• Misclassifying Employees as Independent Contractors Can Be Costly
  • April 20, 2010
  • Law Firm: Larkin Hoffman Daly & Lindgren Ltd. - Minneapolis Office
  • Over the years, companies have developed alternative working arrangements with their workers. In one popular working arrangement, the company engages the services of an individual as an independent contractor rather than as an employee. The independent contractors may desire such a relationship because of the autonomy and economic perks the relationship can provide. Companies may, of course, value the independent-contractor relationship because independent contractors are not entitled to certain benefits and protections provided to traditional employees.

    Independent contractors, for example, are not covered by company benefit plans, and payroll withholdings and deductions do not apply. They are not entitled to statutory benefits and protections afforded to traditional employees, such as unemployment compensation and workers’ compensation. Moreover, in many instances, independent contractors cannot take advantage of various federal and state antidiscrimination, minimum wage, and overtime laws.

    Use of the independent-contractor relationship is not, however, without its costs. Because independent contractors are not entitled to certain benefits provided to employees, misclassifying individuals as independent contractors can result in many forms of liability. Misclassification also creates problems for the state and federal governments. A report prepared by the U.S. Government Accountability Office in the fall of 2009 concluded that misclassification of employees is a “significant problem” with “adverse consequences” because it reduces government tax revenues. Indeed, the misclassification of employees is estimated to cost the Treasury Department over $7 billion in lost payroll tax revenue over the next ten years.

    Although it has always been risky for companies to misclassify individuals as independent contractors, stepped-up enforcement actions by the IRS and the federal government will likely increase these risks. In February 2010, for example, the IRS launched its first Employment Tax National Research Project in 25 years, which will target 2,000 taxpayers each year for the next three years for “comprehensive” audits. The purpose of the audits is to determine the “employment tax gap”—the difference between taxes that are owed and taxes that are not paid because of underpayment, underreporting, or unfiled taxes—and how to collect such payments.

    The Obama Administration has also expressed concern regarding the misclassification of employees. In fact, President Obama’s 2011 budget, which was released at the beginning of February, includes funds to start a joint initiative between the Department of Labor and the Department of the Treasury to eliminate legal incentives for employers to misclassify their employees. The budget for the Department of Labor also allocates $25 million to add 100 enforcement personnel to target misclassified contractors and provide competitive grants to states to assist them in combating the misclassification problem.

    Congress may also weigh in on the misclassification issue. In 2009, Senator John Kerry (D-MA) and Rep. Jim McDermott (D-WA) introduced legislation that would make it more difficult for employers to classify workers as independent contractors for employment tax purposes and would increase employer penalties in the event of misclassification. Although neither bill left committee, there could be promise for these bills in 2010 given the federal government’s recent focus on misclassification.

    With the risk of liability associated with misclassification of individuals as independent contractors and the increased efforts to target misclassification, it is imperative that companies utilize the independent-contractor relationship only where the individual would be deemed independent under the various legal tests. Although the legal tests differ from jurisdiction to jurisdiction, the legal tests focus on substance rather than form. That is, labeling an individual as an independent contractor is not conclusive proof of the individual’s status. Instead, courts and agencies look beyond the label to the true nature of the relationship.

    In evaluating the relationship, courts and agencies look to a series of factors. No one set of factors applies to all situations, and particular factors and tests have been developed for different statutes. In general, however, the most frequently used test is the common-law test as set forth in the Restatement (Second) of Agency, a test which has been ratified and modified by the U.S. Supreme Court. The Minnesota Supreme Court has adopted its own version of the common-law test and looks to five factors:

    1. The right to control the means and manner of performance;

    2. The method of payment;

    3. The furnishing of material or tools;

    4. The control of the premises where the work is to be done; and

    5. The right of the employer to discharge.

    Although no one factor is determinative, the key consideration is the degree of control exercised over the individual. Courts and agencies will look at whether the individual actually operates independently, or whether the individual is subject to the supervision and control of the company. If an individual is routinely subject to supervision and control in his or her day-to-day services, the individual is most likely an employee, not an independent contractor.

    Not surprisingly, challenges to independent contractor status typically arise at the end of the relationship—when the relationship has soured. A displeased contractor might, for example, contact the Department of Labor and allege that he or she should have been classified as an employee and paid overtime. Or, a displeased contractor might file a charge of discrimination with the Equal Employment Opportunity Commission or state agency alleging the he or she should have been classified as an employee and was subject to illegal discrimination.

    A recent Eighth Circuit case, Ernster v. Luxco, Inc., provides an example of how these challenges to independent-contractor status can arise. Barbara Ernster was initially hired in 1999 by a liquor and wine brokerage company. She did not sign an employment contract, was paid a fixed monthly stipend, and earned commissions or bonuses based upon sales volumes. The brokerage company did not withhold income taxes from Ernster’s monthly compensation. Although Ernster testified that she was expected to make at least 11 customer visits per day and that the company’s owner called her each day to discuss her daily activities, the owner denied that there was a minimum customer call requirement or that he called Ernster each morning. Notably, Ernster admitted that she was free to decide when to visit particular customers, she could start and end her work days at different times, and she was not required to work a fixed number of hours each week.

    The brokerage company was eventually sold and the new management decided to hire employees as marketing representatives. Ernster applied but was not selected. She stopped working for the brokerage company, and the company allegedly hired a younger woman to take over part of Ernster’s former territory. Ernster sued the brokerage company alleging that she was wrongfully terminated in violation of the Age Discrimination in Employment Act (“ADEA”) and the Iowa Civil Rights Act (“ICRA”).

    The issue in the case involved whether Ernster was an independent contractor or an employee, because the ADEA and the ICRA protects employees, not independent contractors. The jury in the district court returned a verdict that Ernster was an independent contractor, and the court entered the judgment and dismissed Ernster’s claims. After the district court denied Ernster’s requests for post-trial relief, she appealed. On appeal, the Eighth Circuit agreed with the district court that there “was ample evidence” to support the jury’s verdict that Ernster was an independent contractor. Ernster paid taxes on self-employment income, paid all her expenses, did not receive employment benefits, worked out of her home, used her own equipment, and had considerable autonomy over her schedule.

    Although the company in the Ernster case succeeded in demonstrating that Ernster was an independent contractor and not an employee, it is important to remember that determining whether an individual is an independent contractor is a highly fact-intensive inquiry—an inquiry that should not be taken lightly.