Wake-Up Call to Employers: Minimize Risks of Worker Misclassification, as appeared in New York Employment Law Letter

As appeared in New York Employment Law Letter, August 2010 (Vol. 17, No. 8).

In recent months, the increased attention worker misclassification has received at both the federal and state levels should provide a clear wake-up call to employers. The potential liability employers face today is growing, with far greater ramifications and costs. The consequences of misclassifying a worker as an independent contractor can be severe. Individual, class, and collective actions concerning workers' status are proliferating. Federal and state agencies such as the New York State Department of Labor (NYSDOL) are stepping up their enforcement efforts. As a result, you need to take steps to ensure your workers are properly classified.

They're looking for mistakes and collecting on them

The potential costs of worker misclassification can be staggering when taking into account unpaid federal, state, and local income tax withholdings, social security and Medicare contributions, workers' compensation and unemployment insurance premiums, work-related expenses, and overtime compensation that aren't provided to workers classified as independent contractors. Additional costs can arise when misclassified workers who otherwise would be entitled to coverage under employee benefits plans haven't been provided those benefits. As state and federal authorities intensify their efforts to address the problem of worker misclassification, it's more important than ever for you to take steps to ensure you have classified your workers properly.

Here in New York, proper classification has become a priority for the government. In June 2010, the state labor commissioner announced the results of a number of recent successful enforcement sweeps by the New York State Joint Enforcement Task Force on Employee Misclassification. The task force, created in September 2007 to address the growing problem of employers inappropriately classifying employees as independent contractors, found widespread violations.

Operating in a coordinated effort with the NYSDOL, the New York State Workers' Compensation Board, the state attorney general, the New York State Department of Taxation and Finance, and the New York City comptroller's office, the task force conducts enforcement sweeps, coordinated investigations, referrals of audit results, and data sharing and aims to hold employers that engage in misclassification of employees financially and legally liable for their violations. A 2009 report by the task force found 12,300 instances of employee misclassification throughout the state and more than $157 million in unreported wages. Those violations led to the recovery of $4.8 million in unpaid unemployment taxes, more than $1 million in unemployment insurance fraud penalties, more than $12 million in unpaid wages, and more than $1.1 million in workers' compensation fines and penalties.

The federal government has also undertaken a concentrated effort to eliminate worker misclassification. The IRS has executed information-sharing agreements with state labor agencies, including agencies in New York, through which the IRS and the state agencies share the results of misclassification audits. In February 2010, the IRS began an initiative to audit 6,000 different employers over a three-year period in an effort to expose worker misclassification and recover lost revenue.

Congress and the U.S. Department of Labor (DOL) also have promised to boost investigations of employee misclassification through new legislation and enforcement actions. On April 22, a proposal to impose federal civil penalties for worker misclassification — the Employee Misclassification Prevention Act — was introduced in Congress. The proposed legislation would require employers to notify workers of their "independent contractor" classification and provide information on what to do if the worker believes the classification is improper. On April 29, the DOL announced an initiative to put the responsibility on employers to demonstrate compliance with federal wage and hour laws, including the proper classification of workers. Also, President Barack Obama recently requested that Congress allocate $25 million to the DOL's 2011 budget to bolster agency efforts to combat worker misclassification.

What is the standard? It depends

Employers may genuinely, but incorrectly, believe that they have engaged workers as independent contractors rather than employees. Indeed, determining the proper worker classification is no easy task, and the absence of a uniform standard is to blame.

In New York, the courts use the common-law "right to control" test to determine whether an individual is an "employee" under the New York Labor Law. Proper classification will depend on the degree of supervision, direction, and control exercised over the worker ? not only with regard to the results but also with regard to the means, manner, and methods of the services provided. The courts have found that no single factor or group of factors conclusively defines the employee or independent contractor relationship. All factors must be examined to determine the degree of supervision, direction, and control.

According to the NYSDOL, indicators of employer control may include:

  • determining when, where, and how services will be performed;
  • providing facilities, equipment, tools, and supplies;
  • directly supervising the services;
  • stipulating the hours of work;
  • requiring exclusive services;
  • setting the rate of pay;
  • requiring attendance at meetings and/or training sessions;
  • requiring oral or written reports;
  • reserving the right to review and approve the work product;
  • evaluating job performance;
  • requiring prior permission for absences; and
  • reserving the right to terminate the services.

On the other hand, properly categorized independent contractors are free from supervision, direction, and control in the performance of their duties. Such persons are in business for themselves and offer their services to the general public. Indicators of independent contractor status may include:

  • having an established business;
  • advertising services in electronic and/or print media;
  • maintaining a listing in the commercial pages of the telephone directory;
  • using business cards, business stationery, and billheads;
  • carrying insurance;
  • maintaining a place of business and making a significant investment in facilities, equipment, and supplies;
  • paying one's own expenses;
  • assuming risk for profits or losses in providing services;
  • determining one's own schedule;
  • setting or negotiating one's own pay rate;
  • providing services concurrently for other businesses, either competitive or noncompetitive;
  • being free to refuse work offers; and
  • being free to hire help.

At the federal level, the IRS recognizes a comprehensive list of factors an employer may take into account when determining how to classify workers. Derived from the common-law "right to control" test, they examine a variety of considerations grouped under the rubric of behavioral control factors (facts that show whether the business has a right to direct and control how the worker does the task for which he is hired), financial control factors (facts that show whether the business has a right to control the business aspects of the worker's job), and factors concerning the relationship between the worker and the company.

A key element in the IRS test is the degree of control an employer exercises over a worker. In essence, employees take direction from employers for the means, methods, and hours of work, whereas independent contractors are in business for themselves and retain the right to determine how to accomplish the tasks they have been hired to perform. The analysis used to make an employee/independent contractor determination must be fact-specific.

It should be noted that if an employer-employee relationship does indeed exist, it doesn't matter that the worker is identified by the employer or worker as an independent contractor or that there is a written agreement designating him as an independent contractor.

Construction industry may have new standard soon

If an employer is in the construction industry in New York, a different standard may apply. In June 2010, the New York State Senate and Assembly approved the New York State Construction Industry Fair Play Act that seeks to eliminate the practice of worker misclassification in the construction industry and, in turn, capture millions of dollars in state tax revenue each year. If the legislation is signed by the governor, construction workers performing work for a contractor will be classified as employees unless one of two exceptions is met.

Under the first exception, a construction worker will be classified as an independent contractor if all of the following criteria are met:

  1. The individual must be "free from control and direction in performing the job, both under his or her contract and in fact."
  2. The service provided "must be performed outside the usual course of business for which the service is performed."
  3. The individual must be "customarily engaged in an independently established trade, occupation, profession, or business that is similar to the service at issue."

Under the second exception, a sole proprietor, partnership, corporation, or worker will be classified as an independent contractor, provided the "business entity" meets a 12-part test demonstrating that it:

  1. performs the service free from direction or control over the means and manner of providing the service, subject only to the right of the contractor for whom the service is provided to specify the desired result;
  2. isn't subject to cancellation or destruction upon severance of the relationship with the contractor;
  3. has a substantial investment of capital in the business entity beyond ordinary tools and equipment and a personal vehicle;
  4. owns the capital goods and gains the benefits and bears the losses of the business venture;
  5. makes its services available to the general public or the business community on a continuing basis;
  6. includes services rendered on a federal income tax schedule as an independent business or profession;
  7. performs services for the contractor under the business entity's name;
  8. obtains and pays for a license or permit in the business entity's name when it's required;
  9. furnishes the tools and equipment necessary to provide the service;
  10. hires its own employees without contractor approval, pays the employees without reimbursement from the contractor, and reports the employees' income to the IRS;
  11. doesn't represent the business entity as an employee of the contractor to the contractor's customers; and
  12. has the right to perform similar services for others on whatever basis and whenever it chooses.

The legislation also provides workers with notice of their classification status, protects them from retaliation for reporting violations, and imposes penalties against employers and corporate officers who knowingly allow violations to occur.

What can employers do?

Given the promise of greater scrutiny at both the federal and state levels, which we are seeing in practice on a daily basis, you are well advised to take steps to ensure that you have classified your workers properly. Such steps include documenting the factors supporting each worker's independent contractor status, reviewing existing arrangements to determine whether classification as an independent contractor is appropriate, and monitoring the arrangements to ensure that each worker maintains financial independence and sufficient control over the work to support the independent contractor classification. While not conclusive, having a thorough independent contractor agreement may assist in addressing some of the key factors at the inception of the relationship. We recommend having such agreements in place.

In certain circumstances, you may wish to renegotiate agreements with independent contractors to ensure their status will be sustained and prepare internal assessments to demonstrate the appropriateness of the classification. If a challenged classification may not be upheld, you may wish to restructure the relationship in advance of enforcement actions. It's better to internally uncover and proactively address any potential misclassification issues than to learn of them when confronted with a governmental audit or lawsuit. Because of the analysis involved in assessing whether workers are properly classified, you are encouraged to seek the advice of your employment counsel.

Dean R. Singewald II may be reached at (203) 326-7410 or [email protected].