The Fair Labor Standard Act (FLSA) has changed very little since it was enacted in 1938. The workplace, however, has changed dramatically over the past 70 years—and the plaintiffs' bar has seized upon this old law to generate a record number of FLSA-related lawsuits recently.
Most employers and human resource professionals have come to know and understand basic requirements under the FLSA and to make good-faith efforts to comply with those requirements. Despite such efforts, this complex and challenging statute can still lead employers to find themselves the subject of a Department of Labor audit or, worse, named as a defendant in a collective action lawsuit.
Many collective action lawsuits have involved challenges under the FLSA in which employees allege their employers improperly classified them as exempt to avoid paying overtime wages and certain other benefits. While these types of lawsuits have been prevalent in virtually every industry over the last decade, recently there has been a steady increase in the number of class actions involving the misclassification of workers as independent contractors. Companies utilizing independent contractors should pay attention to this trend for a variety of reasons.
Increased Funding for Examination of Worker Classification
Thanks to increased funding from the Obama administration, one of the most comprehensive Internal Revenue Service (IRS) examination of worker classification and employment tax compliance is underway. A February 17, 2010, article in the New York Times discussed the increased scrutiny businesses might face at both the state and federal levels, pointing out that the IRS crackdown on proper worker classification is estimated to yield $7 billion over 10 years. The article went on to say that the IRS will expand its ability to conduct investigations by hiring an additional 100 enforcement personnel and that the IRS has already begun auditing approximately 6,000 companies to see whether they have misclassified employees as independent contractors. In addition to increased funding to the IRS, the Obama administration has also provided increased funding to the U.S. Department of Labor and the Equal Employment Opportunity Commission.
Multiple Tests, Different Results
Determining the proper worker classification is no easy task. Depending on the nature of the challenge or the state or federal agency involved, there are different legal tests for determining whether an individual is an "independent contractor" or an "employee."
The "economic reality" test is typically used to determine a worker's status under various employment laws, such as the FLSA, Title VII, the Age Discrimination in Employment Act, the Americans with Disabilities Act and the Family and Medical Leave Act. The IRS "control" test is used to decide whether an organization correctly classified a worker for purposes of wage withholdings. The "common law" test may also come into play in different employment situations. Furthermore, each state may apply an altogether different test when determining a worker's classification.
The plethora of tests used to determine worker classification applied across federal and state laws makes it possible for a worker to be classified as an independent contractor under one law, but as an employee under another. Employers must be familiar with all of the tests and meet the specific criteria used by the investigating agency or the courts to prove a worker is an independent contractor.
Financial Consequences of Misclassification
To illustrate the financial consequences of misclassification, suppose your company is one of the 6,000 chosen by the IRS for an audit. During the audit, the IRS finds that the company has a regular practice of hiring workers whom the company classifies as independent contractors. Each worker has a signed independent contractor agreement. The company has not withheld taxes or paid any Social Security or Medicare taxes on their behalf, nor has it provided them with employee benefits.
The IRS observes that the independent contractors work at the company worksite each day, work side by side with company employees, use company equipment and supplies, attend employee meetings and follow company work rules. Upon conclusion of the audit, the IRS determines that the company has treated these workers as employees, not as independent contractors, and tells the company it should have paid and withheld payroll taxes on their behalf.
Not only must the company pay back taxes, penalties and interest to the IRS, it is highly likely that at least one of these misclassified workers will learn of the IRS's determination and threaten or initiate a lawsuit demanding full employee benefits for the time they were misclassified, as well as any overtime compensation and other employee protections that they were previously denied. This is exactly what happened to Microsoft in the late 80s and early 90s. Not only was Microsoft required to pay overdue employee withholding taxes and to compensate the misclassified workers for back overtime worked, several of the workers subsequently sued Microsoft in federal court to obtain lost stock purchase and 401(k) benefits. Microsoft eventually settled the case for $97 million.
Audits by Other Federal Agencies
The IRS is not the only federal agency that can come knocking on a company's door. A company might also face an audit from the U.S. Department of Labor (minimum wage and hour laws), National Labor Relations Board (employees' rights to form a union), Equal Employment Opportunity Commission (anti-discrimination laws), or the Occupational Safety and Health Administration (workplace safety laws).
At the state level, a company can attract the attention of its state's unemployment compensation or workers' compensation agency if a worker makes a claim for benefits, alleging that he or she was treated as an employee rather than an independent contractor, and is therefore entitled to benefits. Importantly, state and federal agencies are being more proactive about sharing information; what once may have been an isolated issue may not be any longer. Now, any kind of audit or compliance finding can possibly set off a domino effect where other agencies may become involved.
Proposed Legislation Concerning Worker Classification
If the task of properly classifying a worker was not already difficult enough, legislation that is being proposed would make it even tougher. In the past several years, legislation has been introduced, but not enacted, to address worker misclassification, including the Independent Contractor Proper Classification Act of 2007 (a bill introduced by Senator Obama and others). This past December 2009, Sen. John Kerry introduced an updated version of this legislation, the Taxpayer Responsibility, Accountability and Consistency Act of 2009 (H.R. 3408). This legislation, if enacted, likely will require businesses to classify more workers as employees rather than as independent contractors, by among other things, repealing Section 530 of the Revenue Act of 1978.
Section 530, otherwise known as the "safe harbor" provision, was enacted in 1978 and provides retroactive and prospective relief to businesses classifying workers as independent contractors for employment-tax purposes. Section 530 allows businesses to classify workers as independent contractors, regardless of the analysis under the IRS control test, unless the business has no "reasonable basis" for such a classification. Under the safe harbor provision, employers may rely on an industry practice of classifying workers in a particular position as their "reasonable basis" for the classification.
Elimination of Safe Harbor for Employers
The Taxpayer Responsibility, Accountability, and Consistency Act, if enacted, would severely curtail the existing safe harbor and eliminate the prospective relief offered by Section 530. Under this bill, a business would have a reasonable basis for classifying a worker as an independent contractor only if the business or its predecessor met the following two-factor test:
- the employer did not treat any worker holding a substantially similar position as an employee since December 31, 1977; and
- the independent contractor classification was based in reasonable reliance on either a written determination from the Department of Treasury that the worker was not an employee, or on an IRS examination that concluded the worker was not an employee.
This bill also requires businesses to issue Form 1099s to every service provider (whether an individual, a partnership, or a corporation) to whom the business pays more than $600 annually and gives workers classified as independent contractors the right to seek a determination of their status for employment-tax purposes from the Secretary of the Treasury.
In addition to federal legislation, many states have current or pending legislation of a similar nature. Some examples include:
- Illinois enacted the Employee Classification Act effective January 1, 2008, which imposes civil and criminal penalties for misclassification of workers
- Colorado enacted H.B.1310 in June 2009, which imposes penalties up to $5,000.00 per employee for a first offense and up to $25,000 per employee for subsequent violations for misclassified workers
- Maryland has instituted the Workplace Fraud Act effective October 2009
Moreover, numerous states, including Connecticut, Iowa, Massachusetts, Michigan, New Hampshire, New York Utah, Vermont, and Washington, have established independent contractor task forces designed to increase enforcement efforts related to proper worker classification.
Mitigating Risk With a Compliance Check
With the increased attention to and enforcement of worker classification, employers should take the opportunity to conduct a compliance check of their existing arrangements with independent contractors. As part of this, employers should, among other things, understand the worker classification rules in play, review current industry standards (also impacts safe harbor "reasonable basis" under current law) and review its independent contractor agreements to confirm they support the worker classification (existence of agreement is not determinative, but courts and administrative agencies will consider the existence of the agreement among other factors).
Of course, if a company determines that it may have misclassified a worker, it should take appropriate action to correct the situation. How to best address and correct the situation requires careful thought and consideration since a reclassified independent contractor may decide to seek to claim substantial benefits, such as health benefits and matching contributions to 401(k) plans or other savings plans, retroactively as well as prospectively.
Documenting Independent Contractor Status
Ideally, an employer should develop the facts necessary to support the worker classification at the time of classification. When evaluating whether to hire a worker as an independent contractor, an employer may want to consider, among other things, having potential workers fill out a questionnaire regarding their independent contractor status. Additionally, an employer should consider requesting and collecting documents from potential workers proving they are indeed independent contractors. For example, the following documents can be helpful to support an independent contractor status:
- The worker's employer identification number
- Copies of any business licenses, if required, and any professional licenses
- Certificates of insurance, including general liability insurance and workers' compensation insurance (if the worker has employees)
- The worker's business cards and stationery
- Copies of any advertisements done by the worker (e.g., yellow pages)
- A copy of the worker's white pages business phone listing, if available
- A copy of the worker's invoice form to be used for billing purposes
- A copy of any office lease or other evidence of the worker's office or workplace;
- The worker's unemployment insurance number issued by the state unemployment insurance agency (if the worker has employees)
- Copies of 1099s issued to the worker from other companies for which he or she has performed work
- The names and salaries of any assistants the worker has used on previous jobs for the past two years and proof that the worker has paid them
- Verification that the worker owns and maintains his or her own equipment and supplies necessary to perform the duties required under the agreement
Conclusion
Now, more than ever, state and federal agencies want to see as many workers as possible classified as employees, not independent contractors. If a worker is classified as an employee, an employer is required to withhold income taxes and pay Social Security, Medicare, and unemployment taxes, whereas employers do not have these same obligations with independent contractors. Furthermore, independent contractors are not entitled to minimum wage, overtime compensation, breaks, benefits, as well as other protections provided to employees.
In the event an independent contractor is deemed to be an employee, the employee may be entitled to an array of remedies. State and federal agencies, including the Department of Labor, could also attempt to impose significant penalties on the employer. In light of the heightened attention on this issue, employers should be extremely diligent when deciding to classify a worker as an independent contractor.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.