Businesses across the country are
continuing to cut costs by replacing employees with independent contractors to save costs.
Some savings are certain - employers don’t pay employment taxes to the IRS or
employee benefits to their workers. However, many hidden costs can reduce these savings or
even erase them entirely. This article focuses on seven legal myths, which can mislead
businesses to believe they are saving costs by blinding them to costly legal risks when
they hire workers as independent contractors instead of employees. These myths result from being uninformed about the
legal differences between employees and independent contractors. Shattering these myths is
the best way to learn how these distinctions affect your business’s legal compliance
and why companies need to include these risks in any cost-cutting calculations.
Myth
#1: Employers Should Use the
IRS’s “20 Common Law Factors Test” to Determine Worker Status as Employee
or Independent Contractor
Reality: The IRS no longer applies its long-standing,
much-publicized and frequently used ”20-Common Law Factors Test” to determine a
worker’s status as employee or independent contractor. The IRS has replaced this test
with a new approach focusing on three categories to determine if a worker is an employee
or independent contractor: Behavioral Control, Financial Control, and Type of
Relationship. Companies relying on the “20
Common Law Factors Test” today risk costly fines and penalties determinations of
worker misclassification by IRS auditors.
The IRS is
specifically targeting companies that have lain off employees to save costs then hired
independent contractors to perform the same work (even if you rehire the same person as a
contractor. Their incentive is the same as that of businesses being audited -- the huge
amounts of money not being paid in employment taxes. In short, employers’
savings becomes Uncle Sam’s losses, and Uncle Sam wants his money back! The answer lies in recognizing this risk
and making sure that you are classifying your workforce properly, complying with the
agency’s new tests.
Reality: The overwhelming focus on the IRS’s worker status tests by business and legal advisors has led many employers to the believe they can avoid legal risks of worker misclassification entirely by pleasing Uncle Sam. However, the IRS’s worker status test only applies when businesses need to determine a worker status for employment tax purposes. Precious little information is provided about the many other federal (and state) laws governing the workforce, yet each has its own tests to determine worker status and all differ from the new IRS approach. Four examples are:
1) Employee benefits: A 12-factor test determines whether a worker is an employee or independent contractor under ERISA, the federal law governing employee benefits;
While it is important to learn the worker status rules under the various laws and regulations governing the workplace, just knowing that “all worker status tests are not the same” is an important first step in reducing legal risks.
Myth #3: You Can Avoid Costly Worker Misclassification
Liability by Complying with Federal Statutes and Regulations Governing the Workforce
Reality:
Even if your company complies with lengthy list of laws and regulations governing the
workforce you still risk liability for worker misclassification for misclassifying workers
as independent contractors who our Courts and the IRS consider to be “common law
employees”.
Many
high-profile worker misclassification lawsuits, whose
staggering
costs to employers made national headlines such as Vizcaino v. Microsoft
(settled for $97 million in June, 2001), Herner v. Time Warner, (settled for $5.5
million in November, 2000), Clark
v. King County,
(settled for $18.6 Million settlement in June,
2000) and Logan v. King County (settled for $24 million in
December,
1997) were
based
on courts’ findings that plaintiffs were common law employees.
The IRS defines a
common law employee as “any individual who, under common law, would have the status
of an employee . .
. a person who performs services for an employer who has the right to control and direct
the results of the
work and the way
in which it is done. For example, the employer provides the employee's tools, materials,
and
workplace,
and can fire the employee.” Compared to
independent contractors, “Common-law employees are not
self-employed and
cannot set up retirement plans for income from their work…”
Our
Courts and the IRS will find that workers are employees if they meet the common law
employee criteria, whether they are hired as independent contractors, free-lancers,
temporary or other “contingent” workers.
Myth
#4: An Employment Contract Expressly Stating that a Worker is Independent
Contractor Means that the Worker is an Independent Contractor
Reality: In a series of recent cases, several Federal
Appeals Courts across the country have ignored or rejected employment contracts that
expressly designated workers as independent contractors. These and other courts have considered written contracts less important than the
actual working relationships, control of worker performance and other factors when worker
status is at issue. A few recent cases
illustrate why relying on an employment contracts and written agreements to determine
worker status is risky business:
1) In
the landmark case of Vizcaino v. Microsoft case the 9th Circuit Court of
Appeals held that Microsoft’s “permatemp” workers were common law employees
despite the fact that they signed written agreements acknowledging that they were
independent contractors;
2) In
Baystate Affiliated Staffing v. Herner the 1st Circuit Court of Appeals
rejected staffing agency argument that temporary workers who signed employment agreements
stating they were independent contractors. The Court held that the workers were employees,
therefore entitled to receive overtime pay as required by the FLSA, and the staffing
agencies (and their business clients) were liable for violating the Fair Labor
Standards Act (FLSA);
3) In
Yak v. Brussels (June, 2001) the 2nd Circuit Court of Appeals held that a worker who signed an employment contract
stating that she was an independent contractor and waiving her rights to employee benefits
was an employee. The Court ruled that: 1) plaintiff’s worker status must be based on
control of work and not an employment contract and 2) ERISA requirements governing
employee benefits must override the terms of an employment contract. It based its ruling on the principle that “the
terms of a contract cannot override either issues of control in an employment relationship
to determine worker status or the legal requirements under ERISA”;
4) In December 2001 the EEOC filed a $2 billion
lawsuit against Allstate Insurance Company after its life insurance agents
signed
written agreements to convert from employee to contractor status as part of a company-wide restructuring program.
The
agency recently charged Allstate with “coercive and intimidating practices” when
it forced its agents to sign written
statements
agreeing to the change of status from employee to independent contractor.
Myth
#6: All Contractors Are The Same When It Comes to Legal Compliance
Reality: All contractors are NOT the same. The IRS considers independent contractors to be self-employed. Each is a business owner with the right to choose from various forms of business entity, including a corporation. An independent contractor’s business entity can affect the potential liability of any company that hires or manages that person when legal disputes arise. Recognizing that all contractors are not the same can help reduce the costs of future potential legal disputes in contractor workforce management.
Myth
#7: Workers Compensation Policies Protect Employers from Liability for Work-Related
Injuries Suffered by Employees, but Not Independent Contractors
Reality: This is true, however the risks of potentially costly legal consequences also need to be considered. Because independent contractors aren’t covered by an employer’s workers compensation plan, hiring independent contractors (or converting employees to independent contractor status) can open the door to personal injury lawsuits when contractors suffer work-related injuries. Because they are not employees, independent contractors who are injured on the job can bring a personal injury lawsuit alleging negligence, defective machinery or equipment, or other grounds for liability just like any other business customer or client. Employers need to recognize the real costs of losing the protective shield that workers compensation provides against such lawsuits.
Conclusion – Education is the Best Defense
As businesses struggle to balance reduced revenue growth against the goal of profitability, laying off employees and hiring independent contractors are the most obvious and convenient short-term cost-cutting fixes. This article has identified 7 illustrative areas of legal risk, which employers need to recognize and include in their business planning before they are faced with unexpected, costly legal surprises down the road. The best remedy for managers needing to cut costs is education – learning the real legal risks in contractor workforce management and the potentially high costs of ignoring these costs in their business planning.
© 2002. REW Associates. All Rights Reserved.