The Fair Labor Standards Act (FLSA) requires covered employers to pay non-exempt employees overtime compensation for all hours worked in excess of 40 hours per week. No overtime pay obligation exists for independent contractors. Consequently, many employers view the use of independent contractors as an alternative to hiring employees – particularly for individuals whose hours may vary or the length of the need for their services may be relatively short.

Many employers misunderstand the requirements associated with treating workers as independent contractors, however. Misclassifying workers who really are employees as independent contractors can have significant negative legal implications, including potential liability under the FLSA and federal and state tax laws. Personal liability of managers and corporate officers also is possible. Recent enforcement efforts by the U.S. Department of Labor (DOL) and the Internal Revenue Service (IRS) highlight the need for employers to examine how they classify workers in order to ensure compliance with applicable federal law.

Case in Point: Department of Labor v. International Detective & Protective Service, Ltd.

Recently, a federal court in Illinois ruled in favor of a group of private security guards, awarding them nearly $205,000 in unpaid compensation and liquidated damages, after finding that their employer, International Detective & Protective Service, Ltd. (International), failed to comply with the overtime requirement of the FLSA, in part because it wrongly classified them as independent contractors. Department of Labor v. International Detective & Protective Service, Ltd., No. 09 C 4998 (N.D. Ill. May 24, 2011).

Upon hiring, International required each of its guards to enter into an “Independent Contractor Contract.” International provided its guards with a set of policies and procedures for conducting their security work and regularly held guard staff meetings regarding the application of its policies and procedures. While the guards were responsible for their own firearms, bullets, uniforms and handcuffs, International supplied them with radios, cellular telephones, cameras, vehicles, and automobile and liability insurance. Following an investigation, the DOL filed suit on behalf of the guards, alleging that International inappropriately classified its guards as independent contractors, and in doing so, failed to pay them overtime pay for their overtime hours. Following the close of discovery, the DOL filed a motion for summary judgment on behalf of the guards on the issues of both liability and damages.

The court began its analysis by noting that the “economic realities” of the relationship between the guards and International governed whether the guards were properly classified – not the text of the “Independent Contractor Contract” that International required them to sign. With respect to the economic realities, the court laid out six factors relevant in determining whether a worker is an employee or independent contractor:

  • the degree and nature of control that the employer has over the manner in which the alleged employee performs the work
  • the chance that the alleged employee has for profit or loss depending on his or her skill
  • the alleged employee’s own investment in the equipment or materials needed to complete the work
  • whether the service at issue requires special skill
  • whether the employment relationship is permanent
  • the extent to which the alleged employee’s services is an ‘integral part’ of the employer’s business  

Degree and Nature of Control

The court began its analysis of the first factor by observing that “[i]f the employer oversees the ‘manner and method’ of how the alleged employees are to perform their work, they are probably employees rather than independent contractors.” Based on the existence of International’s policies and procedures, which prescribed how the guards were to perform security services, the court concluded that this factor favored a finding that the guards were indeed employees.

Chance for Profit or Loss

Independent contractor status is indicated when a worker shares in the risk or reward of business profits or losses. In the International case, the guards earned the same amount per hour – regardless of the quality of their performance or the profit of International. Thus, this factor tipped in favor of employee status.

Equipment and Specialized Skills

A worker’s use of his or her own equipment and materials tilts in favor of independent contractor status. Additionally, independent contractor status is more likely where the skills utilized by the worker are highly specialized. While the court in International acknowledged that the guards supplied their own firearms, bullets, handcuffs, and uniforms, the court also observed that International provided the guards with vehicles, cellular telephones, and car and liability insurance. The court also noted that the guards worked under International’s Illinois security contractor license. Thus, ultimately the court determined that this factor supported a finding that the guards were employees. With respect to the specialized skills associated with the guard position, the court characterized the work involved as “normal, unspecialized security guard work,” which also supported employee status.

Permanency and Integral Part of Business

The more permanent the relationship between a worker and his or her employer, the more likely the worker is an employee. The circumstances surrounding the relationship between International and its guards “contemplated a long-term relationship.” Further, the guards were “integral” to the day-to-day operations of International. Thus, these two factors suggested that the guards were employees.

Based on its analysis of the factors above, the court concluded that the guards were indeed employees and that International violated the FLSA by treating the guards as independent contractors and failing to pay them overtime compensation.

Damages and Personal Liability of Senior Executives

Utilizing the DOL’s calculation of damages, the court awarded actual damages of approximately $101,500. The court also awarded liquidated damages, resulting in a total award of nearly $205,000. Notably, in International, the court also addressed whether the President/Owner and Chief Operating Officer of International could be held liable under the FLSA in their individual capacities. In accordance with the majority of legal authority, the court held that because these individuals had “operational control” over the business and were involved with day-to-day operations, they were “employers” as that term is defined under the FLSA and could be held personally liable for the full damage award.

Tax Consequences of Worker Misclassification

The IRS has also recently made worker classification a priority. It announced in 2010 that it will conduct comprehensive audits of 6,000 employers from 2010 through 2012, focusing on 2,000 employers per year. The Internal Revenue Code requires an employer to deduct and withhold income and social security taxes from the wages paid to employees. 26 U.S.C. § 3102(a) and 3402(a). An employer who fails to withhold and pay employee income taxes and employee FICA taxes during a calendar year because it erroneously treated an individual as an independent contractor instead of an employee must pay a civil penalty equal to 1.5 percent of the employee’s taxable wages and 20 percent of the employee’s FICA taxes not withheld. 26 U.S.C. § 3509. Also, any person required to collect, account for, and pay over income and FICA tax who willfully fails to do so faces criminal prosecution with penalties of an additional $10,000 per violation and up to five years in prison. 26 U.S.C. § 7202.

The IRS uses a multifactor analysis to determine independent contractor status. No single factor is determinative of the status of an independent contractor or employee. Notably, to further complicate matters, the test for independent contractor status used by the IRS is not necessarily the same as the test used by the courts for purposes of applying overtime and minimum wage laws.

Two Recent Enforcement Actions

Two recent IRS enforcement actions that resulted in criminal penalties demonstrate the need for careful analysis of whether to treat individuals as employees or independent contractors. In United States v. McLain, an officer of a corporation was convicted of failing to account for and pay over taxes for employees of the corporation. 597 F. Supp. 2d 987 (D. Minn. 2009). The court found that the temporary nursing staff utilized by the employer were employees, not independent contractors, and held that individual liability against the corporate officer was appropriate under the statute. The court rejected the officer’s argument that as an officer and not the owner of the corporation, he should not be subject to a criminal felony conviction, holding “just as an individual corporate officer or employee can be civilly liable under § 6672, that officer or employee can be criminally liable under § 7202.”

Similarly, the U.S. Court of Appeals for the Tenth Circuit recently affirmed criminal liability for a corporate officer who failed to account for and pay over income tax and FICA tax for part-time nurses found to be employees, and not independent contractors. United States v. Crabbe, 364 Fed. Appx. 412 (10th Cir. 2010). The court affirmed the criminal conviction even though the corporate officer took remedial measures to try to correct the corporation’s past withholding errors, he was excluded from access to important information in the corporation, and he was not specifically responsible for paying the corporation’s taxes.

Employers who have misclassified employees and independent contractors have long been able to take “safe harbor” in Section 530. A taxpayer who satisfies Section 530 can preserve the independent-contractor status of covered workers and have assurance that that status will be respected for purposes of federal employment taxes so long as the taxpayer takes no action that would violate Section 530’s requirements.

A business satisfies the requirements of Section 530 with respect to a worker if all of the following are true:

  • the business has, since 1978 or since opening, consistently treated the worker (and all other workers holding “substantial similar” positions) as nonemployees for federal employment-tax purposes (the substantive consistency requirement)
  • for the tax year at issue, the business reported on a Form 1099 the amount of compensation paid each worker at issue during the year (the Form 1099 requirement) (at least $600)
  • the business treated the workers as nonemployees in reliance on a reasonable basis

Proposed legislation introduced by House Ways and Means Committee Member Jim McDermott (D-WA) and Senate Finance Committee Member John Kerry (D-MA) in September 2010 would repeal Section 530 and permit the Secretary of the Department of the Treasury to issue new guidance for worker classification. The bill failed to pass, but a McDermott staffer has said that the representative intends to re-introduce the legislation. President Obama’s fiscal 2012 budget also targeted Section 530’s safe harbor provisions.

Conclusion

Employers must use caution in treating workers as independent contractors. Proper classification of a worker as an independent contractor is complex and situation-specific. Employers should consult legal counsel in order to obtain appropriate guidance and advice on the status of their independent contractors. If a misclassification is observed, counsel should be sought on whether the employer should enroll in the formal settlement program available through the IRS, known as the Classification Settlement Program. This program allows employers to prospectively change their treatment of a worker from an independent contractor to an employee in order to reduce their tax liability. Holland & Knight’s Wage and Hour Team, in conjunction with our tax controversy and tax litigation attorneys, can provide guidance about the program, and about worker classification issues more generally.