On April 22, a bill was introduced in Congress to make misclassification of
employees as independent contractors a federal labor law violation. The
Employee Misclassification Prevention Act (EMPA) would also impose
record-keeping and notice obligations upon companies and subject them to hefty
penalties for noncompliance with the proposed new law. Upon the likely
enactment of EMPA sometime this year, businesses will be confronted with an
anticipated onslaught of private actions by workers claiming they are misclassified
"employees" who have been improperly paid on an Internal Revenue
Service (IRS) Form 1099 basis.
Prior to the enactment of EMPA - and, to a lesser extent, prior to the date
when businesses will be required under EMPA to provide a mandatory notice to
their workers stating whether they have been classified as
"employees" or "non-employees" (six months following
enactment of the law) - there is a window of opportunity for companies to
enhance their compliance with existing and proposed laws governing independent
contractors. Three options for companies to minimize their exposure to
misclassification liability are bona fide restructuring of their relationships
with their independent contracts, reclassifying workers and choosing employee
leasing or other staffing options.
Under current law, companies are permitted to use independent contractors,
as long as such workers are not "employees" under existing tax,
employee benefit, and labor and employment laws. If independent contracts are
correctly classified, they may be paid on a Form 1099 basis without the
withholding or payment of any employee taxes, Federal Insurance Contributions
Act (FICA) allocations or unemployment or workers' compensation premiums. They
may also be excluded from participation in a company's employee benefit plans.
In contrast, employees misclassified as independent contractors under
current laws can lead to costly liabilities, even if the employees have been
mistakenly misclassified. For those companies whose business models rely on the
use of independent contractors, the potential costs of misclassification can be
extremely high. Risks include liability for years of unpaid federal, state and
local income tax withholdings; Social Security and Medicare contributions;
unpaid workers' compensation and unemployment insurance premiums; and unpaid
work-related expenses and overtime compensation. Another costly liability risk
arises when misclassified employees, who may be entitled to coverage under
employee benefit plans, have not been provided with health, pension and other
employee benefits.
Recent Enforcement Actions
The enactment of many state laws during the past two years regulating the
use of independent contractors has made misclassification an even greater
liability risk. Some new state laws severely limit the type of workers who may
qualify as independent contractors and impose extraordinarily high penalties
for misclassification of employees, including disbarment from state contracts
and loss of licenses to do business in the state.
The long-awaited EMPA bill recently introduced in Congress by both the House
and Senate would amend the federal Fair Labor Standards Act (FLSA) to make
misclassification a federal labor offense. Under current law, failure to
withhold or failure to file a W-2 is a federal offense, but not the
misclassification itself. The EMPA bill would also impose strict record-keeping
and notice requirements upon businesses with respect to workers treated as
independent contractors, expose such businesses to fines of $1,100 to $5,000
per employee for each violation of the law and double the liquidated damages
provisions under the FLSA.
The EMPA is one of two bills introduced in this legislative term that deals
with misclassification of employees. In 2009, both the House and Senate
introduced the Taxpayer Responsibility, Accountability, and Consistency (TRAC)
Act. If enacted, the TRAC Act would limit the availability of the so-called
"safe harbor" provisions relied upon by many businesses to designate
workers as independent contractors for federal employment tax purposes, afford
workers the right to petition the IRS for a determination of their status and
increase penalties upon companies for filing incorrect Form 1099s.
Businesses that use independent contractors have also been targeted by
plaintiffs' class action lawyers, focusing on companies that make use of
independent contractors as part of their business model. The lawsuits seek
damages for unpaid employee benefits such as medical and pension benefits, as
well as unpaid overtime and unreimbursed employee expenses.
Three Options for Employers
No states have outlawed the use of independent contractors, and the proposed
federal legislation continues to permit businesses to utilize independent
contractors - provided they are properly classified. Nonetheless, most lawyers
routinely advise businesses to reclassify their independent contractors as
employees to avoid the potential for misclassification liability. There are,
however, no fewer than three measures that businesses can take to minimize or
avoid the risk of future liability - and one of these allows companies to
maintain their business models that rely upon the use of independent
contractors. The three options are bona fide restructuring of the relationship
between a company and its independent contractors, employee leasing and
voluntary reclassification.
Most companies concerned about the potential for misclassification liability
recognize that their independent contractors probably fall within the
proverbial "gray area," presenting businesses with a real dilemma.
But rather than changing a successful business model, a company may wish to
consider undertaking a bona fide restructuring of its independent-contractor
relationships, using independent-contractor diagnostics to determine the extent
that restructuring of the independent-contractors position will minimize or
avoid future misclassification liability. As described below,
independent-contractor diagnostics refers to a process beginning with an
examination of whether the position would pass the applicable
independent-contractor tests under governing state and federal laws, using each
of the applicable 48 factors used by different decision-making bodies in
determining independent-contractor status.
A 2006 Government Accountability Office report addressing employee
misclassification stated that the tests used to determine whether a worker is
an independent contractor or an employee are "complex, subjective, and
differ from law to law." With the exception of a few state laws, most
tests used by the courts and administrative bodies are based in whole or large
part on whether the hiring party has the "right to control the manner and
means" by which the worker accomplishes the end product of his or her
work. For companies interested in maintaining their use of independent
contractors but eager to minimize or avoid future misclassification liability,
the first step in restructuring their independent-contractor relationships is
to consider what adjustments they are prepared to make to their present level
of control over the manner and means by which their independent contractors
accomplish their work.
At the end of the independent-contractor diagnostics process, the company's
degree of compliance with each of the applicable laws can be measured on an
"IC Compliance Scale." This process can provide a company with an
informed means by which to determine the extent that the restructuring
alternative may minimize or eliminate future misclassification liability.
If independent-contractor diagnostics indicate that the bona fide
restructuring option is a sound choice, the business can proceed with this
alternative and memorialize the bona fide restructuring in a modified
independent contractor agreement. Companies must ensure that the words used in
the independent-contractor agreement will be actually implemented in the field
and are not empty recitals, which the law disregards. Other steps may include
reviewing and revising company operating manuals and procedures,
documenting the implementation of certain of the provisions in the
independent-contractor agreement and putting safeguards in place to ensure that
actual business practices conform to the terms of the modified
independent-contractor agreement. If, however, independent-contractor
diagnostics suggest that, even with restructuring, the workers will not likely
pass the governing tests for determining independent-contractor status when
measured on the IC Compliance Scale, the business has at least two other
alternatives to avoid or minimize future risks of misclassification liability.
Although employee leasing or other staffing alternatives cannot completely
eliminate all potential liability for misclassification, the use of a
responsible and sophisticated staffing organization can dramatically reduce the
risk of such liability, as well as the likelihood of a lawsuit challenging the
classification of a group of workers paid on a 1099 basis. When an
employee-leasing organization hires some or all of a company's independent contractors
as their employees, the leasing company withholds income taxes, makes Medicare
and Social Security contributions, pays workers' compensation and unemployment
insurance premiums, provides an array of benefits to the former independent
contractors, including health insurance under a plan maintained by the leasing
company, and handles the employee relations of the leased employees.
Although use of an employee-leasing or -staffing company can substantially
lessen the risk of future misclassification liability if all legal
documentation and procedures are carefully observed, it is not a panacea. For
example, a business that contracts with an employee-leasing organization may
still need to account for the leased employees in the employer's benefit-plans
language and perform "nondiscrimination" testing required under the
Employee Retirement Income Security Act (ERISA).
If legislation at the federal level is enacted as expected, companies will
be obligated to notify all independent contractors that they have the right to
a governmental determination as to whether they have been properly classified
as an independent contractor. Voluntary reclassification is likely to be far
less painful and costly than being forced by a government agency or court to
reclassify in connection with an order to make payment of back taxes, unpaid
Social Security and Medicare contributions, and unpaid unemployment insurance
and workers' compensation premiums.
Reclassification, whether voluntary or compelled by a state or federal
agency or court, requires businesses to consider relevant federal and state
tax, employee-benefits and employment laws, and is labor intensive.
Reclassification, however, does not require that all workers previously
excluded from an employee-benefit plan must be included in the future.
Exclusions are permissible if the governing documentation for the company's
plans is drafted properly and the exclusion does not violate applicable tax or
ERISA rules.
There are a number of alternatives from which businesses can choose to
reduce or eliminate the risk of future misclassification liability. In view of
the current legislative, regulatory and judicial landscape, the only
unacceptable alternative is inaction.
The material in this
publication is based on laws, court decisions, administrative rulings, and
congressional materials, and should not be construed as legal advice or legal
opinions on specific facts. The information in this publication is not intended
to create, and the transmission and receipt of it does not constitute, a
lawyer-client relationship. Internal Revenue Service rules require that we
advise you that the tax advice, if any, contained in this publication was not
intended or written to be used by you, and cannot be used by you, for the
purposes of (i) avoiding penalties under the Internal Revenue Code or (ii)
promoting, marketing or recommending to another party any transaction or matter
addressed herein.
This article is
republished with permission of Pepper Hamilton, LLP. Further duplication
without the permission of Pepper Hamilton, LLP is prohibited. All rights
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