Currently, one of the fastest growing areas of litigation, including class action suits, is in the proper classification of workers as either employees or Independent Contractors. The dictionary defines an Independent Contractor as:
a person who contracts to do work for another person according to his or her own processes and methods; the contractor is not subject to another’s control except for what is specified in a mutually binding agreement for a specific job.
Misclassifying a worker as an Independent Contractor can have far reaching implications including high dollar liabilities.
The Internal Revenue Service (IRS) has very strict criteria for determining the Independent Contractor vs. Employee status that has been in place for many years (discussed later in this article). Federal Express has been a poster child for this issue, owing the IRS $319 million in back taxes. In a suit filed against Northwestern Mutual Life Insurance Company, the proposed class is seeking $200 million for misclassified workers.
At the federal level, the IRS is in the midst of a misclassification crackdown. It is important to note that on the Federal level there has been previously proposed federal legislation – the Independent Contractor Proper Classification Act – that is expected to be revisited by Congress. This act imposes strict penalties on employers for worker misclassification. A brief summary of the act is below;
Independent Contractor Proper Classification Act of 2007 – Amends the Revenue Act of 1978 to:
(1) require employers to treat workers misclassified as independent contractors as employees for employment tax purposes upon a determination of misclassification by the Secretary of the Treasury;
(2) repeal the ban on Treasury regulations or revenue rulings on employee/independent contractor classifications; and
(3) eliminate the defense of industry practice as a justification for misclassifying workers as independent contractors.
In addition to the Federal Act discussed above, many states have current or pending legislation of a similar nature. Some examples are:
- Illinois: Enacted The Illinois Employee Classification Act effective January 1, 2008, which imposes harsh civil and criminal penalties for misclassification of workers.
- Colorado: Enacted H.B.1310 in June 2009. Imposes penalties up to $5,000.00 per employee for a first offense & up to $25,000.00 per employee for subsequent violations for misclassified workers.
- Maryland has instituted the Workplace Fraud Act effective October 2009.
You might be wondering at this point: what’s the big deal is if a worker is classified as an Independent Contractor or an employee? Workers that are misclassified as independent contractors are denied many protections afforded to employees including, but not limited to, wage & hour laws, benefits (including workers compensation and unemployment insurance payments), and protection under non-discrimination laws.
Thomas E. Perez, Secretary of Maryland, offered this quote on regarding Maryland’s Workplace Fraud Act, “This new law will ensure that employers who attempt to cheat the system, their workers and their competitors, will pay a steep price for their actions. It should send a message that we will be fair to those employers who are trying to play by the rules, but we will not tolerate flagrant and intentional violations of the law for personal gain.”
Both the federal and state governments are recognizing that in many cases employers intentionally misclassify workers as Independent Contractors in order to avoid payroll tax liabilities, workers compensation premiums, and/or wage & overtime responsibilities on these workers. The IRS estimates that the federal lost tax revenue for misclassified workers as $3 – $5 billion (yes, billion) dollars per year. It is estimated that 7 – 15% of workers are misclassified as Independent Contractors.
As you can imagine, there are many federal and state entities that have an interest in the misclassification of workers:
- United Stated Department of Labor
- Internal Revenue Service
- State Tax Departments
- Unemployment Agencies
- Workers Compensation
- National Labor Relations Board
- Federal Courts
- State Courts
The penalties for misclassification include civil fines, criminal penalties, being barred from federal and/or state contracts, and private rights of action for the aggrieved workers.
To determine if a worker is an Independent Contractor can be challenging, especially since there are different criteria for the various federal and state entities mentioned above. Even though there are different tests, most tests flow from the long established principles of the IRS. The IRS employs a 20 Factor Test that determines the employers level of control in these categories: Behavioral, Financial and Type of Relationship.
In times of confusion or if you are unsure, it always best to speak to an employment law attorney or a Human Resources professional who understand the special circumstances in correct worker classification. Reduce your exposure to risk by making sure you are are in compliance with all rules and regulations.