When engaging a worker to perform paid work services, a first and critical step in the hiring process is the determination of the worker's status as an employee or independent contractor. Classification missteps can translate to significant legal and economic risk, including the potential assessment of back pay damages, punitive damages and attorneys' fees under the Fair Labor Standards Act (FLSA), penalties under the Affordable Care Act (ACA), tax assessments and penalties, and other potential damages and tax liabilities under both federal and state laws.

Workers who are not properly classified also face negative consequences, as they are not afforded overtime and/or minimum wage protections pursuant to the FLSA, workers' compensation benefits, entitlement to health insurance or other fringe benefits, payment of unemployment insurance or protections under various anti-discrimination laws.

UNDERSTANDING THE DIFFERENCES BETWEEN CONTRACTORS AND EMPLOYEES

Companies engaging workers must consider the jurisdictions and laws applicable to their workers in order to identify the appropriate test to apply in assessing classification, and they may find that workers can be properly classified as an independent contractor in certain states and in compliance with certain laws, while other states and other laws require classification of that same worker as an employee.

As a result, companies are advised to consult with legal counsel before engaging a worker as an independent contractor to assist with a classification analysis, and to conduct regular workforce audits of their independent contractor relationships to assess whether the relationship, the applicable law or the jurisdictional requirements have changed since the original assessment was completed.

IRS guidelines for worker classification

The Internal Revenue Service has distilled its analysis of independent contractor classifications into an examination of the following three categories: (1) behavioral control, (2) financial control and (3) the relationship of the parties. Any analysis under the IRS test should consider all factors examined together in order to determine the appropriate classification for federal tax purposes.

To assess behavioral control, companies should focus their analysis on whether the business has the right, even if not exercised, to direct and control the work performed by the worker. Factors to consider in analyzing behavioral control include an examination of the nature of the instructions provided to the worker, including where work should be performed, what tools should be used and where supplies and services should be purchased.

An analysis of financial control must necessarily consider whether the business has the right to direct or control the financial and business aspects of the worker's job. Factors to consider include whether the worker has made significant investment in the equipment that the worker uses in performing services, whether the worker is responsible for the expenses he incurs in performing work services, whether the worker makes his or her services available to the larger marketplace and the method in which the worker is compensated for services. In analyzing compensation structures, businesses should consider that employees are typically guaranteed a regular wage amount for hourly, weekly or other time periods worked while independent contractors are typically paid on a flat fee basis or per job worked.

The IRS guidelines also consider the type of relationship between the parties and how the parties perceive that relationship. Factors to consider in analyzing this third category are the written contracts governing the relationship between the parties and how those documents describe and characterize the relationship, whether employee benefits are provided, the permanency of the relationship between the parties and whether the services provided are key to the business. The mere existence of a written agreement, which simply states that the worker is an independent contractor, is not sufficient on its own to establish an independent contractor relationship between the parties. This is true under virtually all tests.

Assessing the worker relationship under the FLSA

Because the FLSA only applies where an employer-employee relationship exists between the parties, individuals who are properly classified as independent contractors (rather than employees) are not covered by the FLSA. Therefore, they are not protected by overtime and minimum wage requirements. The definition of "employ" is, however, very broadly defined by the FLSA as "to suffer or permit to work."

Courts utilize a balancing test commonly known as the "economic realities" test to evaluate whether, as a matter of economic reality, the worker is economically dependent on the business to which he or she renders services, in order to determine whether a worker is an employee or independent contractor under the FLSA. In applying this test, courts evaluate a number of factors, including (1) the degree of control exercised by the alleged employer; (2) the extent of the relative investments of the both worker and the alleged employer; (3) the degree to which the worker's opportunity for profit or loss is determined by the alleged employer; (4) the requisite skill and initiative required for the performance of the job; and (5) the permanency of the parties' relationship.

Various states apply disparate tests to analyze worker classification

In addition to the various tests under federal law, different states apply varying tests in determining worker status for purposes of determining state law protections or benefits, eg, unemployment insurance.

Many states follow what is commonly referred to as the ABC test, under which paid work services are considered employment if (a) the worker is free from the company's direction or control in the performance of work services both under the applicable contract and in actual practice; (b) the work services are performed either outside of the usual course of business for which they are performed or are performed outside of all places of business of the enterprise for which the services are performed; and (c) the worker is customarily engaged in an independent trade, occupation, profession or business.

Other states follow a variation of the ABC test applying, for example, only portions (a) and (c), and still others supplement the ABC test with additional factors for a more rigid analysis. Yet other states apply a 20-factor analysis, weighing 20 different factors, which fall within the IRS's three categories for consideration of behavioral control, financial control and the relationship of the parties. This is not, however, a comprehensive summary of all the different state law tests, but rather, a summary of the more common approaches.

Employers with operations and workers in multiple states should consult legal counsel to ensure compliance with the various applicable state law requirements to avoid misclassification claims in a single jurisdiction.

BEST PRACTICES FOR CLASSIFICATION

The various applicable laws can leave even the most savvy companies with questions regarding proper worker classification. There are, however, several ways to avoid missteps.

1. Conduct regular internal audits in connection with legal counsel

Companies are well advised to conduct an audit of independent contractor relationships in connection with legal counsel and to refresh such audits on a regular basis. To begin the audit, the company should take the following initial steps: (1) designate an audit team, which should, if possible, include a human resources representative and a member of the legal department and/or outside counsel, (2) collect all independent contractor agreements and any other applicable documentation related to terms of work and pay for independent contractors and (3) identify the work location of each individual who is currently designated as a contractor in order to identify the state laws that may be implicated by the audit. The audit should include not only an assessment of the independent contractor agreement (if one exists) but also an analysis of the terms and conditions of the individual's work. Companies should also avoid reliance on industry practice or past practice in conducting the audit, as a classification analysis should be individualized.

The audit team should prepare both a plan for reclassification or renewal of independent contractor agreements where necessary but also a plan for how to address mistakes. Legal counsel can help assess both applicable laws and legal risks, and in some cases, the involvement of legal counsel can help shield audit results and analyses from disclosure pursuant to the attorney work product doctrine or attorney client privilege protections.

2. Review and revise independent contractor agreements

Under the various legal standards, simply labeling a worker as an independent contractor, advisor or consultant is not, on its own, sufficient to establish a contractor relationship. This is the case even where a written agreement exists between the parties to establish the designation or where the worker has requested such a designation.

Independent contractor agreements should include language to establish the appropriateness of the classification, and companies should approach each independent contractor arrangement with a renewed analysis of the applicable agreement, rather than using a one-size fits all form for all independent contractors.

Companies should consider inclusion of the following (or similar) language in the independent contractor agreement, which may help bolster its position that the individual worker is an independent contractor rather than an employee:

  • the worker will not receive instructions from the company as to how to accomplish the services for which he/she was retained
  • the worker will not receive training from the company
  • the contractor may hire others to assist him/her in the performance of the services, and the contractor retains the right to control the work activities of those assistants
  • the worker shall have control over his/her hours of work
  • the worker acknowledges, and the company agrees, that the worker shall have the opportunity to pursue other work when and for whom he/she chooses
  • the worker has the right to choose where the work will be performed
  • the worker may select the order and sequence of the work to be performed
  • the worker shall be responsible for completing the final project, and no interim reports shall be required
  • the worker shall be compensated per job and not compensated based on the hours required to complete the job
  • the worker shall be responsible for his/her business expenses
  • the worker shall supply his own tools and equipment to perform the job
  • the worker may be terminated for failure to comply with the terms of the contract (rather than on an at-will basis)
  • the worker is responsible for the satisfactory completion of the job, and shall be liable for failing to complete the job in accordance with the contract.

Where possible, the company should make clear that the relationship between the contractor and the company is not continuing but shall terminate at the conclusion of the project. This may require that the contract be renewed multiple times for various work assignments or simply supplemented by new exhibits to the master agreement, which outline supplementary projects as requested.

Agreements which state that the relationship is, essentially, indefinite may later be viewed as characteristic of an employment relationship. Similarly, agreements which contemplate near full-time work are more likely to be characterized as employment relationships if scrutinized by a government agency or court at a later date.

PARTING THOUGHTS

The lack of consistency among state and federal laws can leave companies scratching their heads over how to classify various workers. However, by conducting regular internal audits, consulting with legal counsel and ensuring that independent contractor agreements are well crafted and tailored for each individual relationship, companies can avoid the headaches and legal risks that come along with misclassification.