1099/Independent Contractor Misclassification: The Development and Rise of the Department of Labor’s “Economic Realities Test”

by Brandon Pavley, Legal Counsel and Compliance Associate at HireGenics


Introduction

In a contingent workforce arena, the proper classification of a worker as an “employee” or an “independent contractor” (“IC”) is critical for purposes of determining whether various employment laws apply to an end customer.  However, because of the circular or largely unhelpful definitions of “employ”, “employer” and “employee” found in these laws – e.g., the Fair Labor Standards Act (“FLSA”) defines “employee” as “any individual employed by an employer” – judges and governmental agencies have attempted to clarify the definitions or even provide their own definitions and standards.  The outcome has been a mixed bag and a source of frustration for many employers, especially those in the indirect workforce industry.

Traditionally – dating from the mid-1930s through present – when challenged with making the determination of whether a worker should be classified as an “employee” or an “independent contractor,” courts used the common law agency test (commonly referred to as the “right-to-control test”).  Under the right-to-control test, courts assess the degree of control an end customer exercises over how and when an IC performs his or her work.  If the end customer is deemed to exercise too much control over the how and when, then the IC would be reclassified as an “employee” of the end customer for purposes of various employment laws.  However, in response to the creation of the FLSA, the United States Department of Labor (“DOL”) recognized a need to evolve the standards of the right-to-control test.  Ultimately, a federal court from Kentucky, in Walling v. Woodbine Coal Co.,[1] agreed with the DOL and determined that the right-to-control standard was not comprehensive enough for IC’s to be classified as an “employee” and accepted the DOL’s proposed standard known as the “economic realities test”. The economic realities test broadened the right-to-control test by not only considering the degree of control that the end customer exercises, but also takes into account the degree to which the IC’s are economically dependent on the end customer.

The Economic Reality Factors

Courts take a holistic approach to the economic realities test: no single factor is dispositive.  Following are the six factors courts generally consider:

  1. The extent to which the work performed is an integral part of the employer’s business;
  2. Whether the worker’s managerial skills affect his or her opportunity for profit and loss;
  3. The relative investments in facilities and equipment by the worker and the employer;
  4. The worker’s skill and initiative;
  5. The permanency of the worker’s relationship with the employer; and
  6. The nature and degree of control by the employer.[2]

The first five factors analyze the degree of economic independence, both in terms of decision-making and in actual terms, into the classification process.  The last factor encompasses the traditional right-to-control test.

The economic realities test does not consider the agreement/contract between the parties a factor when determining worker classification. A misconception is that the agreement/contract governing their relationship is an end-all-be-all determination of the status of their working relationship.  In fact, the DOL stated that an agreement “[i]s not controlling because the reality of the working relationship – and not the label given to the relationship in an agreement – is determinative.”[3] Thus, the DOL has taken the position that the actual working relationship is more important than the contract details describing that relationship.

Scope of the Economic Realities Test

Since Walling, the economic realities test has been applied to numerous statutes – e.g., FLSA, Family Medical Leave Act (“FMLA”), Title VII of the Civil Rights Act (“Title VII”), Age Discrimination in Employment Act (“ADEA”), Americans with Disabilities Act (“ADA”), and the Worker Adjustment and Retraining Notification Act (“WARN”) – even though it was implemented by the DOL for purposes of the FLSA.  The principal reason for this broad application of the test is because the definition of “employee” in the FLSA is the same or similar to those other employment statutes.  Further, Congress referred to the definitions of the FLSA in other statutes, e.g., the definition of “employee” within the definitions section of the FMLA states, “Employee has the meaning given the same term as defined in section 3(e) of the Fair Labor Standards Act…”; therefore, courts use the same economic realities test when determining “employee” status.

Following is a non-exhaustive list of common worker claims to which courts have applied the economic realities test to determine whether the worker is properly classified as an IC:

  1. Claims for overtime under the FLSA;
  2. FMLA violations such as denying proper leave or employment disciplinary action for using FMLA time;
  3. Race discrimination claims under Title VII;
  4. Age discrimination under the ADEA;
  5. Job discrimination against persons with disabilities under the ADA; and
  6. Improper notice of a mass layoff under WARN.

Modern-Day Importance of the Economic Realities Test

In 2000, the DOL commissioned a study to determine the extent of misclassification in the Unemployment Insurance (“UI”) system and found, in relevant part: (1) up to 30 percent of audited firms had misclassified employees as independent contractors; (2) states lost nearly $200 million in UI tax revenue per year throughout the 1990s; and (3) roughly 80,000 workers lost UI benefits annually.[4]   In addition, the Congressional Research Service estimates that changes in misclassification laws could yield $8.71 billion in back taxes by the year 2021.

Because of the staggering misclassification numbers, the DOL, with the support of Vice President Biden’s Middle Class Task Force, launched a “Misclassification Initiative” to combat the use of misclassified workers. Further, in September 2011 former Secretary of Labor Hilda L. Solis announced the signing of a Memorandum of Understanding (“MOU”) between the DOL and the IRS. Under this agreement, the agencies will work together and share information to reduce the incidence of misclassification of employees, to help reduce the tax gap, and to improve compliance with federal labor laws.[5]  In 2012 and 2013, after hiring 300 additional investigators, the DOL collected more than $18.2 million in back wages on behalf of 19,000 misclassified employees.[6]

In addition, Labor Commissioners and other agency leaders representing at least 20 states have signed MOUs with the DOL in order to reduce the amount of employee misclassification. These MOUs enable the DOL to share information and to coordinate enforcement efforts with participating states in order to ensure that employees receive the protections to which they are entitled under federal and state law.[7] With the aggressive DOL efforts to combat misclassification – and as more states sign MOUs – the economic realities test will be increasingly applied.

Conclusion

The economic realities test is broadly applied and considers more than just an employer’s “right-to-control” a worker.  As enforcement efforts continue to rise on the state and federal level, end customers should ensure that they are testing for compliance with the economic realities test or that their 1099/IC compliance vendor is doing so.


[1] 64 F. Supp. 82 (E.D. Ky. 1945).

[2] See DOL Fact Sheet 13 found at http://www.dol.gov/whd/regs/compliance/whdfs13.pdf

[3] Ibid.

[4] “Misclassification of Employees as Independent Contractors, Fact Sheet 2014.” Department for Professional Employees, AFL-CIO. Retrieved from http://dpeaflcio.org/programs-publications/issue-fact-sheets/misclassification-of-employees-as-independent-contractors/#_edn22.

[5] “Employee Misclassification as Independent Contractors.” Wage and Hour Division, the United States Department of Labor, 2015. Retrieved from http://www.dol.gov/whd/workers/misclassification/#stateDetails

[6] “Misclassification of Employees as Independent Contractors, Fact Sheet 2014.” Department for Professional Employees, AFL-CIO. Retrieved from http://dpeaflcio.org/programs-publications/issue-fact-sheets/misclassification-of-employees-as-independent-contractors/#_edn22 citing “How some employers skirt paying benefits.” CBS News, December 2, 2011. Retrieved from http://www.cbsnews.com/8301-500202_162-57335427/how-some-employers-skirt-paying-benefits/ – See more at: http://dpeaflcio.org/programs-publications/issue-fact-sheets/misclassification-of-employees-as-independent-contractors/#_edn39

[7] “Employee Misclassification as Independent Contractors.” Wage and Hour Division, the United States Department of Labor, 2015. Retrieved from http://www.dol.gov/whd/workers/misclassification/#stateDetails.


Legal Disclaimer – The contents of this article are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.

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