Construction companies must be aware of the difference between employees and independent contractors. State and federal agencies are increasingly targeting the misclassification of workers in the construction industry. The repercussions for misclassifying employees as independent contractors, intentionally or not, include government audits, lawsuits by the government or by the misclassified worker, and payments of back wages, past taxes, civil penalties, and damages.

The United States Department of Labor (“DOL”) recently introduced Interpretation No. 2015-1, explaining the proper classification of workers as either employees or independent contractors for purposes of the Fair Labor Standards Act (“FLSA”) compliance. An estimated 3.4 million employees are misclassified as independent contractors annually. Employer avoidance of the FLSA causes state and federal governments to lose millions of dollars in tax revenue every year.

Under the FLSA, “employ” is broadly defined as “to suffer or permit to work.” To determine whether a worker is an employee or an independent contractor, the DOL examines six “economic reality” factors in light of this broad definition of employ.

Difference in Employees and Independent Contractors in the Workplace

The difference between employees and independent contractors is an important one. Employees are subject to the FLSA’s minimum wage and overtime requirements, while independent contractors are not. Further, employers must pay state and federal unemployment tax, social security and Medicare taxes, and unemployment taxes on employees’ wages, but not wages of independent contractors. When employers misclassify employees as independent contractors, the workers lose workplace protections and state and federal agencies lose tax revenue.

Classifying Workers Using “Economic Reality” Factors

Whether a worker is an employee or an independent contractor depends on an analysis of six “economic reality” factors in light of the FLSA’s directive that the term “employee” is broadly applicable. The economic reality factors are taken as a whole, as indicators of a worker’s economic dependence or independence.

1) The Extent the Work is an Integral Part of the Principal’s Business

The more “integral” work is to the principal’s business, the more likely that the worker is an employee. An independent contractor’s work is typically not integral to the principal’s business. DOL includes as an example the difference between a carpenter and a software developer on a construction project. The carpenter is integral to the business of a construction company that frames homes because making and repairing wood is critical to framing homes. On the other hand, a software development company that schedules projects and tracks bids and orders performs work that is not integral to a construction project.

2) The Extent a Worker’s Managerial Skill Can Affect Opportunity for Profit or Loss

If a worker’s managerial skills, including hiring, purchasing, and advertising decisions, affect the worker’s opportunity for profit or loss on a future job, the worker is typically an independent contractor. On the other hand, if a worker’s only opportunity for profit or loss is in earnings and overtime on the current job, the worker does not have any managerial skills that may affect his profit or loss, likely making him an employee.

3) The Extent of the Worker’s Investment in Relation to the Principal’s Investment

If a worker makes substantial investments as a business beyond working on the current project, the worker is typically an independent contractor. However, if the worker makes minimal investments, such as minor investments in tools in relation to the investment of the principal, the worker is likely an employee. DOL explains that a worker who provides a substantial investment in relation to a principal’s investment, such as investments in vehicles, rental space, and advertising, is likely an independent contractor. However, a worker who invests in some tools on a project would not be making an investment beyond working on the current project. Therefore, a worker who makes minor investments in relation to the principal would typically be an employee.

4) The Amount of Special Skills or Initiative Used by the Worker

When a worker uses special skills in an independent manner while demonstrating business-like initiative, the worker is typically an independent contractor. This includes exercising business skills and judgment in ordering materials and determining the quantity of materials needed. On the other hand, workers who exercise their skills in a dependent matter and rely on a principal to dictate when and where to perform work are typically employees.

5) The Permanence of the Relationship Between the Worker and the Principal

A worker who does not have a permanent or indefinite relationship with a principal due to his or her own independent business initiative is typically an independent contractor. Workers that are at-will, or permanent, are typically employees because they work continuously for the principal. Even seasonal workers are considered employees when they work continuously during the season.

6) The Nature and Degree of the Principal’s Control

If a worker exercises meaningful control over his or her work and functions as a separate, independent entity running his or her own business, the worker is typically an independent contractor. A worker who is economically dependent on a principal and relies on the principal to dictate the terms of how work is performed is an employee.

Recent Judgments Against Construction Companies

DOL, the Internal Revenue Service (“IRS”), and state agencies have identified a number of industries where misclassification is prevalent. One of these industries is construction. As a result of increasing investigations regarding misclassification of workers in the construction industry, a number of large enforcement actions against construction companies have occurred.

Sixteen companies in Arizona and Utah deceptively classified construction workers as members and owners of limited liability companies. This allowed the construction companies to avoid FLSA compliance and certain state and federal taxes. In April 2015, after a five-year federal investigation of these companies, federal courts in Arizona and Utah issued consent judgments, requiring the 16 companies to pay a combined $600,000 in back wages and liquidated damages and $100,000 in civil penalties.

A construction contractor in Illinois also entered into a consent judgment with the DOL after misclassifying 96 workers as independent contractors. These workers included carpenters, electricians, masons, laborers, painters, and drywall hangers and finishers, who were denied proper compensation for overtime. The contractor paid $395,465 in back wages and liquidated damages.

Lessons for the Construction Industry

DOL has stated that most workers should be classified as employees under the FLSA’s broad definition. With federal and state agencies increasingly scrutinizing classifications of workers in the construction industry, construction companies that employ independent contractors should be on alert.

Companies should keep documentation of its relationship with independent contractors, including any contracts or agreements, tax information, and invoices received from the independent contractor. Further, companies should keep any documentation showing that the independent contractor is a separate economic entity. This can include the independent contractor’s business license, office address and lease, documentation of owned or rented business equipment or vehicles, tax returns, advertisements, and a list of former or current clients. Companies can also conduct internal audits of workers classified as independent contractors to determine whether independent contractor classification is proper.

If upon examination of the six economic reality factors, a company believes that a worker currently classified as an independent contractor should be classified as an employee, the company should reclassify the worker as an employee to avoid a government audit or a lawsuit. While the company would be liable for back wages and past taxes, the company could apply for the IRS’s Voluntary Classification Settlement Program to decrease its federal tax liability.