Independent Contractor Classification Causes Confusion, Potential Penalties (8/10)

Employers beware.  The IRS and DOL are stepping up their enforcement efforts to ferret out misclassified independent contractors.  Find out what the different tests are for contractors and steps you can take to ensure you're not a target.

     Here’s a suggestion that sounds like a great cost-saver: Use independent contractors instead of employees to work on special projects or even to fill key positions in your organization.  Typically, these workers are not on your payroll and are self-employed.  As a result, you don’t have to pay taxes, give benefits, or cover them for unemployment or workers’ compensation.  Sounds pretty smart, doesn’t it?       But, watch out. These workers can actually end up costing you more in headaches, back taxes, overtime costs, and penalties if you improperly classify them as independent contractors.  In March, we reported on initiatives by the Internal Revenue Service (IRS) and the Department of Labor (DOL) to target worker misclassifications more aggressively than they have in the past.  So, if you use independent contractors, you should make sure your classifications are proper and not a shortcut to an expensive nightmare.  Below, we explain what the different independent contractor tests require and five steps you can take to ensure you are in compliance. Advantages of Independent Contractors Clearly, there are many advantages to using independent contractors.  First, if you have a special project that requires a level of expertise none of your employees have, hiring a consultant to do the work can jump-start the project and ensure it is completed correctly.  In addition, using independent contractors gives you more flexibility to “staff up” or cut back, without incurring the costs of hiring or layoffs.        Further, because independent contractors are not considered your employees, the organization does not have to pay taxes on their behalf or allow them to participate in any benefits plans.  Also, they typically are not covered under state workers’ compensation or unemployment compensation statutes; they are not entitled to overtime under wage and hour laws; they cannot sue under discrimination statutes; and they cannot take leave under the Family and Medical Leave Act.  Misclassification Costs Big Money There is a downside to using independent contractors, however.  If you miscategorize an employee as an independent contractor, you may face claims under the many laws that protect employees.  Both the DOL and the IRS have collected millions in back taxes and penalties from employers that incorrectly categorized employees as independent contractors.             And, both agencies are stepping up their enforcement in highly public campaigns aimed at employer misclassifications.  In February 2010, the IRS launched its first Employment Tax National Research Project in 25 years, targeting 2,000 taxpayers each year for the next three years for “comprehensive” audits.  The purpose of the audits is to determine what the “employment tax gap” is, i.e., the difference between taxes that are owed and taxes that are not paid because of underreporting, underpayment, or unfiled taxes, and how to collect these payments.  In 2005, the IRS estimated the overall tax gap to be a whopping $345 billion, and so clearly the agency is interested in increasing its collections.      Similarly, the DOL has added 250 more field investigators and is focusing on misclassified workers as a way to ensure employees are being properly paid wages and overtime but also to bring in more revenue to the federal government by identifying workers for whom employers do not pay federal Social Security and Medicare taxes.   Three Different Tests So, how do you prevent misclassification?  Answering that question is particularly tricky since three different standards commonly are used by the courts and agencies to determine independent contractor status: (1) the IRS 20-factor analysis, for coverage under federal withholding requirements; (2) the “economic reality” test, used to determine compliance with requirements of the Fair Labor Standards Act (FLSA); and (3) the common law “right to control” test, used by many courts to administer discrimination and benefits statutes.  These three tests, discussed below, share several common factors, the most important of which is the amount of control the employer exercises over the work relationship. The IRS 20-Factor Test The IRS considers the existence of an employer-employee relationship to depend on whether the worker is subject to the will and control of the employer, based on the following factors: 1.     Instructions.  Employees typically must follow instructions as to when, where, and how to perform the job. 2.     Training.  Requiring training supports employee status. 3.     Integration.  Integration of the worker’s services into the business operations suggests that the hirer directs and controls the worker. 4.     Services rendered personally.  If services must be rendered personally by a specific worker, the hirer controls the methods used to complete the work. 5.     Control of assistants.  Control by the hirer over the hiring, supervision, and pay of assistants implies employee status.  6.     Ongoing relationship.  A continuing relationship suggests that an employer-employee relationship exists.  7.     Set hours of work.  The establishment of set hours by the hirer implies control over the worker. 8.     Full-time work.  A worker who must devote full working time to the hirer is being controlled. 9.     Work on hirer’s premises.  On-premises work indicates employer control, especially when the work could be done elsewhere. 10.     Order or sequence.  Work that must be performed in an order or sequence established by the hirer suggests control. 11.     Reports to hirer.  A requirement that the worker submit regular oral or written reports to the hirer implies control. 12.     Payment method.  Payment by the hour, week, or month generally indicates an employer-employee relationship.  Payment by the job or commission indicates independent contractor status. 13.     Payment of expenses.  Payment of the worker’s business or travel expenses suggests an employer-employee relationship; the hirer is regulating and directing the worker’s activities. 14.     Furnishing tools, materials.  Provision of tools, materials, and other equipment by the hirer shows an employer-employee relationship. 15.     Significant investment.  Independent contractor status is implied if the worker invests in the facilities used for the work.  Absence of investment indicates an employer-employee relationship. 16.     Realization of profit or loss.  A worker who can realize a profit or suffer a loss as a result of providing services is usually an independent contractor. 17.     Serving more than one firm.  A worker who provides services to several unrelated firms at the same time generally is an independent contractor. 18.     Serving the public.  A worker whose services are regularly available to the general public is an independent contractor.  19.     Right to discharge.  The right of the hirer to discharge the worker at any time is a factor indicating an employer-employee relationship.  But, an independent contractor may not be fired if his result meets contract specifications. 20.     Right to quit.  A worker with the right to terminate the relationship with the hirer at any time without liability is generally an employee.      The presence or absence of any one of the 20 factors is not determinative or conclusive; rather the IRS will consider all of the factors affecting the relationship.  You can request a determination from the IRS by filing Form SS-8, “Determination of Worker Status,” available online at www.irs.gov/pub/irs-pdf/fss8.pdf.   You also can find helpful information on correctly classifying and correcting misclassification of workers from IRS Publication 15-A, “Employer’s Supplemental Tax Guide,” available online at www.irs.gov/publications/p15a/index.html. The FLSA Analysis The DOL uses the “economic realities test” to determine coverage under, and compliance with, the minimum wage and overtime requirements of the FLSA.  The following are among the factors considered by the DOL:  (1) the degree of control exercised by the hiring party over the manner in which the work is performed; (2) the relative investments by the hiring party and the worker in materials and equipment; (3) the degree to which the worker’s opportunity for profit and loss is determined by the hiring party or the worker’s own managerial skill; (4) the skill and initiative required in performing the job; (5) the permanency of the relationship; and (6) whether the service is an integral part of the hiring party’s business.      So, for example, in Johnson v. Unified Gov’t of Wyandotte County/Kansas City, 371 F.3d 723 (10th Cir. 2004), the Tenth Circuit determined that off-duty police officers who worked as housing project security guards were not employees of the housing authority for purposes of overtime entitlement since the housing authority exercised very little control over the officers’security patrols.  The officers could come and go as they pleased within certain hours, their starting times were flexible, they could quit after working only a few hours, they did not need permission to move from one project to another, they required no additional training by the housing authority, and their activities were not integral to its business.       In contrast, in Reich v. Circle C Invs., Inc., 998 F.2d 324 (5th Cir. 1993), the Fifth Circuit found that nightclub dancers were employees since the nightclub scheduled them to work weekly, fined and disciplined them, made a significant investment compared to that of the dancers, and controlled factors affecting the dancers’ profits.  In addition, the dancers were not required to exercise initiative or have much skill. Common Law “Right to Control” Test The common law “right to control” test is used by courts to determine employee status in various types of cases, including employment discrimination and benefit cases, tax cases, and tort (wrongful act) liability cases.  The common law test, as applied by the courts, includes the following ten factors: (1) the extent of control which, by agreement, the hiring party may exercise over the hired party; (2) whether the hired party is engaged in a distinct occupation or business that is usually done by a specialist without supervision; (3) how the worker’s helpers are hired and whether they are paid by the hiring party or the worker; (4) the skill required in the particular occupation; (5) who supplies the means, tools, and place of work; (6) the length of time for which the person is hired; (7) the method of payment, whether by time or the job; (8) whether the work is part of the regular business of the hiring party; (9) whether the parties believe they are creating an employment relationship; and (10) whether the hired party is an actual business entity.      So, for example, in Suskovich v. Anthem Insurance Co., 553 F.3d 559 (7th Cir. 2009), the Seventh Circuit determined that a computer programmer was an independent contractor for purposes of the Employee Retirement Income Security Act because he controlled the details of his work, was accountable to the company only for the results of his work, and was never promised that his work would extend beyond short projects.  And in FedEx Home Delivery v. NLRB, 563 F.3d 492 (D.C. Cir. 2009), the D.C. Circuit used the common law test to determine that FedEx delivery drivers were independent contractors and not protected by the National Labor Relations Act.  The court found that the drivers could contract with FedEx to serve multiple routes and could hire their own employees, the drivers provided their own trucks. and the drivers had the right to assign (sell, trade, give or bequeath) the contractual rights to their routes without permission from FedEx.      In contrast, in Jenkins v. Southern Farm Bureau Cas., 307 F.3d 741 (8th Cir. 2002), the Eighth Circuit applied the common law test and refused to dismiss an insurance agent’s age discrimination claim on the basis of his employment status.  According to the court, evidence tended to show that he was an employee rather than an independent contractor.  It noted that the insurer for whom he had worked for more than 30 years controlled the location of his office and business hours, paid for his utilities and office equipment, provided him with a company-sponsored insurance plan, maintained ultimate authority over his underwriting decisions, and could hire and fire his agents. Five Simple Steps Towards Compliance  A few simple steps can protect your organization against misclassifying employees.  First, make sure you understand the various tests and apply them to each independent contractor relationship.  It is not enough to meet the standards of one of the tests. You could face a challenge from one agency that results in an investigation by another, so you should try to comply with all of the factors.       Second, enter into a contractual agreement with the worker that explains the independent contractor relationship.  The contract will help show what both the hiring party and the worker understood and intended the relationship to be.  However, the contract by itself is not determinative; the worker still must meet all independent contractor criteria.  Third, use independent contractors that are set up as separate business entities.  Fourth, if you are using an independent contractor to perform a job that is also performed by current employees, consider carefully whether the independent contractor really meets the criteria.  Courts and administrative agencies are less likely to accept the classification if the independent contractor is doing the same job as employees.  Finally, be particularly careful if you have an employee who works two jobs for you, and you classify the second position as an independent contractor.  This action may raise a red flag.

Supreme Court:  Two-Member NLRB Is Not a Legal Quorum (8/10)

The Supreme Court rebuffed the National Labor Relation Board’s (NLRB) decision to issue hundreds of judgments made by the only two members of the NLRB, effectively calling into question the validity of the rulings.  The Court, in New Process Steel, L.P. v. NLRB, No. 08-1457 (June17, 2010), declared that the National Labor Relations Act (NLRA), as amended, requires a quorum of three members (out of a possible five) to issue binding judgments.   The Court’s decision means that hundreds of cases may be sent back to the NLRB for reconsideration.      The NLRA is the federal law that gives nonsupervisory employees the right to self-organize; to form, join, or assist labor organizations; to bargain collectively through their own representatives; and to engage in concerted activities for collective bargaining or other mutual aid or protection.  The NLRB is charged with enforcing the NLRA and is a five-member, quasi-judicial board that determines whether the NLRA has been violated.  Board members are appointed by the President for five-year terms and approved by the Senate, generally ensuring that the political party in charge will enjoy a majority.  Ideally, cases are referred to a full five-member NLRB to decide, but the NLRA does allow for the Board to delegate its decision-making power to “a group of three or more members.” In December 2007, the NLRB had only four members and the terms of two of them were about to expire.  The four members delegated their decision-making power to a three-member panel.  When the Board membership then shrank to only two members, it still continued to issue decisions as a two-member quorum of a three-member group.  It based its authority on the so-called “vacancy clause” of the NLRA that allows two members of the three-member group to act if the third is unavailable.  So, from January 2008 until April 2010, the two-member NLRB issued approximately 600 decisions.  Several of the decisions were challenged in the appeals courts, with mixed results.  The Seventh Circuit Court of Appeals declared that the NLRB had the authority to make decisions with only two members, while the District of Columbia Circuit Court of Appeals disagreed.  The Supreme Court took the case to resolve the conflict between the courts.      The Court agreed that the NLRA allows the NLRB to delegate its decision-making authority to three members, and that two members may act if the third is unavailable, such as when one of the members must recuse himself from a matter because of a conflict.  However, the Court disagreed that the two-member quorum could continue to make decisions when the third member’s term expired, as happened to the NLRB in January 2008.  The Court described the NLRB’s attempt to delegate authority to the two-member quorum as a “Rube Goldberg-style delegation mechanism” (referring to the 20th Century political cartoonist famous for depictions of overly complex machines created to perform simple tasks).  According to the Court, “delegating to a group of three, allowing a term to expire, and then continuing with a two-member quorum of a phantom delegee group—is surely a bizarre way for the Board to achieve the authority to decide cases with only two members.”  The Court did not find any evidence in the text of the NLRA to support this delegation.        The Court’s decision did not address, however, what should happen to the 600 plus cases decided by the two-person NLRB.  More than 70 cases were already awaiting review by the courts at the time of this decision, so those cases likely will be sent back to the NLRB for new consideration by the full NLRB.  (As of June 2010, the NLRB had its full five members.)