Employers Facing Increased Scrutiny over Worker Classification

by Robert C. Nagle

Employers can expect increased enforcement efforts from federal and state labor and tax authorities over what’s believed to be a rising tide of misclassification of employees as “independent contractors.”

There can be significant payroll savings associated with classifying workers as contractors. For example, employers typically aren’t required to withhold or pay taxes for contractors, make state unemployment fund contributions or pay workers’ compensation premiums on their behalf, or include them in their employee benefits plans.

Moreover, independent contractors often don’t fall within the ambit of various employment laws, including Title VII of the Civil Rights Act of 1964, the Fair Labor Standards Act (FLSA), and state wage and hour laws.

The danger is that many employees are misclassified as independent contractors, but they don’t meet the legal tests to qualify as nonemployees. While this practice has gone on for many years, governments hungry for revenue and creative attorneys who recognize the considerable potential of such claims are actively targeting employers that misclassify workers.

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Increased scrutiny at federal and state levels
The federal government has several reasons to be concerned about worker misclassification. First, employers generally don’t pay or withhold federal payroll taxes, including social security (FICA) taxes and unemployment (FUTA) taxes, from contractors. Instead, the burden is on the putative contractor to pay the full amount, and it’s more difficult for the IRS to police FICA and FUTA compliance by the millions of workers classified as contractors.

In addition, the U.S. Department of Labor (DOL) is charged with enforcing the FLSA, which requires most employers to pay a minimum wage and overtime to employees, but not contractors. From the perspective of the DOL, labor groups, and many employers, companies that fail to comply with the FLSA’s minimum wage and overtime requirements derive an unfair advantage over employers that comply with their obligations.

In view of those concerns, President Barack Obama has announced a proposed 2011 budget that includes a $25 million allocation for a DOL “Misclassification Initiative” targeting employers that misclassify workers as independent contractors rather than employees. The initiative includes the DOL’s hiring of 100 additional enforcement personnel and the introduction of competitive grants to boost the states’ incentive and capacity to address misclassification. The initiative follows a joint proposal by the DOL and the U.S. Treasury to enhance both agencies’ ability to penalize employers that misclassify employees as independent contractors and eliminate incentives to continue doing so.

The proposal follows Senator John Kerry’s (D-Massachusetts) December 2009 introduction of the Taxpayer Responsibility, Accountability, and Consistency Act of 2009, intended to increase penalties for filing incorrect employment tax information on tax returns. The Act includes an increase from $50 to $250 per occurrence, with the cap on penalties per year increasing from $250,000 to $3 million. More recently, Senator Sherrod Brown (D-Ohio) and Representative Lynn Woolsey (D-California) introduced the Employee Misclassification Prevention Act, which would amend the FLSA to require employers to keep records of nonemployees who perform labor or services for remuneration and penalize employers that misclassify workers as nonemployees.

Additionally, the IRS has announced an initiative to audit some 6,000 employers over the next three years in industries deemed to have a high rate of employee misclassification, including home health care, construction, food services, and manufacturing.

State governments are enacting new laws to crack down on worker misclassification as well. In 2009, Delaware and Maryland passed laws imposing new penalties on employers that knowingly misclassify workers as independent contractors. Similar legislation has been introduced in Pennsylvania to address misclassification of construction workers.

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Complex legal analysis
While some lawmakers and labor groups like to attack employers that misclassify workers as unscrupulous or “greedy,” in reality employers are faced with a complex patchwork of laws that determine whether a worker is an employee or a contractor. Merely designating a worker as a “contractor” or papering the relationship with a “contractor agreement” isn’t sufficient.

Instead, courts and government agencies apply a variety of legal “tests” to determine whether someone is a contractor or employee. A common thread among these tests is the degree to which the employer exercises control of the worker’s performance of work. However, there are nuances that vary from state to state, and sometimes even within a state, depending on the specific subject.

At the federal level, different tests are used for different purposes. For example, the Third U.S. Circuit Court of Appeals, which covers Pennsylvania, New Jersey, Delaware, and the U.S. Virgin Islands, applies one test for determining whether someone is an employee under Title VII and another test under the FLSA. Finally, the IRS has developed its own 20-factor test for distinguishing between contractors and employees.

Learn more about wage laws and correctly classifying workers in the Wage and Hour Compliance Manual

What’s an employer to do?
Employers that misclassify workers as independent contractors face numerous consequences, including federal and state agency audits and enforcement actions, claims by individual employees, and possibly even class-action lawsuits. Employers found to have misclassified workers also face potential liability for:

• minimum wage and overtime premiums;
• unpaid Medicare and social security contributions;
• unpaid workers’ comp premiums;
• unpaid unemployment compensation contributions;
• pension payments or 401(k) plan contributions;
• medical benefits;
• stock options; and
• related penalties and interest.

In the current economic climate, with increased scrutiny of independent contractor classification, this is a good time to review your worker classifications. Performing such a review now could reduce the risk of a full-blown audit and costly penalties if you’re found to have misclassified employees as independent contractors.

State-by-state comparison of 50 employment laws in all 50 states, including wage laws