Overview:
Over the past several years, the use of workers known as independent contractors, (self-employed workers hired to perform a specific task for an employer), has increased dramatically. According to the Bureau of Labor Statistics, the number of U.S. citizens working as independent contractors grew to 8.6 million by 2001. The financial advantages of hiring independent contractors can be significant. But did you know that employers also assume significant business, tax, and legal risks by hiring these workers? And the consequences of misclassifying employees as independent contractors can be devastating.
Third-party staffing is the answer. A full-service staffing firm is capable of transforming this high-risk adventure into a safe one. A full-service staffing firm that assumes most or all of the daily oversight, supervision, and control over these workers, can reduce and even eliminate the tax and legal risks of hiring independent contractors. By offloading these risks to the staffing firm, companies can safely take full advantage of the benefits of hiring independent contractors. |
Picture the following conversation. You may be surprised that this CEO may not have made a shrewd business decision, but rather a potentially disastrous mistake:
CEO: We need 20 workers to complete this project, but we can’t afford to hire 20 full-time employees. What should we do?
Human Resources Manager: We can get around this problem by hiring 20 workers for this project only. We’ll have them sign contracts stipulating that they are independent contractors, we’ll issue different identification badges to them, and we won’t pay them through our payroll department. Because they’ll be independent contractors, we won’t have to pay employment taxes for them or withhold their earnings, and they won’t be able to sue us for discrimination. It’s a win-win situation.
CEO: Good idea. Let’s start interviewing immediately.
Of course, this conversation is fictitious, but unfortunately for many companies, the risks of hiring individuals who call themselves “independent contractors” are all too real. Over the past several years, the use of workers known as independent contractors–self-employed workers who are hired to perform a specific task for an employer–has increased dramatically. In fact, according to the Bureau of Labor Statistics, the number of U.S. citizens working as independent contractors grew to 8.6 million by 2001. But did you know that employers also assume significant business, tax, and legal risks by hiring these workers? Employers often presume that they cannot only circumvent their state and federal tax obligations, but also shield themselves from employment discrimination lawsuits by merely entering into an agreement that a particular worker is an independent contractor. This assumption often furnishes employers with a false sense of security that can lead to dire consequences.
Employers that misclassify employees as independent contractors can be liable for back taxes, interest, and penalties to the IRS, as well as back pay, front pay, costs, attorney’s fees, and compensatory and punitive damages in litigation expenses. Indeed, this seemingly trivial mistake can cost employers millions of dollars in damages and penalties, and can even force an employer into bankruptcy. In short, the consequences of misclassifying employees as independent contractors can be devastating.
There is, however, a viable and cost-effective solution to this dilemma for employers: the use of a third-party staffing firm. A full-service staffing firm that assumes most or all of the daily oversight, supervision, and control over contract workers can significantly reduce and even eliminate the tax and legal risks of hiring individuals who call themselves independent contractors. In addition, a staffing firm can purchase business liability insurance to insulate an employer from the danger that an independent contractor will negligently or intentionally damage the employer’s business. By transferring these risks to the staffing firm, companies can take advantage of the benefits of hiring independent contractors while also reducing the risks.
Ramifications of Misclassification
1. Tax Consequences
The IRS aggressively investigates and prosecutes cases of employee misclassification because employers typically comply with income-reporting requirements at a higher rate than independent contractors. Therefore, the IRS has an incentive to uncover and penalize instances of misclassification because reclassification increases the government’s revenue. Accordingly, employers must be particularly cautious in distinguishing between employees and independent contractors.
The Internal Revenue Code obligates employers to pay employment taxes (federal unemployment insurance, Social Security, and Medicare) for employees and to withhold taxes (income, Social Security, and Medicare) from employees’ wages. Employers must also comply with the Code’s record-keeping and reporting requirements in connection with employees. None of these obligations applies to employers of independent contractors.
When the IRS determines that an employer has mischaracterized an employee as an independent contractor, employers are subject to severe state and federal penalties, such as back taxes, interest, and penalties. The employer’s liabilities may include: the full amount of the worker’s income tax that the employer should have withheld; both the employer and the employee’s portions of the FICA tax; payment of federal and state unemployment taxes; and a penalty of up to 25 percent of the amount due. Moreover, an employer is not entitled to offset its liability with tax payments that the worker made before the reclassification. In addition, penalties can be assessed against both the employer as well as its corporate officers.
2. Legal Consequences
Laws prohibiting discrimination on the basis of race, sex, age, disability, and other protected characteristics protect employees but not independent contractors, and these laws only apply to employers of a certain number of employees. Thus, only employees are entitled to sue employers for discrimination in the workplace.
However, employers who presume they are insulated from discrimination claims because of the independent contractor relationship can be liable to the employee for back pay, front pay, costs, attorney’s fees, compensatory damages, and punitive damages if the employer is mistaken about the relationship. In addition, the employer may be compelled to reinstate an aggrieved employee. Even in cases where the employer is found not to have discriminated against an employee, the legal fees incurred in the defense of such cases can be staggering.
Independent Contractor or Employee?
1. The IRS’ Right-to-Control Test
The IRS utilizes a 20-point test to determine whether a worker is an employee. The following factors indicate that a worker is an employee if he or she:
- must comply with the employer’s instructions about work and procedures
- receives training from or at the direction of his or her employee
- provides services that are integrated into the existing business
- provides services that must be rendered on a personal basis
- is responsible for hiring, supervising, and/or paying assistants for his or her employee
- has a continuing working relationship with his or her employer
- must follow an established schedule
- works full-time for his or her employer
- does his or her work on the employer’s premises
- must do his or her work in a sequence set by his or her employer
- must submit regular reports to his or her employer
- receives financial pay of regular amounts at set intervals
- receives financial pay for business and/or traveling expenses
- relies on his or her employer to furnish tools and materials he or she needs
- lacks a major investment in the facilities he or she uses to perform service
- cannot make a profit or suffer a loss from his or her services
- works for one employer at a time
- does not offer his or her services to the public
- can be fired by his or her employer
- may quit work at any time without incurring liability
Although this test is clearly subjective, employers should be familiar with a few general principles. First, the mere statement in an agreement that a worker is an independent contractor is not dispositive. Second, control is the defining factor that permeates this test–whether the employer exerts behavioral as well as economic control over the worker. In contrast, for a worker to be classified as an independent contractor, he or she must be both physically and economically autonomous of the employer. Nevertheless, it can be extremely difficult to predict whether the IRS will find that an employment relationship exists in a given situation.
2. The Courts’ Tests
Depending on the jurisdiction, courts use one of three tests to determine whether a worker is an employee, and thereby entitled to protection under the various employment discrimination laws:
i) the “common law test,”
ii) the “economic realities test,” and
iii) the “hybrid test.”
The common law test is essentially the same as the IRS’ 20-point test, but courts usually analyze only 13 factors, instead of 20. Both approaches, however, emphasize the employer’s right to control the worker’s activities.
The economic realities test, which typically evaluates about five or six factors, is slightly more liberal than the common law test. This test focuses on whether, as a matter of economic reality, the worker is dependent on the employer.
Finally, as its name suggests, the hybrid test combines the common law test with the economic realities test. Its most important component, however, is the employer’s right to control the worker. Like the IRS’ 20-point test, it is often difficult to predict whether an employment relationship exists under each of these three tests.
Third-Party Staffing Firms Can Be the Solution
Employers expose themselves to tremendous risks when they treat employees as independent contractors. The IRS’ policy of aggressive enforcement can lead to unforeseen costs and penalties, while the vagaries of litigation can result in expensive settlements, costly awards, and enormous legal expenses. To compound these hazards, deciding whether an employment relationship exists is no easy task. After all, every job situation is different and even courts struggle with making this decision. In fact, neither the IRS’ nor a court’s determination of whether an employment relationship exists is binding on either entity, so a worker could conceivably be considered an employee for tax purposes and an independent contractor for employment discrimination purposes, or vice versa. Therefore, it is essential for employers to have a clear understanding of whether its workers are employees and how to handle the numerous issues that frequently arise over the course of these work relationships.
A third-party staffing firm can significantly reduce the danger of hiring independent contractors by transferring these risks from the employer to the staffing firm. A company that relinquishes payroll responsibility and most or all of the day-to-day oversight, supervision, and control over these workers to a staffing firm often insulates itself from these obligations and risks altogether. This strategy increases the likelihood that a court will determine that the staffing firm, not the employer, is the proper defendant in an employment discrimination lawsuit. It also makes it more likely that the IRS will decide that the staffing firm is solely responsible for the tax obligations and penalties resulting from employee misclassification. Indeed, companies that decide not to take these precautions often regret their decisions to roll the dice.
Microsoft’s Hard-Learned Lesson
Microsoft learned this lesson the hard way. In the late 1980s, Microsoft supplemented its regular workforce with a substantial number of freelance IT professionals who signed contracts acknowledging that they were independent contractors. Even though Microsoft treated the workers differently from its regular employees in several respects, the IRS determined that Microsoft should have classified the workers as employees. As a result, Microsoft was forced to pay overdue employee withholding taxes and to compensate them for back overtime worked. Many of the workers subsequently sued Microsoft in federal court to obtain lost stock purchase and 401(k) benefits. Microsoft eventually settled the case for $97 million.
Not all staffing firms, however, are equipped to effectively assume tax and legal risks for employers. In fact, only a full-service staffing firm is capable of transforming this high-risk adventure into a safe one. Accordingly, employers should contract with a staffing firm that maintains an in-house Human Resource Department, which can assist companies in resolving any tax and legal issues that may arise during the employment relationship. More significantly, an in-house HR Department can classify workers at the outset of the working relationship to prevent employers from 1) incurring unforeseen legal costs and penalties, and 2) unnecessarily expending resources on workers who should have been treated as independent contractors.
Employers should also utilize a staffing firm that is capable of implementing training and policy procedures to prevent incidents of discrimination and harassment in the workplace. In addition, it is important that employers contract with a staffing firm that possesses the resources to investigate complaints when they arise to minimize companies’ exposure to liability. After all, finding the right staffing firm is especially critical for employers because the law surrounding independent contractors is always subject to change. Therefore, employers must keep themselves apprised of any trends and developments to avoid the pitfalls of misclassifying employees as independent contractors.
Figure 1: Projected Growth of Workers in the Temporary Staffing Industry
US Bureau of Labor and Statistics
In short, third-party staffing firms’ specialized expertise in handling these complex issues can prevent employers from incurring unnecessary expenses and penalties. Even if your organization does not currently utilize temporary staffing, it likely will in the future, as the Bureau of Labor and Statistics projects the use of temporary workers to increase rapidly in the coming years (See Figure 1). With the benefit of a full-service staffing firm, employers can reduce the risks associated with hiring and maintaining a flexible workforce.
About the Authors
Michael D. Kaufman is a partner at Troutman Sanders LLP, with more than 26 years of experience in labor and employment law. Mike specializes in employment matters representing management in labor relations. He has had considerable experience in union campaigns, created numerous union preventative programs, and had extensive supervisory training in all employment matters. Mike has also tried many employment litigation matters, including unfair labor practice cases, claims under Title VII, and age and disability discrimination. Mike received his undergraduate degree from Furman University in 1973 and graduated from the University of South Carolina School of Law in 1976. He has served on the board of trustees of a number of local private schools and is active in civic community affairs in the Atlanta area.
Wood Lovell is an associate at Troutman Sanders LLP and practices in the firm's labor and employment group. Prior to joining the firm, Wood served as a judicial clerk for The Honorable G. Ernest Tidwell, former Chief Judge and current Senior Judge for the United States District Court for the Northern District of Georgia, from 2000-2002. Wood received his undergraduate degree in history from Duke University in 1997 and graduated from the University of Georgia School of Law in 2000. Wood was extremely active in moot court at Georgia Law School, where he and his teammate won the prestigious Talmadge Competition as well as the Competition's Best Brief Award. |