Independent Contractors: Overcoming the Legal Perils and Challenges

Independent Contractors: Overcoming the
Legal Perils and Challenges
October 17, 2013
Presenters

Moderator

Thomas F. Hurka
Morgan, Lewis & Bockius LLP

Heidi Winzeler
Practical Law Company

Craig A. Bitman
Morgan, Lewis & Bockius LLP

1

Agenda
 Tests Used to Determine Employee vs.
Independent Contractor
 Laws and Obligations that May be Implicated
and Risks in Misclassifying Individuals
 Litigation Trends
 Government Initiatives/Enforcement
 Recommendations for Reducing Risk

2

PART I:
Tests Used to Determine
Employee vs. Independent
Contractor

3

Classification Criteria:
Employee or Independent Contractor
 Different tests used, and must know each one to
consider how to manage contractors and staffing
agencies:





4

Common Law Test: ―Control/Right of Control‖
IRS Three-Factor Test
Economic Reality Test
―ABC‖ Test

The “Right to Control” Test
 Many statutes and regulations based on ―right to
control‖ test
 Question whether employer exercises ―control‖ or has
the ―right to control‖ the individual’s performance of
the job and how the individual accomplishes the job

5

(continued)

 Although the factors may vary slightly depending on
jurisdiction, the following are the typical factors
considered by courts under this test (none of which is
dispositive):
 Degree of ―employer‖ control
 Whether the individual’s business is a distinct occupation
or business
 Whether the individual’s occupation is usually done
without supervision
 Whether a high level of skill is required

6

(continued)

 Whether the worker provides the supplies, tools,
and place of work
 Length of time the services are provided
 Method of payment, e.g., by the job rather than
the hour or day
 Whether the work is part of the regular business of
the ―employer‖
 Whether the parties intend to create an
independent contractor relationship
 Whether the ―employer‖ is engaged in a business
enterprise
7

IRS Three-Factor Test
 For audit purposes, IRS auditors use a modified
version of the 20-Factor Test that focuses on three
factors:
 Behavioral control factors
 Financial control factors
 Relationship of the parties factors

 The IRS Three-Factor Test considers the work that is
being performed and the business context in which it
is being performed

8

 Used by DOL and courts for Title VII, ADEA, ADA,
FLSA, and FMLA
 Primarily examines:
 the extent to which the services rendered are an integral
part of the ―employer’s‖ business
 the permanency of the relationship
 the amount of the worker’s investment in facilities and
equipment

9

(continued)

 Primarily examines:
 the nature and degree of control by the ―employer‖
 the worker’s opportunities for profit and loss
 the amount of initiative, judgment, or foresight in openmarket competition with others required for the success
of the claimed IC
 the degree of independent business organization and
operation.

10

ABC Test
 Used in a growing number of states
 Creates a presumption of employee status for
purposes of wage and hour laws
 Employers have the burden of overcoming the
presumption
 Test is difficult to meet if workers are providing
services that are within the company’s usual
course of business

11

ABC Test
(continued)

 This stringent state law test creates a presumption of
employee status for purposes of wage and hour laws,
unless all of the following are true:
 (A) the worker is free from the company’s control and
direction in performing the service, both under a
contract and in fact
 (B) the service provided by the worker is outside the
employer’s usual course of business
 (C) the worker is customarily engaged in an
independent trade, occupation, profession, or
business of the same type

12

What Standard Is Applied
Under the NLRA?
 Common law of agency: NLRB v. United
Insurance Co. of America, 390 U.S. 254 (1968)
 ―All of the incidents of the relationship must be assessed
and weighed with no one factor being decisive‖
 Analysis involves ―no special administrative expertise‖
 Court deference to Board’s choice between ―two fairly
conflicting views‖

13

Current NLRB Standard
 Restatement (Second) of Agency 220(2)
 Examination of all factors, not just ―right of control.‖
Roadway Package System, 326 NLRB 842 (1998);
Dial-A-Mattress, 326 NLRB 884 (1998)
 Recent focus on ―entrepreneurial opportunity for gain
or loss.‖ FedEx Home Delivery v. NLRB, 563 F.3d 492
(D.C. Cir. 2009) (D.C. Circuit vacated NLRB Order and
found drivers to be independent contractors)

14

What Standard Is Actually Being
Applied by the Obama Board?
 Focus on ―economic dependence‖ or ―economic
realities‖
 Former Chairperson Liebman’s dissent in St. Joseph
News-Press, 345 NLRB 474 (2005):
 ―[I]t is entirely appropriate to examine the economic
relationship … to determine whether the carriers are
economically independent business people, or substantially
dependent on the Respondent for their livelihood‖

 Argues that increasing use of ―contract labor‖ and other
―nontraditional‖ relationships ―makes the question of labor law
coverage worthy of a fresh evaluation‖

15

Joint Employer Standard Under NLRA
 Whether two (or more) entities ―share or codetermine
those matters governing essential terms and
conditions of employment‖. Did the ―non-employer‖
exercise actual or ―de facto‖ control over:






Hiring
Firing
Discipline
Supervision/Direction
Wages, benefits, working hours, overtime

 High Risk in WARN situations

16

PART II: Laws and Obligations
that May be Implicated and
Risks in Misclassifying
Individuals

17

Downside Risks
 Misclassification carries significant risks and potential
exposure:
 Multimillion-dollar wage and hour and other employment
claims
 Liability for payroll taxes subject to withholding from
―wages‖
 State unemployment insurance payments
 Workers’ compensation insurance premiums (and
potential liability for workplace injuries)

18

Downside Risks
(continued)

 Misclassification carries significant risks and potential
exposure to:
 Immigration issues, attorney general suits
 Eligibility for benefits under existing employee benefit
plans

19

Joint Employer Status Risk
 Independent contractors are found to be employees
or co-employees
 Potential liability under employment-related laws,
including for discrimination, harassment, and wage
and hour issues
 Potential liability for wrongful acts of outside vendors
or independent contractors against a company
employee (e.g., discrimination)
 Potential liability for unpaid overtime, vacation,
medical leave, and other wages

20

Wage and Hour–Related Risks
 Failure to pay applicable minimum wage or overtime
 High-stakes civil litigation – class actions, double
damages, long statute of limitations periods, attorneys’
fees

 Violation of laws concerning meal and rest breaks,
deductions from wages, reimbursement for business
expenses
 Corporate officers may be individually liable

21

Employee Benefit Plan–Related
Liability/ERISA
 Vizcaino v. Microsoft (9th Cir. 1997) charted course
for exclusion of misclassified workers from ERISAgoverned plans
 Plan sponsors tightened language to exclude contractors
 Prototype pension plans usually contain the right
language

 Welfare plans (life insurance, long-term disability,
etc.) often prepared with less care to plan sponsor
liability

22

Select Benefits Issues
 Watch the 1,000-hour rule - generally individuals with
the status of common law employees need to either
be eligible for retirement plans after they work 1,000
hours or have limited tenure
 Non-discrimination testing
 PPACA Requirements
 Transitioning employees to IC status
 Separation from service issues
• Pension
• 401(k)
• Deferred and equity compensation

23

Independent Contractor Status
and Tax Consideration
 Statutory liability in ―worst case‖ scenario equal to at
least 40% of payment—









24

25% Federal Income Tax Withholding exposure
7.65% Employer FICA
7.65% Employee FICA
FUTA tax exposure
Information reporting penalties
Negligence —potential 20% penalty
Failure to deposit
Interest

Independent Contractor Status
and Tax Considerations
 IRS is inherently skeptical of independent contractor
relationships
 Understand the relief provisions and programs (e.g.,
Code Section 530, IRS Classification Settlement
Program)
 Retroactive tax liability for failure to withhold income
and FICA taxes

25

Immigration Risks
 Increased enforcement by U.S. Immigration and
Customs Enforcement (ICE) of laws governing the
hiring of undocumented workers
 Unlawful to hire a foreign national not authorized to be
employed in the United States – I.N.A. § 274A(a)(1)

 Forms I-9 must be used for all new employees
 Criminal or civil penalties can be imposed

26

Additional Risks
 Discrimination: Liability for discriminatory acts of
outside agency as a joint employer
 Traditional Labor: Employees can engage in
―concerted activity‖ and can organize to have unions
 Trade Secrets/Confidential Information

27

PART III: Litigation Trends

28

Litigation Trends
 Class actions are common because misclassification
seldom limited to one or two people
 Exposure for back wages, overtime, Social Security,
deductions, and penalties for breaks and failing to
keep ―employee‖ records, etc.
 Benefits, workers’ compensation, unemployment
 Depending on the particular state, can be liable for up
to six years

29

Litigation Trends
(continued)







30

Company practices are often difficult to defend
Low bar for certification
Written agreement is not controlling
Employees have minimal burden of proving damages
Courts and governmental agencies tend to be
suspicious of classification

PART IV: Government
Initiatives/Enforcement

31

Government Initiatives: Proposed
Federal Legislation






32

S. 2004 (110th): Independent Contractor Proper
Classification Act of 2007 (Failed)–requires employers to treat
workers misclassified as independent contractors as employees for
employment tax purposes upon determination of misclassification
H.R. 3408 (111th): Taxpayer Responsibility, Accountability,
and Consistency Act of 2009 (Failed)–allows independent
contractors to petition IRS for a determination of classification,
and increases penalties for misclassification
S. 3254 (111th): Employee Misclassification Prevention Act
of 2010 (Failed)–requires recordkeeping for independent
contractors and imposes penalties for misclassification

Government Initiatives: Proposed
Federal Legislation
(continued)









33

H.R. 3178 (112th): Employee Misclassification Prevention Act
(Referred to Committee)–requires recordkeeping for independent
contractors and imposes penalties for misclassification
S. 770 (112th): Payroll Fraud Prevention Act (Referred to
Committee)–requires notice to independent contractors of basis for
classification and creates penalties for misclassification
H.R. 4123 (112th): Fair Playing Field Act of 2012 (Referred to
Committee)–eliminates Section 530 of the Revenue Act of 1978 (the
―safe harbor‖), which businesses rely upon to justify contractor status
H.R. 6643 (112th): Independent Contractor Tax Fairness and
Simplification Act of 2012 (Referred to Committee) –would codify
Section 530 in a new code section and create a broader safe harbor that
applies to federal and income taxes and applies to the business receiving
the services, the individual and the service provider

Government Initiatives: State
Legislation
 State activity is increasing
 CA and NY stepping up enforcement efforts
 20+ states have enacted or are considering laws and/or
have task forces
 Increased penalty legislation in several states (e.g., CT,
NE, NY)

 Financial pressure will force more state action

34

Government Initiatives: California
Willful Misclassification Act, SB 459
 Prohibits persons and employers from engaging in
willful misclassification and charging certain expenses
to contractors (or making deductions) if forbidden for
employees
 $5,000-$25,000 penalty misclassification
 Must post content of Act in the workplace

35

Government Initiatives: DOL
 DOL and IRS sharing information on audits
 ―Plan/Prevent/Protect‖ Program
 Wage and Hour Division (WHD) proposed ―Right to
Know‖ regulation increasing transparency and disclosure
to workers
 WHD has not yet announced any regulations
 The DOL plans to conduct a 30 months survey of
employees on their understanding of worker
misclassification laws. This may suggest the agency is
moving forward on the right-to-know regulations it
announced in 2010

 WHD continues to take aggressive positions regarding
contractor status
36

Government Initiatives: DOL
(continued)

 WHD has requested 14 million dollars to investigate
and combat misclassification of workers as
independent contractors
 $3.8 million to investigate misclassification
 $10 million for Employment Training & Administration
(ETA) grants to states to identify misclassification and
recover any unpaid taxes within the unemployed
insurance

37

Government Initiatives: IRS
 IRS Employment Tax National Research Program
(NRP)
 Targeting misclassification with goals to
 (i) close the tax gap
 (ii) study trends in compliance/noncompliance
 (iii) increase future compliance

 IRS conducting payroll tax audits to determine
employee misclassification

38

Information-Sharing Programs:
IRS/DOL Memorandum of
Understanding
 IRS/DOL joint initiative to improve classification
compliance
 DOL to refer to IRS any wage and hour investigation
information ―and other data‖ that DOL believes raise
employment tax misclassification compliance issues
 IRS to share DOL employment tax referrals with state
and municipal taxing agencies under existing sharing
agreements
 Currently, 14 states have signed memoranda of
understanding with IRS and DOL regarding employee
misclassification
39

Information-Sharing Programs:
IRS/State Programs
 State Information-Sharing Program
 The IRS/state information-sharing program facilitates
and expands joint tax administration relationships
between IRS and state authorities
 The shared information includes
 Audit results
 Individual and business tax return information
 Employment tax information

40

PART IV: Recommendations
for Reducing Risk

41

Best Practices for Structuring the
Independent Contractor Relationship
 Allow independent contractors to determine how,
when, and where work will be performed
 Manage only results, not methods
 Avoid treating employees and independent
contractors the same
 Avoid training
 Arrange for independent contractors to use their own
tools, equipment and resources
 Off-site work preferable
 Limit duration of independent contractor relationship
42

(continued)

 Avoid retaining former employees as independent
contractors/contingent workers
 Do not allow independent contractors to perform core
business functions
 Limit building access to where work performed
 Only provide policies that relate to their status as
independent contractors (harassment, workplace violence,
security, confidential information, insider trading)
 If feasible, workers should be physically separated from the
company employees
 Issue 1099s to independent contractors
43

(continued)

 Do not discipline and/or terminate workers except
under the terms of the contract
 The company should not grant awards, bonuses, or
―annual raises‖ to nonemployee workers
 No formal or informal performance reviews
 Allow subcontracting or independent contractor’s own
employees
 Workers should not hold themselves out as company
employees (e.g., cards and email addresses)

44

(continued)



Do not treat identical or substantially similar workers differently
(i.e., some as employees and others as ICs)



Obtain services from ICs who have incorporated or who are provided
by third parties



Avoid audit red flags - do not issue Forms W-2 and Forms 1099MISC to the same worker in the same year



Ensure ICs remain current on their payroll taxes (consider obtaining
Forms 4669 or similar statements from ICs)



Adopt and implement standardized IC contract language



45

Neutralize employee benefit risks associated with disgruntled ICs
•
Use proper IC contractor language
•
Add ―Microsoft language‖ to all plans—qualified plans,
nonqualified plans, fringe programs, etc.

(continued)

 Review definition of ―covered employee‖ in benefit
plan documents
 Benefit plans should exclude workers who are not receiving
Forms W-2 from the plan sponsor
 Amend plans to add ―Microsoft language‖
• Paid from accounts payable
• Workers ineligible for benefits even if the worker is subsequently reclassified
as an employee
• Reclassification will not be done on a retroactive basis

 Review employee communications (including handbooks and
benefits websites) to ensure documentation accurately
describes the categories of eligible individuals

46

Self-Assessment to Avoid Risks of
Employee Misclassification
 Perform regular internal audits to ensure proper
classification
 Review what is actually occurring in the relationship
 Update, review, and limit the tenure of independent
contractors
 Consider cost/benefit of alternative arrangements
(short-term employment)
 Review agreements and relationships with
vendors/staffing agencies providing contingent
workers to ensure compliance with relevant laws
47

Voluntary Classification Settlement
Program
 The Voluntary Classification Settlement Program
(VCSP) seeks to encourage prospective worker
reclassification
 VCSP is an alternative to the Classification Settlement
Program, which only applies to taxpayers actually
under audit
 Under the VCSP, there is no IRS audit in exchange
for:
 A taxpayer’s agreement to treat a class of workers as
employees for future tax periods for payroll tax
purposes, and
 A payment of 10% of the Section 3509 rates
48

Suggested Points for Independent
Contractor Agreements
 Suggested points to address in independent
contractor agreements to reduce risk of employee
misclassification:
 Contractors and subcontractors have specialized skills
 Vendor does not supply workers exclusively for the
company and workers are free (or contractor is free) to
work for other firms
 The company does not hire or supervise or have control
over independent contractors or subcontractors’
employees

49

(continued)

 More suggested points to address in independent
misclassification:
 The company does not provide employee benefits; or,
specify that independent contractors waive employer’s
coverage
 The company does not maintain or have access to
independent contractors’ or subcontractors’ payroll,
time, or other records
 Require the independent contractor or subcontractor to
comply with all wage and hour and wage payment laws
as well as federal, state, and local taxes
50

(continued)

 More suggested points to address in independent
misclassification:
 Broaden and strengthen indemnification provisions in
agreements
 Require that independent contractors and subcontractors
require workers to sign confidentiality agreements
specific to temporary work
 Independent contractors and subcontractors should pay
for and control background checks for their own
employees
51

Related Resources
 Independent Contractor Classification
 Using Independent Contractors and Outside Firms:
Avoiding Employee Misclassification Checklist

 Independent Contractor/Consultant Agreement (Proclient)
 Independent Contractors: State Q&A Tool

52

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