The Risk of Using Independent Contractors

The authors highlight some of the recent changes which may effect companies who employ independent contractors. State and federal regulators and legislators have taken steps to address the widely used, (and often abused) practice of misclassifying entire classes of employees as independent contractors. The report reveals why large and small employers alike should take care in assigning independent contractor status to individuals engaged in consulting, delivery and transportation, sales and marketing, management, personal and technical services.

Compliance and the fear of litigation is just one of the reasons that so many employers are seeking the services of third party employee management firms. Many service models exist, from payrolling companies - providers who serve contingent workforces, employee leasing companies, and PEO's - Professional Employer Organizations.

Below are excerpts from a recent article in the New York Law Journal.
http://www.nylj.com

By Richard J. Reibstein, John A. Nixon, Dan A. Schulder, Stuart A. Shorenstein and Tiffany Raspberry.

The legal landscape involving independent contractors has dramatically and swiftly changed. For decades, legal challenges to an employer's use of independent contractors were infrequent, and many companies were willing to risk the remote chance that they would have to defend a lawsuit or a regulatory inquiry that they had misclassified certain employees as independent contractors.

Over the last year, however, there has been a wave of regulatory and legislative initiatives at both the federal and state levels seeking to stem the use of independent contractors. In addition, companies have been faced with substantial judgments in highly visible lawsuits brought on behalf of classes of workers who have successfully established that they were common law employees improperly classified by their employers as independent contractors.

Regulatory Initiatives

Within the past year, there have been a number of initiatives regulating the use of independent contractors. In May 2007, the Internal Revenue Service undertook a worker misclassification program and announced that the misuse of independent contractors would be a major area of emphasis for the IRS in fiscal 2008. By Nov. 6, 2007, the IRS had entered into data-sharing agreements with 29 state workforce agencies to share the results of employment tax examinations. The IRS has also started to focus in earnest on large corporate employers that allegedly have misclassified employees as independent contractors. In December 2007, the IRS assessed FedEx Ground for $319 million in unpaid employment taxes and penalties, just for calendar year 2002, following the IRS's determination that FedEx Ground drivers had been misclassified as independent contractors.

The Risks of Misclassification

Some of the most substantial risks faced by employers that are found to have improperly reported the income of employees as independent contractors are liability for unpaid federal, state and local income tax withholdings and liability over Social Security and Medicare contributions that are not paid on a Form 1099. Other large financial risks include unpaid unemployment insurance premiums, unpaid Workers' Compensation premiums and unpaid overtime compensation and work-related expenses. These types of liabilities (plus interest and penalties for non-payment) can be potentially devastating for employers that make considerable use of independent contractors.

Another substantial risk is a claim of benefit entitlement by or on behalf of common law employees misclassified as independent contractors. Claims have been successfully brought for pension and profit-sharing benefits, medical benefits and even stock options.

Reclassification

One way to avoid future liability is to reclassify questionable independent contractors as employees. After determining the identity of the 1099ers, counsel should undertake an individualized assessment as to whether each person or class of persons so identified is legally an independent contractor or actually a common law employee.

The legal test for independent contractor or employee status varies according to the law being enforced. The IRS abandoned its fabled 20-factor test several years ago; its current test is supposedly more simplified, focusing on three principal aspects of the worker's relationship with the business: (1) the degree of behavioral control that the business can exercise over the individual; (2) the degree of financial control that the business can exercise over the individual; and (3) the parties' views and perceptions of the relationship. In the employee benefits arena, the U.S. Supreme Court has stated that the test under ERISA focuses upon the hiring party's "right to control the manner and means by which the product is accomplished."⁴ Although the Supreme Court, the IRS and state agencies have articulated their criteria for determining employee status, the application of these criteria is oftentimes vexing, even to experienced legal practitioners.

Employee Leasing

The use of a responsible employee leasing organization is a practical and viable alternative that allows 1099ers to continue to provide services to the company, yet it substantially minimizes a company's exposure to liability under the tax, employee benefits and labor laws. This alternative can dramatically reduce a company's risk of liability and substantially diminish the likelihood of a lawsuit or an audit by a governmental agency.

Unlike payrolling companies, an employee leasing organization is a third-party employer. Some or all of the company's 1099ers (as well as its long-term temps, project employees, per diems and consultants) can be hired as employees of the leasing organization, which withholds taxes; makes Social Security, Medicare and unemployment payments; pays Workers' Compensation premiums; and may also provide basic medical and dental benefits and offer participation in a 401(k) plan maintained by the leasing organization.

Employers have allowed themselves to be imperiled by such risks because there is a very significant economic inducement to avoid an array of payments required to be made for employees but not for independent contractors. Along with lax enforcement in the past by the IRS and state agencies, these financial incentives have led many businesses to overuse the independent contractor classification.

Conclusion

Now that the IRS and the states have prioritized and targeted employer misuse of independent contractors, companies that use 1099ers to supplement their work force should examine whether they may have legal exposure for employee misclassification. If the potential tax, employee benefits or labor law liability is significant, companies would be wise to seek the most appropriate ways to eliminate or minimize their exposure and comply with laws governing the use of independent contractors. A coordinated, interdisciplinary approach may best serve the company's interests.

There is a significant economic inducement to avoid an array of payments required to be made for employees but not for independent contractors. Along with lax enforcement in the past by the IRS and state agencies, these financial incentives have led many businesses to overuse the independent contractor classification.

The authors are members of WolfBlock's independent contractor compliance working group. Richard J. Reibstein (rreibstein@wolfblock.com) (employment), John A. Nixon (jnixon@wolfblock.com) (employee benefits), Dan A. Schulder (dschulder@wolfblock.com) (tax), and Stuart A. Shorenstein (sshorenstein@wolfblock.com) (government relations) are partners of WolfBlock. Tiffany Raspberry (traspberry@wolfblock.com) is a government relations specialist with WolfBlock Public Strategies.