Independent Contractor or Employee?
May 21, 2008
Steven L. "Steve" Gillman- Chicago
The U.S. Department of Labor has made the issue of misclassification of employees one of its top enforcement priorities for 2008. The issue is already a priority for some states. Last year, the Massachusetts attorney general announced that Federal Express (FedEx) violated state law by misclassifying delivery drivers as independent contractors. The state ordered FedEx to provide restitution to the affected drivers, fined the company $190,000, and cited the company for failing to withhold payroll taxes, provide workers’ compensation insurance and pay overtime wages. The New York Department of Labor recently decided that FedEx drivers are employees entitled to unemployment compensation upon termination of employment. The company was directed to make quarterly unemployment compensation contributions retroactive to the beginning of 2005 for all single-route drivers who were fired for eligible reasons.
Other states have launched similar initiatives to uncover companies that are misclassifying employees as independent contractors. These initiatives on the federal and state level, coupled with a surge in class action lawsuits filed on behalf of misclassified employees, suggest that misclassification of workers will be a hot issue in 2008 and beyond. Businesses with large concentrations of “independent contractors” (i.e., delivery drivers, home care workers, landscapers and grounds-keepers, and other types of “captive” agents) could be at significant risk.
There are numerous benefits for companies who choose to classify workers as independent contractors:
- There are large tax savings. A business does not pay social security taxes, federal unemployment taxes, workers’ compensation premiums and state unemployment insurance contributions for individuals classified as independent contractors.
- A business does not need to provide independent contractors with leave rights under the Family and Medical Leave Act and its state counterparts.
- A business does not need to pay time-and-one-half under the Fair Labor Standards Act to independent contractors who work more than 40 hours per week or time-and-one-half to individuals who work more than eight hours in a day as provided by some state laws.
- A business is insulated from employment discrimination charges, complaints and lawsuits brought under statutes requiring an “employer-employee” relationship, including claims under Title VII of the Civil Rights Act of 1964, the Age Discrimination in Employment Act, and the myriad of state and local laws which expand the protected categories under federal law.
- A business does not need to provide costly employee benefits, including health insurance, vacation pay and/or sick pay, to independent contractors.
The exposure for companies that misclassify workers can be enormous when spread over large groups of “independent contractors.” On March 25, 2008, a federal judge in Indiana certified 19 separate classes of current and former FedEx ground delivery drivers in 19 states who claim that the company misclassified them as independent contractors and denied them entitlements guaranteed to employees under various laws, including wage and hour laws and common law. The judge relied upon the operating agreements between the parties and the extensive policies issued by FedEx detailing the nature of the parties’ relationship. The newly certified classes include between 25,000 and 30,000 current and former FedEx drivers. The drivers seek hundreds of millions of dollars in lost wages, benefits and expenses. Meanwhile, the Internal Revenue Service (IRS) is considering levying a $319 million dollar penalty on FedEx for not withholding taxes from drivers during 2002 and is considering similar actions for subsequent years. In addition, a shareholder suit claims that the FedEx board of directors breached fiduciary duties by wasting millions of dollars defending the company’s conduct and exposing the company to millions in potential damages and tax penalties.
The IRS Test
So what makes an individual either an employee or an independent contractor? Many courts apply the traditional test used by the IRS known as the “20 Factor Test.” Courts utilizing the traditional 20 Factor Test typically engage in a highly fact-intensive application of these factors to the parties’ relationship. Often the tipping point is the degree of control exerted by the employer over the individual. The IRS has attempted to simplify its test by consolidating the 20 factors into 11 considerations which are organized into three main groups: behavioral control, financial control and the type of relationship between the parties.1
Behavioral control focuses on facts that show whether the employer has a right to control how the worker does the task for which the worker is hired, including the instructions and the training the business gives the worker. An employee is generally subjected to the employer’s instructions about when, where and how to work, but even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. The key is whether the employer has retained the right to control the details of a worker’s performance.
Financial control addresses facts surrounding the financial aspects of the job such as whether the worker is reimbursed for business expenses; invests in the work by paying for facilities, equipment and/or advertising; makes services available to others and does not work exclusively for the employer; is paid a wage or salary as opposed to a flat fee or commission for the job; and has an opportunity to make a profit or loss.
Consideration of the type of relationship includes whether written contracts or other writings describe the relationship, whether the business provides benefits such as health insurance or vacation pay, the permanency of the relationship (a relationship which continues indefinitely rather than for the duration of a specific project or time period is generally considered evidence of an employer-employee relationship), and the extent to which services performed by the worker are fundamentally intertwined with the regular business of the company. If a worker provides services that are integral to the core business activity of the employer, it is more likely that an employer will direct and control the worker’s activities and the relationship will not be deemed independent.
Businesses must weigh all of these factors when determining whether a worker should be classified as an employee or an independent contractor. Some factors may weigh in favor of finding an employee relationship, while other factors indicate that the worker is an independent contractor. All factors must be considered and weighed with the overriding consideration being the degree or extent of the employer’s right to direct and control the worker’s daily activities.
State Laws Have Varying Tests for Classifying Employees
Complicating matters is the fact that state laws have varying tests for distinguishing independent contractors from employees. For example, in Illinois, the weight given to various factors changes depending upon whether the relationship is analyzed under the Illinois Workers’ Compensation Act, the Illinois Unemployment Insurance Act, or the Illinois Minimum Wage Law. The workers’ compensation analysis applies a common law approach developed by the state courts which emphasizes the employer’s right to control, but considers other specific factors such as the degree of supervision exercised by the employer, the nature of the work as it relates to the employer’s core business, and whether the employer provides the tools, material and/or equipment. In contrast to this common law approach, the Illinois Unemployment Act sets forth a three-part test to determine an individual’s status and requires that an employer prove all three to establish that an individual is not eligible for unemployment compensation. There are regulations which address additional factors to consider when making this determination. The Illinois Department of Labor uses another test to determine eligibility under the state’s Minimum Wage Law. The department’s regulations set forth six factors to consider. Furthermore, on January 1, 2008, the Illinois legislature added yet another test to the mix by enacting the Employee Classification Act (ECA) to prevent misclassification of employees as independent contractors in the construction industry. The ECA follows an analysis similar to the approach under the Illinois Unemployment Act by creating a presumption of employee status and requiring the contractor to overcome that presumption by showing that each of three factors are met – the so-called “ABC” test.2
Notably, in the recent case where a federal judge in Indiana certified 19 separate classes of current and former FedEx ground delivery drivers in as many states, the judge denied class certification in Illinois, Massachusetts and Michigan based upon state laws that give workers a rebuttable presumption that they are employees and place the burden on employers to demonstrate that a worker is not an employee. In those states, the judge said that FedEx has a right to present evidence and testimony on a driver-by-driver basis so a determination can be made as to whether the drivers were employees or contractors. In several other states in which class certification was denied, such as Missouri and Virginia, the judge relied upon case law that requires a particularized analysis beyond FedEx’s policies and the operating agreements between FedEx and the drivers.
Is Your Company in Compliance?
Businesses have an incentive to seek to save costs by classifying individuals as independent contractors. But now that the U.S. Department of Labor and the states are focusing on the classification issue, not to mention the class action lawyers, businesses have to seriously consider whether workers are being properly classified. Companies dependent upon “independent contractors” may need to restructure their business model or business relationships to minimize the risk of lawsuits and government investigations. The switch from independent contractor to employee presents many of the same challenges as the painful switch many employers endure in re-classifying employees from exempt to non-exempt status for purposes of paying overtime wages.
For more information, email Steven L. Gillman at steven.gillman@hklaw.com or call toll free, 1.888.688.8500.
1 See Department of Treasury Internal Revenue Service Publication 15-A, “Employer’s Supplemental Tax Guide” (2008), for a more complete description of the IRS test.
2 See Poulos, Binetti, and Reiter, Jr., “Employees or Independent Contractors? A New Test for the Construction Industry,” Illinois Bar Journal, p. 206 (April 2008), for a more complete description of tests used in Illinois.