The New York Times on December 18, 2019, found that 92% of self-employed 1099ers also are employed in regular employment and are simply seeking to supplement their income. Those workers reported a far higher satisfaction rate for their working arrangements that those who were limited to W-2 income. The article concludes: “Workers rather than employers seem to be driving the trend in self-employment, since the increase comes from people combining self-employment with traditional employee relationships. Some politicians [in states] like California, have sought to curb self-employment, on the theory that employers have created the gig economy in an effort to evade their tax and regulatory obligations. The reality is more complicated.”

The next day, an article appeared in Slator that interpreters and translators have been canceling contracts with freelance translators and interpreters. The article concludes that A.B. 5 “also affects translators, therapist, musicians, owner-operator truck drivers, engineer in Consultants, and more.” These types of reports of disruption in self-employment and businesses that engage independent contractors are likely to cascade and fill up the airwaves over the next month.

In conclusion, the question is not, what should be done to combat IC misclassification?  It should be re-characterized as, what should be done to combat the first three degrees of IC misclassification:  unpardonable, uninformed, and unprepared? The answer is stricter enforcement of existing laws. That will fully protect businesses that comply with the law, adequately protect workers, raise a tremendous amount of tax revenues, level the playing field, permit legitimate ICs to remain self-employed, and allow small- and medium-size companies with legitimate IC relationships to remain open for business.

Written by Richard Reibstein

This blog post was updated December 19, 2019

[1]  This commentary reflects the views of the author as the publisher of Independent Contractor Misclassification and Compliance Legal Blog, found at www.IndependentContractorCompliance.com; it does not reflect the views of the publisher’s law firm or any of the firm’s clients.

[2]   See, e.g., Florida test for IC status under the state’s workers’ compensation law, where 4 of 6 factors may be met to qualify for IC status.  Fla. Stat. 440.02. Under Wisconsin’s test for I*C status for unemployment insurance benefits, only 6 of 9 factors need be met.  Wisc. Stat. 108.02(12)(bm).

[3] For example, as we noted in a February 5, 2015 blog post, the New York Joint Enforcement Task Force on Employee Misclassification issued a report on February 1, 2015 citing that task force agencies conducted over 12,000 audits and investigations, resulting in detection of employee misclassification involving over 133,000 workers, culminating in the discovery of $316 million in unreported wages, leading to the assessments of $40.4 million in unemployment insurance contributions.

This blog post is based on an article by the author that was published in Law360.com on December 16, 2019. © Copyright 2019, Portfolio Media, Inc., publisher of Law360.  It is republished here with permission.

This entry was posted in IC Compliance. Bookmark the permalink.