I.

INTRODUCTION

Increasingly, employers are seeking to cut costs and increase efficiency by reducing employee headcount. To augment leaner staffing levels while at the same time minimizing employment and benefit costs, many employers are replacing employees with "independent contractors." By doing so, employers hope to avoid many of the burdens and potential liabilities associated with hiring and termination decisions, managing a transitory workforce, and implementing layoffs.

In these arrangements, independent contractors are typically not entitled to paid vacations or sick leave and are generally not eligible for benefits like health insurance or a retirement pension. Likewise, the employer typically does not pay Social Security taxes (FICA), unemployment taxes, or workers' compensation insurance. There are indirect advantages to the independent contractor relationship, as well. Courts have ruled that true independent contractors may not pursue claims against their principal for wrongful discharge, employment discrimination or harassment. Indeed, employee leasing and temporary agencies continue to market their services as providing creative solutions for reducing employee benefits, workers' compensation and employment costs, as well as for solving other employment problems.

Sure, this sounds great. But using independent contractors is not without legal risks. To manage these risks, employers must fully understand the practical and legal implications of these classifications. On the practical side, employing independent contractors means loss of control over the day-to-day performance of the work. On the legal side, misclassifying employees as "independent contractors" can be an expensive proposition, potentially exposing the employer to liability for overtime pay, employee benefits, unemployment insurance, workers' compensation benefits, etc. If this occurs, not only has the employer wasted the time and money invested in constructing the original arrangement, it may have to pay all those costs they sought to avoid, as well as penalties for "noncompliance" with the law!

II.

A ROSE BY ANY OTHER NAME . . . WHEN IS AN INDEPENDENT CONTRACTOR TRULY INDEPENDENT?

True independent contractors work for no one; they are self-employed. There are various "tests" for determining whether a true independent contractor relationship exists. Most of these tests incorporate the common-law test that focuses on the employer's "right to control" the means and manner of the individual's work. Independent contractor status is determined by evaluating the individual's actual duties and the individual's "right to control" the manner and methods of performing his or her services.

Under this standard, actual control by the employer is not determinative. Nor is the description that the parties give to their relationship. Although a written employment agreement between an employer and an individual may state the individual is an independent contractor, courts will look beyond the written agreement to determine whether the individual is actually an independent contractor. The key is whether the employer has the ability to control the details of the work, even if that control is not exercised. If the hiring organization exercises sufficient control, an employment relationship will be found - despite a contract defining the individual as an independent contractor and even if the individual is employed through a temporary or leasing agency.

A.

The Common Law Employee Test

The common law test is used by most courts and agencies in defining who is an employee. The common law test looks to the law of agency to determine whether an employment relationship exists and considers the hiring party's right to control the manner and means by which the individual in question accomplishes the work. Factors relevant to this inquiry normally include:

• The skill required of the individual - the greater the skill, the less likely the individual is an employee;
• The source of the instrumentalities and tools used in the work - if they are provided by the individual, the individual is less likely an employee;
• The location of the work - if it is away from the central worksite, the individual is less likely an employee;
• The duration of the relationship between the parties - the shorter it is, the less likely it's an employment relationship;
• Whether the hiring party has the right to assign additional projects to the individual - if the contract is limited to specified projects, it's less likely an employment relationship;
• The extent of the individual's discretion of when and how long to work - the more discretion, the less likely the individual is an employee;
• Whether the individual can or does hire and pay assistants - if the individual does, he is less likely an employee; and
• The tax treatment of the individual - treating the individual for tax purposes as an employee, i.e., deducting withholding and paying employment taxes, will probably create an employment relationship; on the other hand, not treating the individual as an employee for tax purposes is no magic wand.

  1. Cases finding employee status

Flint Engineering constructs, installs and services oil and gas pipelines. Flint hired a group of rig welders to perform the welding for a project. Flint set the welders' hourly rate and required them to arrive, take breaks and leave at times specified by Flint foremen. The welders typically worked ten to 14 hour shifts, six days a week. During their shifts, they were supervised by Flint foremen. Prior to 1991, the welders were required to sign an "Agreement with Independent Contractor" which stated the relationship between the individual and Flint was an "independent relationship."

The welders sued Flint for overtime pay under the Fair Labor Standards Act. Flint argued that they were not entitled to overtime pay because they were independent contractors, not employees. The Court of Appeals disagreed and concluded that the welders were entitled to overtime pay. According to the court, the "focal point is whether the individual is economically dependent on the business to which he renders service or is, as a matter of economic fact, in business for himself." The court found Flint had complete control over the hours plaintiffs worked and the manner in which they worked. The welders were paid hourly, so there was no opportunity for them to incur a loss of profit depending on the time required to complete the project. And, because plaintiffs stayed on the job site until the necessary welding was done, the court concluded the plaintiffs were not relying on other projects for income during that period.

Nash v. Resources, Inc., 982 F. Supp. 1427 (D. Ore. 1997).

In 1996, Marcus Nash worked for Resources, Inc., as a cable television installer. He was paid by the job. He later was promoted to installation supervisor, making $100 per day. Nash's duties included supervising the installers on a daily basis and acting as liaison between Resources and its customer, Paragon Cable. As supervisor, Nash was required to pick up daily work orders from the customer and assign them to installers. If installers could not complete all of the work orders, Nash handled the overflow. He either had to do the work himself or find someone to complete it. Resources made frequent deductions to Nash's pay, without authorization and without explanation. The company had a policy for wage deductions for late paperwork. At times, the company paid him $9 per hour instead of $100 a day. Nash's supervisor scheduled the hours and days he was expected to work

On Nash's claim for unpaid overtime pay under the FLSA, the district court granted partial summary judgment to Nash, ruling that he was an employee, not a contractor. Resources maintained control to hire and fire Nash and to supervise his work. The company also determined the rate and manner to pay Nash, including making deductions from his wages.

B.

Cases Employing Other "Control" Tests

State Farm Fire & Casualty Company v. Luciano's Landscaping Service, Inc., 1998 U.S. Dist. LEXIS 2439 (E.D. Pa. 1998).

Sean Haggerty worked as a part-time landscaper at Luciano's Landscaping Service, Inc. He was paid $8.50 per hour and worked two days a week. Luciano's withheld state and federal taxes from Haggerty's pay. Haggerty suffered an injury while working at Luciano's, and the company filed an insurance claim with State Farm Fire & Casualty.

State Farm's insurance agreement excluded claims for bodily injury to an employee arising out of the course of employment, and the insurer filed an action for declaratory relief to determine whether Haggerty was an employee or an independent contractor. The court held that State Farm had no duty to pay the claim because Haggerty was an employee and therefore coverage was excluded. The court rested its decision on the fact that Haggerty was paid hourly, that the employer withheld federal and state taxes, that the company supplied tools necessary to complete the work and provided transportation to job sites.

C.

Cases Finding Independent Contractor Status

1. Control and independence factors

Dykes v. DePuy, Inc., 140 F. 3d 31 (1st Cir. 1998).

DePuy-Morse hired Jim Dykes as a sales associate at its facility in Massachusetts. At the time it hired Dykes, DePuy-Morse was a sales representative of DePuy, Inc., an India-based company that manufactures orthopedic products. DePuy-Morse was an "exclusive sales representative for all products sold by DePuy." In 1988, Dykes formed Health Systems, Inc. Health Systems and DePuy entered into an agreement whereby Health Systems would become a sales representative for DePuy. The contract stated that Dykes was the "principal" of Health Systems and expressly stated Health Systems was an independent contractor. DePuy gave Health Systems the discretion to determine the time and manner of making sales calls and the responsibility for paying taxes, unemployment compensation, workers' compensation, and insurance premiums. The agreement was for a one-year term and would be renewed automatically unless either party gave the other party 90 days' notice. The agreement also contained a termination bonus that would entitle Dykes to 10 years' pay upon termination, but only if (1) he remained a sales representative for 15 years, or (2) he worked a total of at least 20 years as a sales associate, combined with at least 10 years service as a sales representative.

In 1994, four years before Dykes would qualify for the termination bonus, DePuy notified Dykes that it would terminate the agreement in 90 days. Thereafter, DePuy employed Dykes as a sales associate on a month-to-month basis. One month later, after Dykes notified DePuy that he would begin cancer treatments, Depuy terminated Dykes as a month-to-month associate.

Dykes sued DePuy for violation of the Americans with Disabilities Act (ADA), the Employee Retirement Income and Security Act (ERISA), and state anti-discrimination laws. The Court of Appeals ruled that Dykes' claims were without merit because he was not an "employee" entitled to protection under these statutes. Although DePuy maintained some control over Health Systems, such as requiring Dykes to abide by the DePuy policies and requiring advance written consent to promote non-DePuy products, the evidence did not establish an employee-employer relationship. The court focused on facts that showed that DePuy truly was in business for himself: Dykes decided his own compensation, he decided his work schedule; he did not report his expenses or profits to DePuy; and he controlled the day-to-day operation of Health Systems, including hiring staff and determining their salaries.

2. Direct payment of compensation as deciding factor

Vakharia v. Little Company of Mary Hospital and Health Care Centers, 2 F. Supp. 2d 1028 (N.D. Ill. 1998).

Plaintiff Usha Vakharia was a physician who worked as an anesthesiologist at the Little Company of Mary Hospital and Health Care Centers. In her complaint, Vakharia alleged that the hospital discriminated against her because of her race and age in violation of Title VII, the ADEA and 42 U.S.C. section 1981. Specifically, Vakharia alleged that hospital officials interfered with her right to contract with patients and failed to assign her full staff privileges. She also alleged that younger anesthesiologists were treated more favorably that she was treated. The federal court rejected Vakharia's claims and dismissed the suit. Since Vakharia was able to use her own judgment in caring for patients, she possessed specialized skills, she received fees directly from patients, not from the Hospital, and she was not put on a normal rotation schedule, she was an independent contractor.

O'Connor v. Davis, 126 F. 3d 112 (2nd Cir. 1997), cert. denied, 118 S. Ct. 1048 (1998).

Bridget O'Connor was a social work student at Marymount College. As part of her studies she was required to perform 200 hours of field work at a school-approved organization. The school placed O'Connor at Rockland Psychiatric Center, a hospital for the mentally disabled. This placement was considered "work study" for financial aid purposes, and O'Connor received work study funds through the school for her work at Rockland. While at Rockland, a psychiatrist, Davis, began making sexually explicit remarks to O'Connor. She complained about the remarks, but Rockland did not take any action. The harassment continued, and O'Connor complained to the school. Marymount removed O'Connor from Rockland and placed her in another facility.

O'Connor sued Rockland for sexual harassment in violation of Title VII. The issue before the court was whether O'Connor was a student intern or an employee during her work at the mental hospital. The district court found that O'Connor was not an employee and the Court of Appeals affirmed. No employment relationship existed, said the appellate court, because there was no intent to create an employment relationship. O'Connor received no salary or other compensation from Rockland. Since O'Connor was not an "employee" under Title VII, her claim was dismissed.

3. Individual's representations of contractor status for tax-reporting purposes held binding

Tagare v. NYNEX Network Systems Co., 994 F. Supp. 149 (S.D.N.Y. 1997).

Neil Tagare developed a concept of privatizing undersea fiberoptic cable projects for establishing international telecommunications systems. In 1991, Nynex undertook work on the project, called the Fiberoptic Link Around the Globe (FLAG). In 1991, Tagare entered into four contracts with Nynex involving the FLAG project. The last contract was signed by Nynex and by Tagare, individually and on behalf of his company, Telematics Business Development Company. Under this final agreement, Telematics was to "perform certain marketing and business development activities with respect to the FLAG project and to undertake certain defined activities relative to the sale of cable capacity." The contract provided that Tagare, as vice-president of Telematics, would devote himself full-time to the FLAG project and (1) supervise the sales and marketing team provided by Nynex, (2) travel worldwide to conduct the sales marketing and business development activities, and (3) plan and conduct data-gathering meetings and other marketing activities authorized by Nynex. The agreement also stated that Telematics and Tagare were independent contractors.

Tagare sued Nynex for national origin discrimination in violation of Title VII. The district court found that Tagare was an independent contractor, and not an employee under Title VII. The court analyzed several factors:

• First, the court found that Tagare had represented on his tax forms that he obtained his income from an independent business, and submitted business expenses as deductions. The court considered this evidence as a "virtual admission" that Tagare was an independent contractor.
• Second, the court considered that Tagare did not receive any employee benefits.
• Finally, the court recognized that, although Nynex had some control over the operations of Telematics, the supervisory relationship was not necessarily inconsistent with independent contractor status because Tagare still maintained control of the day-to-day operations. The court also found that Tagare had a specialized skill, and that all tasks assigned to him were within the scope of the agreement.

III.

WHAT ARE THE CONSEQUENCES OF MISCLASSIFYING EMPLOYEES AS INDEPENDENT CONTRACTORS?

There are a number of possible ramifications if a employer is found to have misclassified its workers.

• Liability for Overtime Pay, Compensation and Employee Benefits: The employer may be held liable on a retroactive basis for additional compensation and benefits (not included in the budget) for "employees" whom the employer considered to be independent contractors.
• Liability for Job-Related Injuries Suffered by the Contractor: If an independent contractor suffers an injury on the job due to the negligence of the employer, the employer may be held liable for those injuries in a lawsuit and it cannot force the injured worker to pursue remedies through workers' compensation.
• Tax Penalties: Employers can be penalized under IRS rules for failure to withhold taxes for workers that are ultimately determined to be employees. Under IRS regulations, even if an individual who received a 1099 from the employer fully paid his or her taxes to the IRS, the employer's liability for failure to withhold is not reduced. Under IRS rules, if a 1099 Form is filed, the employer can be held liable for failure to withhold an amount up to 1.5% of the amount that should have been withheld. If a Form 1099 is not filed, the amount of liability is increased to 3% of the amount that should have been withheld. An employer can also be penalized $50 per form for failure to file W-2 forms, up to a maximum of $250,000 per year.

The employer may be found liable for damages and penalties for not withholding for social security and unemployment taxes for independent contractors who are later found to be employees. Under the Internal Revenue Code, an employer who fails to withhold and pay FICA taxes for an employee is liable for the employer's share of those taxes plus a penalty equal to 20% of the employee's share. That penalty increases to 40% of the employee's share if the employer failed to report the compensation on a 1099 Form. Notably, employer liability is not reduced even if the employee paid the full amount of FICA taxes owed.

• Benefit Plan Disqualification: Pension plans, deferred compensation plans and 401(k) plans, among others, are regulated by the Internal Revenue Code, which requires that all employees be treated alike under those plans. If the IRS were to determine that individuals who the employer deemed independent contractors were, in fact, employees and would have been allowed to participate in those plans, the IRS could and has disqualified those plans. This means that the employer could be jeopardizing its tax-sheltered plans and their favorable tax status by improperly characterizing employees as independent contractors.
• Possible Exposure to Claims for Wrongful Discharge and Employment Discrimination: If independent contractors are found to be employees, they will have certain rights and the employer will have certain obligations to them that generally do not exist in an independent contractor relationship. Many employers believe they are largely immune from suit by independent contractors, because the independent contractor relationship can be terminated under the terms of the contract or when the project is completed and because state and federal anti-discrimination laws generally do not apply to individuals who are not "employees."¹ However, if the contractor is a misclassified "employee," then those wrongful termination and non-discrimination rules will apply to them, as well.

IV.

PLANNING STRATEGIES TO AVOID RECLASSIFICATION OF WORKERS AS EMPLOYEES

Although the risk that an agency will reclassify an employer's workers cannot be eliminated, employers can take several steps to minimize the risk of reclassification.

A.

Identify Problem Areas

• Develop a strategy for identifying all your independent contractors, consultants, temporary and leased employees.
• Communicate with human resources, line management, and legal counsel to identify the issues and discuss the potential risks.
• Create a task force with a cross-sampling of employees to find potential exposure and resolve those problems.

B.

Determine Why These Individuals Are Not Your Employees.

• What are your reasons for using non-traditional workers? Is there a real benefit in using independent contractors instead of employees?
• Are organization employees doing the same work as "independent contractors?" If so, why? Are there differences? Are they justified?

C.

Is There Is A Benefit To Maintaining An Independent Contractor Relationship?

• Identify the strengths and weaknesses of any claim that the contractor is actually an employee.
• Can the contractor's duties and responsibilities and work relationship with the employer be altered to bolster the argument that he or she is not your employee, but really an independent contractor?
• How will implementation of these changes impact the administration and functioning of the work? For example, the employer may have to eliminate or minimize its supervision and oversight of the individual. If that is not possible, this person should be an employee.

D.

How To Keep Independent Contractors "Independent"

• Insist that the contractor have indicia of an independent business. For example, the contractor should file an assumed name certificate and have its own letterhead and business cards, a bank account in the business's name, a valid tax ID number and advertisements in the Yellow Pages.
• Do not pay the independent contractor out of the payroll account; rather, pay him from the same account used to pay lawyers and outside accountants.
• Draft a written independent contractor agreement to be signed by both parties that spells out the relationship. The document should make it clear the employer does not have the right to control the procedures for accomplishing the contracted services.
• The contract should specify that the contractor is obligated to pay income and self-employment taxes. An IRS Form 1099 should be filed reporting the compensation paid to the contractor.
• Whenever possible, contractors should have an investment in the work being performed. For example, they should be required to bear their own business expenses and license fees, and supply their own tools, equipment, transportation, liability insurance.
• When the contractor is highly skilled, set forth those "special skills" in the recitals.
• The agreement should specify that the worker has responsibility for hiring, supervising, training and paying assistants.
• The agreement should not limit the contractor's ability to provide services to others during the contract term, except as may be necessary to protect the employer's trade secrets and other confidential and proprietary business information.
• The agreement should set forth what tools and equipment the independent contractor is to provide.
• If the contractor must rely on the company's facilities, the agreement should specify what will be provided and how much the contractor will pay the employer for use of such facilities.
• Specify in the agreement that the independent contractor has discretion to determine the manner and means of accomplishing the project.
• Service should be paid for by project (when an invoice is received) and not on an hourly, weekly or monthly basis.
• Deadlines should be set specifying when the work should be completed, with penalties for overruns.
• Do not provide that employment is at-will, since this is strong evidence negating the existence of a bona fide contractor relationship. The agreement should provide for termination at the completion of the project or upon completion of a negotiated notice period (e.g., 15 or 30 days).

Footnotes

1 See, e.g., Birchem v. Knights of Columbus, 116 F. 3d 310 (8th Cir. 1997) (insurance agent, as independent contractor, had no claim under North Dakota Human Rights Act against insurer); Sistare-Meyer v. Young Men's Christian Assoc., 58 Cal. App. 4th 10 (1997), rev. denied, (Jan. 21, 1998) (contractor who was discharged by YMCA cannot sue association for wrongful termination in violation of public policy); Pukowsky v. Caruso, 312 N.J. Super. 171, 711 A. 2d 398 (1998); but see, Marquis v. City of Spokane, 130 Wash. 2d 97, 922 P. 2d 43 (1996) (female golf pro who was independent contractor could sue employer for sex discrimination under Washington state law against discrimination).