Recent years have seen a significant rise in the use of non-traditional employee arrangements, from part-time, to temporary, to freelance workers, or independent contractors. Why are so many companies restructuring their workforce? Successful companies have learned that it is possible to operate at maximum efficiency by relying on a relatively small Core Group (See our White Paper, "The Core Group Strategy," Volume 1, Number 1.) of permanent, or regular, employees, supplemented by a variable number of experienced temporary workers who are available to meet the company’s changing personnel needs. In addition to enhanced flexibility, many companies who have structured their workforce in this way have achieved a tremendous reduction in costs by limiting the eligibility for medical and retirement benefits to their regular employees.
However, both the IRS and the courts may look beyond a worker’s "temporary," or "contractor," label if the company treats the worker as a regular employee. For that reason, the use of temporary workers is a viable option only if the company maintains a clear distinction between its temporary workers and its regular employees. This is a matter of the utmost importance in light of the potentially enormous cost associated with a court order to "involuntarily convert" temporary workers for benefits purposes. A company that inadvertently fails to maintain this necessary distinction may learn, to its dismay, that all of its temporary workers are actually regular employees under the law -- meaning that it has quite a few more employees than it knew of, and that each of these newly declared employees are retroactively entitled to the same benefits as the regular employees.
Distinction is unclear
Drawing a clear line between temporary workers and regular employees may not sound like a difficult task. After all, if a company openly informs its temporary workers of their independent contractor status at the time of hire and does not place the temporary workers on its payroll, the temporary workers may appear to have no claim to regular employee status. Many companies have been under the impression that they could effectively ensure independent contractor status by reaching a signed written agreement with every temporary worker specifically delineating the worker’s temporary status and disclaiming any duty to pay benefits to temporary workers. After all, if the company and the temporary worker reach an agreement that the worker is not entitled to any benefits, the temporary worker obviously has no claim to those benefits that are restricted to regular employees, right?
Not necessarily. Just ask Microsoft Corporation, which recently suffered a major legal setback on this very issue in a decision which may have far-reaching implications for all companies that engage temporary personnel. Microsoft’s regular employees were eligible for a wide array of benefits, including a generous employee stock-option plan and a 401(k) plan with matching funds paid by Microsoft. Like many employers, Microsoft supplemented a relatively small regular workforce with a large number of temporary technical personnel. These workers, who were classified as "freelancers," were hired to work on specific projects and often worked alongside regular employees performing similar functions. At the time of hire, each of the freelancers signed two agreements specifically acknowledging their independent contractor status and accepting responsibility for their own taxes, withholding, social security and benefits. Moreover, Microsoft treated the freelancers differently from the regular employees in that freelancers wore a different type of badge, had a different type of e-mail address, attended a less formal orientation, were not permitted to assign work to others, were not invited to official company functions and were not paid overtime. Unlike the regular employees, who were paid through Microsoft’s payroll department, the freelancers submitted invoices of their hours and projects and were paid through the accounts payable department.
The IRS sees it differently
For years, this independent contractor arrangement worked out well for both Microsoft and the freelancers -- many of whom received greater compensation on an hourly basis than their regular employee counterparts, and Microsoft. Unfortunately for Microsoft, however, the Internal Revenue Service ultimately determined that for purposes of withholding and employment taxes, the freelancers were actually regular employees rather than independent contractors. The IRS applies twenty different factors relating to the employer’s control over the worker to determine whether, on balance, the worker is a true independent contractor or an employee in disguise. In response to the IRS’s ruling, Microsoft paid overdue employee withholding taxes for its freelancers and compensated them for back overtime worked.
Microsoft did not offer the freelancers retroactive benefits, however, on the grounds that the freelancers clearly had no anticipation of receiving benefits at the time of hire. Both the 401(k) plan and the stock-option plan specifically restricted eligibility to "common law employees," and information concerning these plans was provided only to regular employees. Nonetheless, a group of freelancers filed a class-action suit against Microsoft after the IRS ruling and demanded inclusion as regular employees under both the 401(k) plan and the stock-option plan. In its defense against these claims, Microsoft relied heavily upon the agreements signed by the freelancers which expressly stated that they were not entitled to any benefits.
Although the IRS ruling was not binding on the court, the plaintiffs prevailed in their lawsuit. In a decision that could ultimately cost Microsoft millions of dollars, the Ninth Circuit Court of Appeals found that notwithstanding their express agreements to the contrary, the freelancers were actually common law employees and thereby entitled to benefits under both the 401(k) plan and the stock-option plan. Rejecting Microsoft’s argument that the payment of benefits to the freelancers was never contemplated by the parties, the court found that since all "employees" were eligible for the plans, Microsoft’s erroneous identification of employees as contractors was no defense to the freelancers’ claim for benefits.
Key is to minimize risks
What is the lesson of the Microsoft decision? For employers, the lesson is not that companies should simply abandon the competitive advantages of a workforce balanced between regular and temporary employees. Rather, the key is to maintain the independence of your contract workers by developing a strategy to minimize the risks. Microsoft got into trouble because: 1) the language of the benefit plans, which granted eligibility to "employees," was found to be ambiguous with respect to employees who had been mistakenly classified as independent contractors; and 2) Microsoft’s distinctions between regular employees and temporary workers were insufficient to pass muster under the complex analysis applied by the IRS. Unfortunately for employers, there is no simple, bright-line test to distinguish between regular employees and temporary workers. Because independent contractor analysis entails a complex, fact-specific inquiry, every aspect of the relationship with temporary personnel should be scrutinized to ensure that the independent contractors have no viable claim for benefits. If an employer chooses to conduct its own hiring of independent contractors, the employer should take care to minimize any evidence of control that supports an employer/employee relationship. For example, to the extent the employer pays workers on an hourly basis at regular intervals, pays business expenses, integrates the workers into its business operation, furnishes equipment, sets the hours of work, requires the regular submission of reports, and provides training, the worker is more likely to be deemed an employee. In some situations, the presence of at least a few factors supporting employee status may be unavoidable. Accordingly, it may be difficult for employers to determine status of their temporary workers with certainty even after analyzing the relevant factors.
For many employers, the most practical solution to the problem of independent contractor status is to retain the services of a contract consulting firm that, among other things, typically provides important health care and other benefits to contractors. Rather than devoting the time and resources necessary to implement a program to ensure independent contractor status of temporary workers, employers may choose to rely upon the experience and expertise of a contract employment firm to guide them through these difficult waters. In any event, because the Microsoft decision may give rise to a new wave of similar class-action lawsuits, it is imperative that companies act swiftly to determine who their real employees are before needless and costly litigation reveals the answer for them.
What is -- or isn’t -- a contract employee?
According to the Internal Revenue Service, some 90 percent of cases it tracks involve persons who have not properly qualified themselves for status as an independent contractor.
The IRS has established the following 20 factors of common law to determine whether workers are "employees" or "independent contractors." Published in the IRS Manual 4600 Employment Tax Procedure, exhibit 4640-1, these factors suggest you are of general employment status - and not an independent contractor - if you:
- must comply with your employer’s instructions about work and procedures
- receive training from, or at the direction or supervision of, your employer
- provide services that already are integrated into the existing business
- provide services that must be rendered on a personal basis
- are responsible for hiring, supervising and/or paying assistants for your employer
- have a continuing working relationship with your employer
- must follow an established schedule
- work full-time for your employer
- do your work on the employer’s premises
- must do your work in a sequence set by your employer
- must submit regular reports to your employer
- receive financial pay of regular amounts at set intervals
- receive financial pay for business and/or traveling expenses
- rely on your employer to furnish tools and materials you need
- lack a major investment in the facilities you use to perform service
- cannot make a profit or suffer a loss from your services
- work for one employer at a time
- do not offer your services to the public
- can be fired by your employer
- may quit work at any time without incurring liability
About the Author
Steven J. Whitehead
Steven ("Steve") J. Whitehead is a partner with the law firm of Troutman Sanders LLP, a full-service law firm based in Atlanta.
Whitehead practices exclusively in the areas of labor and employment law, and is a specialist in employment discrimination law; union avoidance; reasonable accommodation under the Americans With Disabilities Act, the Family and Medical Leave Act and the Fair Labor Standards Act; intellectual property protection; and noncompetition agreements and independent contractors. Whitehead is a graduate of George State University College of Law and Georgia State University.
Whitehead can be reached at (404) 885-3434 or steve.whitehead@troutmansanders.com.
John P. Kelly
John P. Kelly is an associate with Troutman Sanders LLP.
Kelly practices exclusively in the area of labor and employment law, including employment discrimination litigation, union avoidance, drug testing, management training, employment agreements, and compliance with state and federal employment laws. Kelly is a graduate of Emory University School of Law and the University of Chicago.
Kelly can be reached at (404) 885-3259 or john.kelly@troutmansanders.com.
Troutman Sanders LLP
Troutman Sanders is one of Atlanta’s largest law firms, with a reputation for excellence in representing its clients. The Firm, known for being progressive and proactive, continually expands its resources and areas of expertise to meet its clients’ changing needs. The Firm has experience in virtually every aspect of commercial law and public policy, and maintains a solid reputation for its international work, with the largest international practice in Atlanta. It is this diversity of experience and dedication to excellence that sets Troutman Sanders apart and has earned the Firm its long-standing position as a leader in the practice of law. Troutman Sanders has offices in Atlanta, Washington, D.C., and Hong Kong. |