A. Introduction
An individual who provides services to another in exchange for payment may be classified as either an "employee" or "independent contractor." Simply stated, an employee works for the organization and is controlled by the organization. For example, the organization supervises an employee's work, sets an employee's schedule, and determines the method the employee uses to perform his work. On the other hand, an independent contractor works for himself but provides particular services to an organization. The organization has much less control over an independent contractor and an independent contractor may set his own schedule, work without supervision, and determine the method used to perform the assigned work. Importantly, the way someone is classified (i.e., whether as an employee or as an independent contractor) is not dispositive of proper classification. Rather, deciding an individual's proper employment status requires considering a number of factors, as explained in detail below.
Employers must take care to properly determine each individual's employment status because the law treats employees and independent contractors very differently. For example, an organization does not need to provide certain employment benefits to independent contractors or withhold income taxes from their compensation. Since there is considerable liability for misclassification, including potential personal liability for an organization's managers and directors, proper classification is essential.B. Is A Worker An Employee Or An Independent Contractor?
Although an individual's employment status can have major consequences on an employer's obligations under various state and federal laws, none of the laws clearly define the term "employee" or "employment." Instead, New York, Connecticut, and New Jersey courts consider a number of factors to classify individuals as employees or independent contractors.
However, the most important factor in determining whether an individual is an employee or an independent contractor is: the organization's right to control the individual's results and the method or means he uses to achieve those results.1 In general, organizations have much more control over employees than independent contractors who, as their name implies, work more "independently." Generally, if an organization can dictate only the result of the work, as opposed to the means or the manner by which the work is done, the person is more likely an independent contractor. Examples of independent contractors may include certain professionals, such as: certified accountants, whose work entails a large degree of independence; artists, whose work requires expressive freedom; and skilled laborers such as plumbers and electricians.
While the level of control over the individual is of primary importance, to determine if person is an employee or an independent contractor, courts examine all facts and circumstances of the working relationship, which may include the following:2
(1) whether, and to what extent, the individual is required to follow the organization’s instructions;
(2) the amount of training of the individual related to the particular job;
(3) amount of integration of the individual into the organization's business;
(4) whether the individual’s services are rendered personally;
(5) whether the organization hires, fires, and pays assistants used by the individual, or whether the individual has discretion to use assistants as he/she sees fit;
(6) the existence of a continuing relationship between the individual and the organization;
(7) the establishment of a set amount of work hours;
(8) whether the individual must devote substantially full time to the organization;
(9) whether the individual works on the organization's premises;
(10) whether the individual works according to a sequence set by the organization;
(11) whether the individual must submit regular or written reports to the organization;
(12) whether the individual is paid by time rather than by project;
(13) whether the individual is reimbursed for expenses;
(14) whether the individual furnishes his or her own tools and materials;
(15) whether the individual has invested in the facilities for performing the services;
(16) whether the individual can realize a profit or a loss;
(17) whether the individual works for more than one organization at a time;
(18) whether the individual makes his services available to the general public;
(19) whether the organization has the right to discharge the individual; and
(20) whether the individual has the right to terminate his or her relationship with the organization.
Determining whether a worker is an independent contractor or an employee is always a fact-specific determination and no single factor discussed above is conclusive. The key however, is to remember that control is the most significant issue when determining a person's employment status. In addition, it is not enough that a worker's contract may call him an "independent contractor" or that he agreed to work as an independent contractor. Rather, organizations must consider each of these factors to properly classify its workers.
Independent contractors and employees are treated very differently under state and federal law. Independent contractors are granted far less protection than employees, and organizations have fewer obligations and liabilities toward independent contractors than they do toward employees. For example, independent contractors are not protected by the federal anti-discrimination laws, the federal wage and hour law (the Fair Labor Standards Act or “FLSA”), or the Employee Retirement Income Security Act (“ERISA”). New York, Connecticut and New Jersey state laws covering workers' compensation, unemployment, and anti-discrimination also fail to protect independent contractors. These laws apply only to employees.
In addition, independent contractors are usually not covered by an employer's benefit package or workers' compensation insurance. Independent contractors are also taxed differently than employees and are responsible for their own tax withholding, so organizations provide independent contractors with an Internal Revenue Service (IRS) Form 1099 rather than a Form W-2. Thus, non-profits may have many financial and administrative incentives to use independent contractors rather than traditional employees.
However, because of the serious implications of misclassifying employees as independent contractors, as well as the increase in independent contractor scrutiny in recent years at both the federal and state levels, organizations must carefully analyze each individual's employment status using the general factors outlined above. In addition, organizations should also review the specific definitions used to determine employment status under various state and federal laws, which are outlined in Appendix B.VI.
D. Implications Of Misclassifying Employees As Independent Contractors
1. FLSA/Wage and Hour Law
Because independent contractors are not "employees" entitled to the protections afforded by the FLSA, it is critical to properly identify and differentiate between employees and independent contractors. Appendix B.VI discusses the definition of "employee" under the FLSA.
An audit under the wage and hour laws could result in substantial financial liability where an individual the employer identified as an independent contractor is determined to be an "employee." Proper classification is especially important because wage and hour violations may result in significant fines and penalties to individual managers as well as to the hiring organization.
2. State Workers' Compensation Law
State workers' compensation laws provide for compensation to any employee who is injured during the course of his or her employment. Organizations must contribute to the workers' compensation system and carry workers' compensation insurance on behalf of their employees. Independent contractors are not covered under New York, Connecticut, or New Jersey law. If a misclassified independent contractor is injured on the job and files a claim for workers' compensation, the employer may be subject to workers' compensation claims, civil tort actions, fines, and criminal convictions if it is determined that the injured individual is actually an "employee." Organizations should secure workers' compensation insurance for their employees to protect against potential workers' compensation claims. Thus, proper classification of independent contractors is imperative.
3. State Unemployment Insurance Law
While independent contractors are not covered by New York, Connecticut, or New Jersey unemployment insurance law, an organization's classification of an individual may be scrutinized if an individual files a claim for unemployment benefits or if the agency performs an audit of the organization. In all three states, organizations must contribute to the state unemployment compensation system on behalf of their employees, but not for their independent contractors. Organizations that misclassify their employees as independent contractors and do not contribute to the system must pay the amount that they should have contributed and are also assessed interest for each month that they are in default. In addition, organizations that are found to have willfully misclassified their employees to avoid paying unemployment benefits may be found guilty of a misdemeanor.3
4. Anti-Discrimination Law
Generally speaking, state and federal anti-discrimination laws only afford their protections to "employees." Nevertheless, some courts (including an appellate court in New Jersey) have found that independent contractors can maintain discrimination lawsuits if the organization exerts the requisite amount of control over the independent contractor’s work.4 Thus, a cautious employer should take care to draft its policies to protect all employees, independent contractors, volunteers, interns, workfare assignees, and customers. In addition, policies should be distributed to all individuals who work for the employer or on the employer's premises.5
5. Employee Benefits
Often, a significant motivating factor in an employer's use of independent contractors is to avoid the cost of providing employee benefits to a segment of its workforce. However, there are several potential pitfalls to this strategy, so careful planning in this area can be critical. In addition to the onerous employment tax liabilities, discussed below, that an employer and "responsible persons" can face if it has misclassified employees as independent contractors, there are also potentially serious liabilities under the employer's benefit plans regarding retroactive benefit entitlements, tax penalties for failure to comply with COBRA, potential disqualification of Tax-Qualified Plans such as pension and 403(b) plans, and possible ERISA liability. Appendix B.VI discusses the definition of "employee" under ERISA.
6. Federal Tax Law
Employers must also be careful when classifying a worker as an independent contractors to avoid later imposition of a tax liability for misclassification of that worker. Appendix B. VI discusses the definition of "employee" under the Tax Code. While using independent contractors relieves the employer from the tax liabilities and reporting responsibilities that are required with employees, the misclassification of a worker as an independent contractor can result in harsh employment tax penalties.
Since organizations do not withhold or pay employment taxes on independent contractors, if the IRS determines that the organization misclassified an employee as an independent contractor, the organization is generally liable for the employment taxes it otherwise was required to pay or withhold on the wages paid to the employee in addition to penalties, interest, Federal Insurance Contributions Act (FICA) payments, and Federal Unemployment Tax Act (FUTA) payments. However, organizations that misclassified their employees but indeed complied with the Form 1099 reporting requirements may qualify for a reduction in the amount of employment taxes that they owe the government.6 Thus, in addition to carefully classifying their employees and independent contractors, organizations should always comply with the Form 1099 reporting requirements for their independent contractors to further reduce any implications of misclassification.
In addition, organizations that misclassify employees and therefore underpay FICA and FUTA taxes or income tax withholding will need to pay the outstanding amount plus interest and may also face numerous civil penalties including (1) late filing of a tax return; (2) failure to deposit employment taxes; (3) negligence or intentional disregard of the rules and regulations; (4) fraud; (5) willful failure to provide employment wage statements; and (6) aiding and abetting the understatement of tax liability.7 Numerous criminal penalties may also be asserted against the employer, including (1) willful attempt to evade or defeat tax; (2) willful failure to collect or pay over tax; (3) willful failure to file a return, keep records, supply information or pay tax; (4) willful failure to provide employment wage statements; and (5) willful filing of a false return.8
In addition to these consequences, the IRS may also impose a 100% penalty on the individuals responsible for the willful failure to withhold or pay over to the IRS the employee's share of FICA taxes or income taxes.9 This penalty appears to be directed at persons who have control or responsibility over the organization's finances, and courts have imposed the penalty on people who ignored an obvious and known risk that the funds would not be paid.10 Thus, any person who exercises hands-on-control over an organization, participates in decisions concerning the disbursement of funds, salaries and payments to creditors, and/or has authority to sign checks, may be held liable individually for these penalties.
Notably, the Tax Code also includes a "safe harbor provision" for organizations. Section 530 of the Revenue Act of 1978 protects employers from having their independent contractors reclassified by the IRS to the status of employee and from incurring penalties for misclassification. Section 530 provides that the IRS is bound by the employer's classification if (1) the employer consistently treated the worker as an independent contractor, (2) the employer filed all federal tax returns consistent with its position, and (3) the employer had a "reasonable basis" for that position.11Recent efforts on both state and federal levels have focused on identifying employers who have misclassified employees as independent contractors, providing further incentives for employers to review their classification practices for conformance with applicable legal standards.
For example, the IRS announced a new state and federal information-sharing plan for employment tax audits in 2007, aimed at reducing fraudulent filings and ensuring proper worker classification.12 New York, Connecticut, and New Jersey all entered into partnership agreements with the IRS to share information under this plan. Additionally, in October 2009, the IRS announced a new audit initiative focusing on misclassification of independent contractors that will target the federal tax returns of 6,000 companies. The two primary goals of the audit initiative are (1) to increase tax compliance and payroll tax collections, and (2) to reduce the number of misclassified independent contractors. The audits, which are scheduled to begin in February 2010, are deeper and more thorough than typical IRS audits. Once the IRS has completed the initial 6,000 audits, it will use the results to further refine the techniques used in additional audits. This audit initiative is the largest audit initiative announced by the IRS in decades, illustrating the seriousness the IRS gives to independent contractor misclassification.
Federal legislation has also been introduced to address classification issues. As a senator, President Obama introduced the Independent Contractor Proper Classification Act of 2007, which would have limited the availability of the safe harbor provisions in section 530 of the Revenue Act of 1978.13 In 2008, the late Senator Kennedy introduced the Employee Misclassification Prevention Act, which would have amended FLSA, requiring employers to keep records of non-employee workers and pay penalties for misclassifying employees as independent contractors.14 Finally, Representative McDermott introduced the Taxpayer Responsibility, Accountability, and Consistency Act in 2008, which would have made it more difficult for employers to classify workers as independent contractors.15 While none of these bills were successful, their introduction illustrates legislative interest in further regulating how employers classify workers.
On the state level, New York, Connecticut, and New Jersey have all enacted laws to identify misclassified employees and hold employers accountable. In New York, former Governor Spitzer issued an Executive Order on September 7, 2007, forming an interagency Task Force charged with addressing the problem of employee misclassification.16 The Task Force, which must issue an annual report to the Governor, conducted numerous enforcement sweeps in 2008 and uncovered millions of dollars in unreported and/or underpaid wages.
Connecticut passed Public Act No. 08-156 in 2008, establishing a similar Joint Enforcement Commission on Employee Misclassification .17 The Commission is tasked with coordinating state agency civil prosecutions due to misclassification, and must submit a report with recommendations to the Governor on or before February 1, 2010.
New Jersey passed the Construction Industry Independent Contractor Act in 2007, which subjects employers in the construction industry who knowingly misclassify workers to severe financial and criminal penalties, including imprisonment.18 In addition, Governor Corzine issued Executive Order #96 in 2008, creating the Governor’s Advisory. Commission on Construction Industry Independent Contractor Reform. The Commission must report annually to the Governor and is authorized to hold public hearings and coordinate with state agencies and community groups to combat employer misclassification.19
Finally, at both the state and federal levels, civil lawsuits by independent contractors who claim they were misclassified are on a steep rise. For example, class actions brought by groups of allegedly misclassified independent contractors who claim they were denied overtime pay and subjected to other wage and hour violations have been filed against numerous companies across the country, including FedEx, Microsoft, Comcast and Home Depot. Employment lawyers predict that this rising trend of misclassification lawsuits both at the individual and class action level will continue in coming years.
F. Liability To Third Parties For Independent Contractors Vs. Employees
A worker's status also determines whether an organization will be held liable to third parties who are injured as a result of the worker's conduct. Organizations are generally liable for the willful or negligent acts of their employees, committed within the scope of employment. For example, an organization may be held responsible for injuries caused to third parties if a truck driver that it employs is involved in a traffic accident. Organizations are not, however, generally responsible for the acts of independent contractors. Nevertheless, some courts (including the Ninth Circuit Court of Appeals) have found that an employer can be liable for alleged discrimination by an independent contractor, regardless of whether or not the independent contractor was misclassified.20
Organizations must take special precautions when employing non-traditional workers such as temporary workers. Although an organization may consider a temporary worker an independent contractor, it may still be held liable for injuries caused to third parties by temporary employees under their control under the theory of respondent superior. In short, organizations should be aware that using independent contractors and other types of non-traditional workers generally will not shield them from liability for personal injury or property damage arising out of these workers' job performance.21 Organizations should therefore review their general liability insurance policy to ensure that the language of the policy is broad enough to cover acts by, and injuries to, non-traditional employees.
1 The primacy of employer control in determining the employment relationship (articulated in Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318 (1992)) has been recently abandoned in the D.C. Circuit. In FedEx Home Delivery v. NLRB, No. 07-1391 (D.C. Cir. April 21, 2009), the court still utilized several common law factors to determine whether or not FedEx workers were independent contractors, but replaced the right to control inquiry with a different “entrepreneurial” standard. Under this new standard, an individual would be deemed an independent contractor if their position “presents the opportunities and risks inherent in entrepreneurialism.”
2 The common law "right to control" test takes its factors from Section 220 of the Restatement (Second) of Agency (1958).
3 Self-Assessment of the Employer-Employee Relationship for Connecticut Un-Employment Taxes, available at http://www.ctdol.state.ct.us/uitax/abctest.doc.
4 See Hoag v. Brown, 397 N.J. Super. 1218, 1227-1229 (2007) (finding that even though plaintiff was considered an independent contractor by defendant, she nevertheless could maintain sexual harassment suit because defendant exerted the requsite amount of control over her work).
5 With respect to contingent workers (workers who are outside an employer’s “core” workforce, including temporary workers), the Equal Opportunity Employment Commission (EEOC) has issued guidelines indicating that both personnel staffing companies and their clients will be held liable for discrimination and harassment. EEOC Policy Guidance on Contingent Workers, available at http://www.eeoc.gov/policy/docs/conting.html.
6 See I.R.C. § 3509. For example, the employer's liability for income tax withholding is reduced to 1.5 percent of wages paid to the employee, and the employee's share of FICA tax is reduced to 20 percent. See I.R.C. § 3509(a). If the Form 1099 requirements were not complied with, the percentages are 3 percent and 40 percent, respectively. See I.R.C. § 3509(b). However, the Tax Code does not reduce the remainder of the employer's employment tax liability (i.e., the employer's share of FICA taxes) and there is no reduction in penalties and interest. See also I.R.S. Publication 15, (Circular E), Employer’s Tax Guide, 9 (for use in 2009), available at http://www.irs.gov/pub/irs-pdf/p15.pdf.
7 See I.R.C. §§ 6651, 6656, 6662, 6663, 6674 and 6701, respectively.
8 See I.R.C. §§ 7201, 7202, 7203, 7204 and 7206, respectively.
9 See I.R.C. § 6671(b).
10See, e.g., United States v. Leuschner, 336 F.2d 246 (9th Cir. 1964); Feist v. United States, 607 F.2d 954 (Ct. Cl. 1979).
11Reasonable basis is established expressly by section 530 by "reasonable reliance" upon (1) judicial precedent, published rulings, technical advice with respect to the employer, or a letter ruling to the employer; (2) a past IRS audit of the employer where no employment tax was assessed in connection with workers holding a substantially similar position; or (3) a long-standing recognized practice of a significant segment of the industry in which such individual was engaged. See Revenue Act § 530(a)(2).
12 Press Release, IRS, IRS and States Share Employment Tax Examination Results, (November 6, 2007), available at http://www.irs.gov/newsroom/article/0,,id=175457,00.html.
13 Independent Contractor Proper Classification Act of 2007, S. 2044, 110th Cong. (2007), available at http://www.govtrack.us/congress/bill.xpd?bill=s110-2044.
14 Employee Misclassification Prevention Act, S. 3648, 110th Cong. (2008), available at http://www.govtrack.us/congress/bill.xpd?bill=s110-3648.
15 Taxpayer Responsibility, Accountability, and Consistency Act of 2008, HR 5804, 110th Cong. (2008), available at http://www.govtrack.us/congress/bill.xpd?bill=h110-5804.
16 Press Release, New York State Executive Chamber, Governor Spitzer Signs Executive Order to Prevent Employee Misclassification (September 7, 2007), available at http://www.state.ny.us/governor/press/0907071.html, see also New York State Department of Labor, Misclassification of Workers, http://www.labor.state.ny.us/ui/MisclassificationofWorkers.shtm.
17 An Act Concerning Employee Misclassification, Public Act No. 08-156 (2008), available at http://www.cga.ct.gov/2008/ACT/PA/2008PA-00156-R00SB-00454-PA.htm.
18 Construction Industry Independent Contractor Act, N.J.S.A. 34:20-1 et seq. (2007), available at http://lwd.dol.state.nj.us/labor/wagehour/lawregs/indep_contractor_act.html.
19 State of New Jersey Executive Order #96, Governor Jon S. Corzine (January 18, 2008), available at http://www.state.nj.us/infobank/circular/eojsc96.htm.20 See Halpert v. Manhattan Apartments, 580 F.3d 86, 88 (9th Cir. 2009) (finding that under the federal Age Discrimination in Employment Act (“ADEA”) an employer can be liable for discrimination by an independent contractor when the independent contractor acts as an agent for the employer).
21 For example, based upon Local Law No. 39, which was enacted in 1991 and extensively revised the New York City Human Rights Law, New York City employers who hire independent contractors may be liable for the actions of those independent contractors as if they were employees. N.Y.C. Admin. Code § 8-101, et seq. The New York City Human Rights Law covers discrimination based upon actual or perceived characteristics of race, color, creed, age, national origin, religion, disability, gender, alienage, citizenship, marital status, sexual orientation, criminal arrest and conviction record. N.Y.C. Admin. Code § 8-107. Under this law, employers are also liable for discriminatory conduct of independent contractors when the discriminatory conduct was committed in the course of furthering the employer's business enterprise if the employer had actual knowledge of and acquiesced in such conduct. Id. at § 8-107(13)