Independent Contractor Compliance: Why Is It So Complicated?

By: Brandon Pavley
Edited by: Mark Zisholtz


The Problem

By statute or rule, all workers default to the classification of “employee.” If you want to be an independent contractor (“IC”) , that means you face an uphill climb. Taxing agencies earn more revenue from employees (as opposed to independent contractors); the Department of Labor and its rules (e.g., overtime rules) generally apply to employees, not independent contractors; independent contractors are not covered by the National Labor Relations Act, thus employers can, at least according to the AFL-CIO, “thwart union organizing or dilute bargaining units by misclassifying workers [as independent contractors].” The list of reasons governmental agencies, judges, employee interest groups/unions, and investigators want a worker to be classified as an “employee” are seemingly endless.

It is not surprising the definitions of an “employee” enacted by law makers are very broad. Probably the most notorious (and circular!) definition of an “employee” is applied to statutes like Title VII of the Civil Rights Act of 1964, which is an anti-discrimination statute commonly invoked by plaintiffs in the employment setting. Title VII defines an “employee” as “an individual employed by an employer.” That definition is very broad and, to put it nicely, essentially useless. In other words, if an individual is technically “employed by an employer” – whatever that means… — then the anti-discrimination protections of Title VII apply to protect that individual.

In response to worker and business complaints about the lack of clarity, various Federal and State governmental agencies promulgated rules, and governors signed into law, statutes attempting to more clearly define an independent contractor. Unfortunately, none of those statutes or rules contain bright line tests, but instead contain a list of factors, ranging anywhere from 3 to 20 factors with countless interpretations of those factors and countless additional sub factors. For example, the Department of Labor issued a 6 factor “Economic Realities” test to determine whether a worker is a bona fide independent contractor for purposes of the Fair Labor Standards Act. The 6th factor – “The nature and degree of control by the employer” – described by the DOL as “a complex factor,” can include 50 or more different sub factors, depending on the circumstances, e.g., who sets pay amounts and work hours?, who determines how the work is performed?, who determines the sequence of the work?, is the worker free to work for others and hire helpers? These are just some of the sub factors. The point is that independent contractor compliance seems more daunting now than it has ever before, and neither legislators nor regulators have helped clarify the issues.

It is also worth mentioning that due to the existence of numerous laws utilizing multiple tests with varying factors and sub factors, it is possible for an individual or entity to qualify as an IC under one test but not qualify as an IC under another test all the while assessing the same details surrounding the worker. This is especially important because the Internal Revenue Service (“IRS”) and the Department of Labor (“DOL”) entered into a Memorandum of Understanding (“MOU”) establishing enhanced information sharing and other collaborative activities (e.g., if the IRS receives information that an audit should commence within a business, the IRS will inform the DOL of the potential misclassification and allow for the DOL to commence its own audit). Thus, if a business passes an IRS audit, they are not in the clear until they also pass a different set of factors under a DOL audit. Additionally, all courts specifically denote that no set of established factors is determinative in and of itself and courts have left every test open-ended to allow for new factors on a case-by-case basis. Therefore, workers and businesses looking to get clarity on worker classification in the United States are left with hundreds of factor application scenarios and a large question mark floating over their head as it relates to qualification as a bona fide IC.

State Differentiators
Each state has its own employment laws and varying definitions of “employee” are enacted within those state laws. Two of the primary reasons an IC misclassification suit are filed are: (1) the worker files for unemployment insurance benefits at the end of their project, and (2) the worker files for workers’ compensation benefits if they are injured while on the job. Unfortunately, unemployment insurance and workers’ compensation benefits are reserved for “employees” only. Thus, when an independent contractor makes a claim for either benefit, this raises a red flag potentially triggering an audit. Mirroring the Federal chaos model, state courts and other state governing authorities followed suit and opted to use a variety of worker classification tests as opposed to a single set of standardized factors. Consequently, there are more than twelve classification tests in use by the states and more than one test is used for classification purposes in at least 43 of the 50 states. Therefore, a worker not only has to qualify as an IC under the Federal laws, but must also qualify under numerous state laws.

Why Is This So Important?

First, you need to understand that judges and regulators apply independent contractor compliance tests to multiple statutes. For example, let’s say a worker is not deemed compliant with the Federal common law independent contractor compliance test, (i.e., is not a bona fide independent contractor under the Federal Common law test). Potentially, that means that the worker will be protected by every statute which relies on the Federal common law test (in contrast, the same worker would not get any protection if he/she were a bona fide independent contractor). The following is a chart which illustrates the point:

Sampling of Federal Statutes that Have Been Applied by Judges to Various Federal Independent Contractor Compliance Tests
Common Law Agency Test (or an expanded version/ variation of the common law agency test)

 

§ Affordable Care Act

§ Federal Insurance Contributions Act

§ Federal Unemployment Tax Act

§ Income Tax Withholding

§ Employment Retirement and Income Security Act

§ National Labor Relations Act

§ Immigration Reform and Control Act

§ Copyright Act (and other intellectual property laws)

§ Title VII (& other federal anti-discrimination statutes) (“Title VII”)

§ Age Discrimination in Employment Act (“ADEA”)

§ Americans with Disabili­ties Act (“ADA”)

Department of Labor “Economic Realities” Test

 

§ Fair Labor Standards Act

§ ADA

§ Family and Medical Leave Act

§ Worker Adjustment and Retraining Notification Act

§ Title VII

§ ADEA

§ Social Security Act

“Hybrid” Test, i.e., a hybrid of multiple tests used by some judges

 

§ Title VII

§ ADEA

§ ADA

Second, you need to understand the repercussions for misclassifying an individual as an independent contractor (when, at least according to the judge or regulator, that individual should have been classified as an employee). The following is a list of factors to consider:

  • Unpaid Federal, state, and local income tax withholdings
  • Unpaid Social Security and Medicare contributions
  • Unpaid workers’ compensation and unemployment insurance premiums
  • Unpaid overtime compensation (including liquidated damages pursuant to a statutory double penalty provision)
  • Debarment from state contracts
  • Unpaid work-related expenses
  • Brand tarnishment/negative press
  • Liability for failure to provide coverage under employee benefit plans
  • Class action targets
  • Attorney’s fees and costs, including compulsory payment of plaintiff’s attorneys fees and costs

Third, you need to understand that governmental entities are entering into information sharing agreements. Thus, if the IRS finds you misclassified, it may share that information with the DOL, and vice versa. Further, nearly 2/3 of states have joined into the collaborative effort and signed MOUs in order to combat worker misclassification. In some cases, these agreements include the cooperation of the Employee Benefits Security Administration, Occupational Safety and Health Administration, Office of Federal Contract Compliance Programs, and the Office of the Solicitor.

Your Options to Solve the Problem

At a high level, you have 3 basic options:

#1: No IC policy, i.e., flat-out prohibition against using ICs
#2 Internally managed independent contractor program
#3: Externally managed independent contractor program

With Option #1, you have no IC misclassification risk. However, you lose access to a significant talent pool and flexibility in your contingent workforce strategy. Additionally, don’t forget that if you use payrollees or staffing, you still have joint employment compliance risk!

With Option #2, you have IC misclassification risk. This misclassification risk can be mitigated by a good compliance process, support from a well-informed legal team, and an increased cost structure (which can become cost neutral or even cost positive through a supplier funded program), while maintaining access to a significant talent pool and enhance the flexibility of your contingent workforce strategy.

With Option #3, the analysis is the same as #2 except you can mitigate (or even eliminate) your compliance risk through an indemnification clause and use of best practices.

With Options #2 and #3, you need to be wary of incremental increase in pay rates if you utilize a supplier funded model, (i.e., the IC may inflate their pay rate in order to cover the anticipated added cost of the markup from the external management company). However, you can control these increases through various methods, such as the use of a rate card or a strong negotiation process with a solid understanding of prevailing local market rates.

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