The decision to classify workers as employees or independent contractors has always been difficult. But recent events suggest that the choice, or at least the consequences of getting it wrong, is also expensive. The benefits of classifying workers as independent contractors, especially where the distinction is close, may no longer be worth the risk.

Only a few weeks ago, shipping giant UPS agreed to pay a staggering $12.8 million to settle a class action lawsuit over the company’s alleged misclassification of delivery drivers as independent contractors rather than employees. In the summer of 2008, several of UPS’s delivery drivers filed a lawsuit in the United States District Court for the Northern District of California. The drivers claimed they were wrongfully classified as independent contractors rather than regular UPS employees, and as a result, were denied the benefits and protections of, among other things, the Fair Labor Standards Act (“FLSA”). Particularly, the drivers focused on the FLSA's minimum wage and overtime guarantees.

According to the drivers, UPS controlled almost every aspect of the working relationship. For example, the drivers alleged that UPS required packages be delivered and picked-up at certain times, that UPS dictated the drivers' dispatches, set the prices, and even controlled what the drivers wore. Essentially, the drivers claimed they were such an integral part of UPS’s business, that they could not be said to have any separate or distinct business of their own. The court allowed the case to proceed as a class action, and the group eventually included roughly 2,400 UPS delivery drivers.

UPS denied the allegations, but eventually agreed to settle the case for $12.8 million (the settlement received provisional approval, but must still receive final approval from the court). Because the case settled before either a judge, jury, or more helpfully an appellate court, could decide the issue, we cannot know whether UPS in fact misclassified its drivers. That is, it is unclear whether the examples listed above necessarily create an employer/employee relationship. What is clear, however, is that the decision to treat its delivery drivers as independent contractors rather than employees ultimately cost UPS far more than it saved.

The real question is whether this case is an outlier or a sign of things to come. There are no reliable, or at least readily available, ways to track the number of misclassification suits filed each year. Thus, we do not know for sure whether these types of cases are increasing. Nonetheless, anecdotal evidence suggest that misclassification cases are far more common today than in years past.

Accordingly, employers should be aware of the general rules for distinguishing between employees and independent contractors. Unfortunately, the distinction is not always clear or straight-forward. There is no single test that the courts will use to determine whether an independent contractor is actually an employee. With that said, there are a few tests that businesses need to be aware of when deciding whether to classify a worker as an employee or independent contractor.

For example, the IRS has adopted its own test for distinguishing between employees and independent contractors. For several years, the IRS used a complicated 20-factor test. Recently, however, the IRS abandoned that test in favor of one based upon general common law principles. Under this new three part test, the IRS considers:

1. the amount of behavioral control;

2. the amount of financial control; and

3. the general relationship between the parties.

There is no magic formula for determining how much control is too much, and the IRS is careful to point-out that no single factor is greater than the others. Businesses must look at the entire relationship. The more a business controls a worker, the more likely it is that an employment relationship exists. Meanwhile, under the FLSA the courts use the “economic realities” test. This test focuses on the degree of economic dependence of the would be employee on the business with which he or she is connected. The more the worker financially relies upon the business, the more likely an employment relationship exists. The courts will consider factors such as:

  • the degree of the employer’s right to control the manner in which work is performed;
  • the degree of skill required to perform the work;
  • the worker’s investment in the business;
  • the permanence of the working relationship;
  • the worker’s opportunity for profit/loss; and
  • the extent to which the work is an integral part of the business.

Control is the key. The more control a business has over the workforce, the more likely a court will find that an employment relationship exists, especially where the tasks being performed are an integral part of the business. Although there are countless situations in which courts will find that a worker is appropriately classified as an independent contractor, the UPS settlement is a reminder that the consequences of being wrong are severe, and that businesses should proceed with caution.