The legal landscape regarding the use of independent contractors has dramatically changed over the past several years. For decades, employers’ use of independent contractors was not only rarely challenged, but it was also a way they could save significantly on labor and other costs associated with hiring employees. In this tough economy, employers may be tempted to use the services of independent contractors instead of employees in order to reduce their bottom-line costs. However, now more than ever, employers need to be extra careful in this area since both state and federal agencies are cracking down on what they believe is the widespread and improper use of independent contractors.

By way of example, the U.S. Department of Labor (DOL) has recently made the misclassification of workers one of its top priorities. President Obama’s proposed 2011 budget for the DOL includes an additional $25 Million for what he characterizes as the “Misclassification Initiative.” In this regard, it is expected that the DOL will hire an additional 100 enforcement personnel to investigate claims of misclassifying workers as independent contractors.

The Internal Revenue Service is also taking the misclassification of employees seriously. The U.S. Government Accountability Office (GAO) recently concluded that employee misclassification is a “significant problem” because it reduces tax revenues flowing to the federal government. In fact, the GAO estimates that over $7 Billion in payroll taxes will be lost over the next ten years. Needless to say, the IRS does not take this loss in revenue lightly and has notified the public that, commencing in 2010, it will increase its employer tax audits with the specific purpose of determining whether employers are misclassifying workers as independent contractors.

States around the country have also seen this as a significant issue. Illinois, New York, Maryland, Colorado and Delaware, to name a few, have either increased penalties for improperly classifying workers as independent contractors or have passed laws specifically designed to penalize employers for misclassifying workers. There has even been legislation pending in Congress, which was sponsored a former Illinois Senator named Barack Obama, called the Independent Contractors Proper Classification Act, that would restrict an employer’s ability to classify a worker as an independent contractor. Specifically, it would grant workers the right to petition the Secretary of Treasury for a determination of their status as employees or independent contractors and obligate employers to provide notice to workers of their right to seek a determination. Simply put, the issue of misclassifying workers is not going away anytime soon.

Unfortunately for employers, there is no single test to ascertain whether a worker should be classified as an employee or an independent contractor. And, to make matters worse, different state and federal agencies utilize different tests and standards in this regard. However, common scenarios that raise red flags to governmental agencies are:

  • Individuals classified as independent contractors who perform the same kind of work or duties that employees also perform for the business;
  • Individuals classified as independent contractors who perform work that is essential to the services or work of the business;
  • Arrangement where the independent contractor either dedicates all his or her time to the business or is restricted from performing services for other businesses;
  • Individuals designated as independent contractors who perform work for which other businesses in the same industry use employees.

In light of the foregoing, all employers must properly evaluate whether any current workers are appropriately classified as independent contractors and, if necessary, change the classification to comply with current federal and state law.