Employee or Independent Contractor? What the Law Says

Employers continually struggle over the question of whether their workers are independent contractors or employees, an issue that is the subject of extensive state and federal regulatory and enforcement efforts.

At the same time, employers are under increasing pressure to cut costs, and one way to do so is to reduce their regular work forces.

Advantage of Outside Workers

In addition to reducing employment costs, there are other incentives for using independent contractors. The advantages include:

* Minimizing the paperwork and administrative burdens associated with employees.

* Saving as much as 40% in benefit expenses.

* Avoiding employer-employee problems such as discipline decisions, performance evaluations, and discrimination and wrongful discharge lawsuits. Also avoided are wage-related taxes and overtime costs.

Danger in Misclassification

As for the downside of classifying workers as independent contractors, if the government and/or the courts determine that these contractors are in fact employees, an employer's economic exposure can be enormous.

Moreover, a contractor reclassified as an employee represents a potential claimant for unemployment compensation insurance premiums, workers compensation insurance, medical and pension benefits, and more - basically all the benefits traditionally accruing to employees.

Further, independent contractors are often privy to proprietary information and, due to the breadth and scope of their freedom, which often includes working for competitors, the security of such information may be jeopardized. Also, an outside worker injured on the job would not be covered by the business' workers' compensation insurance and may thus create issues as to liability for job-related injuries and illnesses.

Despite the risks involved, many employers have determined that the potential for significant savings is just too great to ignore.

The National Labor Relations Act, as amended, is the primary body of federal law governing labor-management relations in the private sector.

An employer violates the labor relations act when it refuses to bargain collectively with a union that represents a majority of its employees in an appropriate bargaining unit. Independent contractors are expressly exempt from the law's definition of "employee."

However, a question over an employee's status regarding the law's purposes may arise in situations involving unfair labor practice cases and union representation elections. In such cases the employer often argues that the workers at issue are not employees and are thus not covered by the National Labor Relations Act.

The Acid Test

Under the law, the "Right to Control Test" governs whether or not an individual is an employee. Importantly, it is the right to control rather than the actual exercise of control that is significant.

The right to control is determined by considering the following traditional principles of agency law:

* Whether the worker is engaged in a distinct occupation or business.

* Whether the work involved is usually done under an employer's discretion or by an unsupervised specialist.

* The degree of skill involved.

* Who supplies the instrumentalities, tools, materials, and place of performance.

* The length of employment.

* The method of payment (by the time or by the job).

* Whether the work is part of the employer's regular business and/or is necessary to it.

* The intent of the parties creating the relationship.

* The right to hire and fire.

* The identity of the party designating the time and place at which work is to be done.

The degree of employer supervision over the agent is perhaps the most important factor. Yet, the entire relationship must be assessed to determine the degree to which the individual has an independent entrepreneurial interest in the work.

The more extensive the supervision and the stricter the enforcement of standards, the greater the likelihood of an employer-employee relationship.

Generally, if an employer refuses to bargain in violation of the law, the National Labor Relations Board may issue an order directing the employer to negotiate on work issues with the employees in question.

If an employer fires an "employee" in violation of the law, that employer may be liable for reinstatement with back pay.

Another Set of Criteria

The Fair Labor Standards Act, as amended, governs minimum wages, overtime pay, employer record keeping, and child labor issues.

In determining whether an individual is an employee or an independent contractor under the Fair Labor Standards Act, federal courts and the U.S. Department of Labor apply what has been called the "Economic Reality Test." The following are the most commonly considered factors under this test:

* The degree to which the worker has the right to set goals and control how the work is conducted.

* The degree to which the employer determines the worker's opportunity for profit and loss.

* The degree of skill, training, and independent initiative required to perform the work.

* The permanency, exclusivity, or duration of the working relationship.

* The extent to which the work in an integral part of the employer's business.

* And the extent of the worker's investment in equipment or materials required for his or her task.

To a lesser extent, the courts will consider the parties' intent and their contractual designation.

But no single factor is overriding. The courts will look at the totality of the circumstances to determine the worker's status. The important question is whether as a matter of economic reality the worker depends on someone else's business for the opportunity to render service or depends on his/her own business;

If an employer violates the Fair Labor Standards Act by treating an employee as an independent contractor, that employer may be liable to the affected employee for the amount of the unpaid minimum wages and/or the unpaid overtime compensation.

That employer may also be forced to pay an additional amount equal to but not more than the value of the back pay as liquidated damages, as well as reasonable attorney's fees and the cost of the action. The secretary of labor may also file suit for back wages and/or for an injunction.

Further, the fair labor act provides that any person who willfully violates the law is subject to a fine of up to $10,000 or imprisonment of up to six months or both. An employer may have willfully violated the law if the employer knew or should have known of the misclassification.

Each employee who was wrongfully classified is considered a separate violation and there is a three year statute of limitations for willfully violations. Thus, the government can go back three years to collect penalties and back pay.

Effect on Benefit Plans

The Employee Retirement Income Security Act, as amended, was established to protect interstate commerce and employee benefit plan participants and beneficiaries.

Benefit plans include such programs as pensions, medical, dental, disability, life insurances, and severance. The law requires that employees disclose financial and other benefit plan information to participants and beneficiaries.

Further, the employee retirement act sets forth standards of conduct, responsibilities, and obligations for fiduciaries of employee benefit plans. Finally, the law was designed to improve the equitable character and soundness of such plans through requirements governing the vesting of accrued benefits of employees with significant periods of service, minimum standards as to funding, and coverage by plan termination insurance.

To determine whether an individual is an employee for purposes of the employee retirement act purposes, the totality of the circumstances is considered to determine to what degree the employer has the right to control the individual's daily work activities. The following are factors gleaned from case law and regulations defining common law employees:

* The degree of the right to control the results to be accomplished and the manner in which the work is performed.

* Whether the worker is engaged in the pursuit of an independent trade or business.

* The right to hire and discharge the worker.

* Whether the worker receives the same benefits as received by the employer's regular employees.

* Who furnishes the instrumentalities, tools, and the premises where the work is done and to what degree.

* How the parties structure their social security and income relations.

* The worker's opportunity for profit or loss.

* The belief of the parties as to their business relationship.

* The amount of skill required in the particular occupation.

* The duration of time for which the person is employed.

* And whether the work is a part of the employer's regular business.

Unlike other courts, the U.S. Fourth Circuit Court of Appeals has applied the following factors under a statutory test rather than the traditional common law agency principles to determine a worker's status: whether the person had a reasonable expectation of retirement benefits; whether the person relied on that expectation; and whether the person lacked sufficient economic bargaining power to contract for nonforfeitable benefits.

As to an employer's exposure with respect to employee benefit plans, if an individual is misclassified as an independent contractor and is later determined to have been an employee, the plan sponsor must compute the amount of accrued benefits to which the employee would have been entitled had the appropriate number of years been credited and then fund the benefits.

There is also a possibility that any medical costs incurred by the independent contractor turned employee are the employer's responsibility.

The Right to Control

Generally, an individual has employee status when the employer for whom the services are being rendered has the right to control and direct the worker. This right to control must not only be for what shall be done but how it shall be done.

To determine whether the required control is present, the Internal Revenue Service, which administers the Social Security Act, examines numerous factors premised on the traditional common law agency principles.

The courts look at what the worker actually did during the period of the business relationship and what each party had a legal right to do under that relationship. All factors are weighed in light of individual circumstances:

* Must the worker comply with instructions concerning when, where, and how the work is to be done?

* Is the worker trained to perform a job in a particular manner or method?

* Are the worker's services integrated into the business operations?

* Must the services be rendered personally?

* Does the employer hire, supervise, or pay assistants to perform services?

* Do the employer and the worker have a continuing relationship?

* Who sets the hours of work?

* Is the worker required to devote full time to the employer?

* Does the worker perform work on another's business premises?

* What is and who determines the method of payment (e.g., hourly, weekly, commission, or by the job)?

* Are business or traveling expenses reimbursed.

* Who furnishes the worker's tools and materials?

* Does the worker have a significant investment in the facilities used to perform services?

* Can the worker work for other employers at the same time?

* Does the worker make his or her services available to the public?

* Is the worker subject to dismissal for reasons other than nonperformance of contract?

* Can the worker terminate his or her relationship at any time without incurring liability for failure to complete a job?

* Can the worker realize both a profit and loss?

* Does the employer have the right to change a worker's job or job site?

If the IRS determines that an independent contractor should be classified as an employee, penalties can be severe.

Tax Returns

The Internal Revenue Code provides that assessments must be made within a three-year statute of limitations.

However, if employment tax returns are not filed (a distinct possibility if employees were misclassified as independent contractors), or are filed fraudulently, or with willful attempt to defeat or evade taxes, there is no statute of limitations.

If the employer has the right to control the manner the work is performed, irrespective of whether such "right" is exercised, the worker will probably be found to be an employee.

Since substantial penalties can be assessed for misclassifying employees, employers are well advised to take preventive measures before engaging workers as independent contractors.

For employers that currently utilize outside workers or plan to use them in the future, they should consider structuring these contractor's work, supervision, and other factors key to their status to confirm that they are independent contractors.

Mr. Gold and Mr. Esposito are attorneys in the labor and employment law department of Blank, Rome, Comisky & McCauley. Mr. Gold is a partner in the law firm's offices in Philadelphia and Cherry Hill, N.J., and Mr. Esposito is an associate in Philadelphia. Rachel Miller, an attorney in the firm, aided in the research.

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