There are tax and financial advantages for businesses that hire independent contractors as opposed to employees. These businesses do not pay FICA for the contractors, withhold taxes, pay unemployment taxes or pay for worker’s compensation coverage. At the same time, these workers are not eligible for minimum wage and overtime, unemployment, employer-provided health insurance and retirement plans, and other employer benefits. Also, these workers cannot join together for union representation and cannot avail themselves of the myriad protections provided employees by federal, state and local laws, including employment discrimination laws. But the consequences of misclassifying employees as independent contractors are potentially huge, including liability for taxes, interest and penalties; unpaid overtime and minimum wages; and liquidated damages and unpaid benefits.

State and federal government efforts to uncover misclassified workers continue to grow, and plaintiff class action/collective action lawyers continue to target employers who incorrectly classify workers as independent contractors. This article addresses the current state of affairs.1

The Controlling Legal Standard

The controlling legal standard is well known, albeit somewhat confusing due to the competing tests being applied. The Internal Revenue Service (IRS) and the courts weigh a host of factors in determining whether the worker is an independent contractor or employee.2 The common law agency test focuses primarily on the employer’s right to control the manner and means by which the work is accomplished. The economic realities test focuses on the realities of the entire relationship. A hybrid test combines the two.3 Fundamentally, all tests overlap to a significant extent and are functionally equivalent, or virtually so. The tipping point is invariably the employer’s right to control the manner and means of the worker’s performance.

State Efforts

Meanwhile, the pressing need to find new revenue has caused a frenzy of activity on the state and federal level to identify employers who misclassify workers. The states have established task forces, commissions, attorney general initiatives and investigations – as well as taken other measures – to identify these employers in an effort to collect taxes and unpaid wages. A few examples on the state level make the point. A New York Joint Enforcement Task Force on employer misclassification has conducted roughly 70 sweeps and identified 35,000 misclassified workers, $407 million in unreported taxes, $13 million in unemployment taxes due, and $14 million in unpaid wages. Many states, including Illinois, have enacted measures to discourage and prevent misclassification of construction workers, an industry where violations are rampant and difficult to detect.

Recent initiatives on the state level include: a revision in Connecticut law to make each day that an employer knowingly or intentionally misclassifies an employee a separate offense, subject to civil penalties up to $1,000 per day; a new section in Wisconsin’s employee classification laws requiring employers to maintain records of all employees and their hours, wages, and deductions and offer worker’s compensation coverage for employees; and an executive order issued by New Hampshire’s Governor instructing state departments with authority in this area to coordinate their respective resources in order to identify and investigate cases of misclassification and to develop strategies to eliminate misclassification.

The efforts on the part of state attorneys general to pursue claims against Federal Express for misclassifying drivers are well publicized. At least 10 state attorneys general are pursuing claims, and others, like Massachusetts, have reached multimillion-dollar settlements.4

Federal Efforts

On the federal level, for the fiscal year 2012 budget the Obama administration has proposed to allocate $46 million to combat employer misclassification of employees as independent contractors. Fifteen million would be allotted to hire new personnel within DOL’s Wage and Hour Division to investigate misclassification, and $25 million would be available to states in grants to conduct audits.

The IRS began its National Research Program in 2010 to conduct extensive employment tax examinations of 2,000 businesses each year for three years. In 2011, the National Research Program is continuing its examinations, which focus primarily on worker classification, payment of employment taxes, and treatment of employee benefit plans.

In 2010, two bills were introduced in Congress for the purpose of curtailing misclassification of employees as independent contractors:

  • The Employee Misclassification Prevention Act (H.R. 5107, S.3254) targets abuses by establishing anti-retaliation protections for workers and incentives for whistleblowing, plus increasing the civil penalties for misclassification.
  • The Fair Playing Field Act (H.R. 6128, S.3786) closes the “loophole” known as the Safe Harbor provision, which allows businesses to classify workers as independent contractors as long as there is a “legal basis” for the classification and the business has consistently treated such employees as independent contractors by reporting their compensation on a Form 1099. A provision of this bill would require businesses which hire independent contractors on a regular ongoing basis to provide a written statement to each contractor that informs them of the federal tax obligations of independent contractors, employment practices that do not cover independent contractors, and the right of any independent contractor to request a status determination by the IRS.

Most likely, one or both of these bills will be reintroduced in March 2011. It is doubtful that either bill will pass in the current political climate, but there is no question that the DOL and the IRS are cracking down on businesses. Overall, there is increased collaboration between the DOL and the IRS, as well as the sharing of tax information between the IRS and most states.


The wildcard in 2011 and future years is the plaintiff class action/collective action bar. While we continue to see, as we have for years, a steady docket of cases filed under the Fair Labor Standards Act for overtime pay based upon a worker’s exempt or non-exempt status, or cases brought by non-exempt employees who claim they are performing work off the clock, a relatively modest number of cases have been filed on behalf of workers who claim they have been cheated out of being paid minimum wage or overtime by being improperly classified as independent contractors. Federal Express is currently defending a considerable number of these cases nationwide.

A huge potential liability for employers is the denial of employee benefits to a class of misclassified workers. The seminal case is Vizcaino v. Microsoft Corp., 97 F.3d 1187 (9th Cir. 1995) (“Vizcaino I”), aff’d, 120 F.3d 1006 (9th Cir. 1997) (en banc) (“Vizcaino II”); 290 F.3d 1043 (9th Cir. 2002) (“Vizcaino III”). In Vizcaino I, the court held that a class of workers was entitled to participate in Microsoft’s qualified Employee Stock Purchase Plan (ESPP) even though they had been told when hired that they were independent contractors and ineligible for such benefits. Microsoft had hired them as “freelancers” or “temps.” The class members had even signed written agreements disclaiming any entitlement to these benefits. The court found that the class members met the definition of employee under the common law and the Internal Revenue Code required that the ESPP permit all common law employees to participate. The fact that the class members were “leased” from an employment agency was deemed immaterial – class members were afforded the same options to require stock as all other Microsoft employees.

Considerations for Employers

Employers must be mindful of the ramifications of misclassifying workers. Again, government agencies, departments and officials have become significantly more aware of the misclassification problem. Legislation and initiatives have been launched on the federal and state level to uncover misclassification cases and collect unpaid taxes and other monies. And we can expect to see an increase in lawsuits filed by the plaintiff class action/collective action bar as the misclassification issue continues to gain attention.