Independent contractors: Rising cost of misclassification

Hiring independent contractors to control labor costs can violate regulations protecting employee benefits, sparking costly penalties.

Shoring up profits in a tough economy means trimming expenses wherever you can. Uncontrolled labor costs, in particular, can eat up the bottom line for most retailers. No mystery, then, about the appeal of independent contractors. They can be utilized to perform tasks without an attendant rise in payroll expenses such as premiums for health care, unemployment insurance and workers’ compensation.

“Cost savings is perhaps the number one reason for using independent contractors,” says Barbara Glanz, a management consultant based in Sarasota, Fla. (barbaraglanz.com). “The second reason, which is maybe even more important, is that outside specialists are experts in their fields as opposed to jacks of all trades.”

And there’s a third advantage to using independent contractors: flexibility. In a volatile economy, after all, it’s difficult to predict how many people you’ll need down the road.

“Many employers want to maintain just a small core of full time employees and hire independent contractors as needed,” says Nancy E. Joerg, managing shareholder and senior attorney of the St. Charles, Illinois office of Wessels Sherman Joerg Liszka Laverty Seneczko P.C. (w-p.com). “That’s much less risky than hiring a large number of full time workers, then terminating some when economic conditions demand. Such terminations can spark lawsuits and additional filings for unemployment benefits.”

For all of these reasons, retailers have taken to using independent contractors for duties such as conducting inventory, performing accounting and computer tasks, tackling security issues, running deliveries, and performing general maintenance and cleaning.

Avoid costly fines

Yet retailers face risks in utilizing independent contractors. The problem is that federal and state agencies can later reclassify such workers as employees, sparking huge fines and penalties.

And the risk has recently escalated. Last summer [of 2015] the Wage and Hour Division of the U.S. Department of Labor (DOL) filed an interpretation of independent contractor law which in essence announces the intention to step up enforcement actions against employers who, deliberately or not, misclassify workers. (You can view this document by going to dol.gov and searching for “Administrator’s Interpretation No. 2015-1”).

“The DOL is sending a clear message that they are going to be harshly evaluating the status of independent contractors,” says Joerg. “They are going to strictly interpret their six-part ‘economic realities’ test to determine if independent contractors are economically dependent on their employers. If they are, then the employers may be in trouble and may be financially in a lot of pain.”

As those comments suggest, the DOL uses an “economic realities test” to determine whether an individual is an employee. (You can view an explanation of the test by going to dol.gov and searching for “Fact Sheet 13: Am I an Employee?”)

This new initiative comes as part of a long-standing effort to stem the increasing use of independent contractors. “Government agencies at the state and federal levels have been cracking down on independent contractor misclassification for the last several years,” says Dallas employment lawyer Barry Hersh (hersh-law.com). 

Why the new enforcement interest? “If employees are not classified properly then taxes (Social Security, Medicare, unemployment) are not being correctly withheld,” notes Hersh. “The government wants its money.  Also, the Government wants to ensure that workers are being afforded their rights under anti-discrimination and other laws that protect employees.”

Multiple threats

Suppose you inadvertently misclassify your workers. What problems can arise? Enough to compose what Hersh refers to as “a parade of horribles.” For starters, federal agencies may assess fines for failure to withhold taxes or to comply with workers compensation laws. More penalties may be assessed for violations of the Family Medical and Leave Act and ERISA.

Among the costliest penalties are those relating to employee remuneration. Under the federal Fair Labor Standards Act (FLSA), misclassified employees can recover unpaid overtime and minimum wages for the past two or three years, and such wages can be doubled under a penalty called “liquidated damages.”

State agencies may levy penalties for failure to collect taxes and to pay into the unemployment insurance coffers. This area gets particular attention for an important reason: economic survival. “Nothing stops independent contractors from applying for state unemployment benefits when their contracts are over,” cautions Joerg. And that’s bad. “States do not want to be paying unemployment benefits to individuals coming from employers who have not been paying into the system.” Too, workers compensation carriers can demand unpaid premiums.

Furthermore, investigations into unemployment insurance violations can quickly broaden. “Often, an investigation of one employee’s complaint is a ‘Trojan horse’ that allows the agency to look into a business’s employment practices as a whole,” says Hersh.

Private Lawsuits

Had enough? Even worse may be in store from an ex-employee’s attorney.  “Good plaintiff lawyers tend to be even more aggressive than federal and state agencies,” says Hersh. “They will look to recover not only double damages for their clients, but will also investigate the possibility of a lucrative class action lawsuit.  And employers can also be liable for their workers’ attorneys’ fees.” In cases where the amount of overtime pay owed to an employee is relatively modest, the attorney’s fees can exceed overtime liability by a significant factor.

You may also end up paying large accounting fees while defending yourself from all of the above. And here’s a parting thought: Overtime mistakes can also expose you to personal liability.

It can all add up. “It can get very expensive not only in terms of dollars, but in emotional distress and in time taken away from running your business to deal with the matter,” says Joerg, who has seen penalties climb higher than $500,000 for egregious cases. “Many companies cannot bounce back and go out of business.”

Innocent errors

Misclassification might not be deliberate. “Small retailers in particular may feel the urge to hedge their bets on new hires, so they tag new workers with a ‘contract’ or ‘temporary’ label,” says Hersh. “Then they might tell the individuals, ‘We are not sure how the relationship will go, so you will be on contract for the first 90 days.’”

It’s easy to fall into the trap of thinking that arrangement creates an independent contractor relationship. But it does not, says Hersh. “Depending on how the business uses those individuals, they may be employees entitled to the same rights and benefits (including minimum wage and overtime pay) owed to the employer’s full time workers.”

What determines employment status is largely the degree of control you have over the worker. For example, do you tell the person to come to work at a certain time and require attendance at meetings held at specified times? Such mandates are more characteristic of an employment status. In contrast, independent contractors usually agree to complete a discreet task and then do their work on their own schedules. There are a number of other indicators of employment status. For a rundown, see the sidebar: “Are You Violating Employment Law? Take This Test.”

Yet another common error is thinking that hiring people from staffing agencies bypasses the risk. In fact, agency workers can also be reclassified as employees if you deal with them in ways (described in the sidebar) that indicate an employment relationship. Says Joerg: “Only very strong, independently established independent contractors are ‘low risk.’”

Avoid trouble

How can you stay out of trouble? Follow these tips to keep on the right side of the law:

#1. Don’t try to mandate employment status.

Employers often ask potential hires to sign documents acknowledging independent contractor status. But such documents do not alone prevail.

“Just because a worker signs an independent contractor agreement does not automatically mean he or she is not an employee,” says Hersh. “Whether the worker is or not is a legal question.” As noted previously, the answer to that legal question involves an analysis of how the employer interacts with the worker.

#2. Avoid packaged resources.

“I see too many businesses get into trouble by using boilerplate forms from the Internet,” says Hersh. “These forms give a false sense of security and often cause more problems than they solve.”

#3. Don’t copy other employers.

Don’t follow the herd. Be more compliant with the law than other employers. “The fact that competitors may be violating employees’ rights does not make it acceptable for you to make the same mistake,” says Hersh. “Industry practice or custom is not a defense in overtime cases.  Moreover, many wage-and-hour investigations are the result of complaints from competitors.”

#4. Treat your people well.

Whether full time employees or independent contractors, people who are happy about their experiences at your business will cause fewer problems.

“Treating workers with respect can prevent a lot of headaches—legal and otherwise,” says Hersh. “Avoid toxic bosses and supervisors, because people who feel mistreated will often talk to lawyers.”

Your ex-employee doesn’t have a case, you say? Maybe the lawyer will find one. Often a lawyer will determine that an employee will not prevail on a stated matter, but then discovers the employer was violating rights in a way the employee did not even suspect.  Overtime violations are a great example of this, says Hersh. His moral: “It’s good business to treat people well, and in the end it’s cheaper.”

Moreover, treating people well can motivate them to treat your customers the same way. And that means the public will be far more likely to be loyal to your enterprise. “You have to remember that to your customers, your independent contractors are your employees,” says Doug Fleener, president of Dynamic Experiences Group, a consultancy in Lexington, MA (dynamicexperiencesgroup.com). “You can’t blame your independent contractors when something doesn’t go right. That’s why it’s so important to manage your relationships with them well.”

Your independent contractors should understand your corporate culture. “Make sure they know the mission of your organization and where they fit into the bigger picture,” says Fleener. They will feel empowered if they understand that they represent you to the outside world. “People perform better when they feel appreciated and feel they are part of an organization and part of its overall purpose.”

#5. Consider your status under the “safe harbor act.”

The Internal Revenue Service does offer what is referred to as a “safe harbor” for employers. “Section 530 of the Internal Revenue Act of 1978 provides a bulletproof vest for companies who can pass a three-part test which will protect them from an IRS legal challenge,” says Joerg. “Companies that do so are protected from huge IRS assessments.”  (Note that Section 530 relief is specific to the IRS--not to the Department of Labor).

To be protected by this legislation you must meet certain conditions. First, have you consistently classified a certain category of worker as an independent contractor? Second, have you a reasonable basis for doing so? Third, have you filed 1099s when required?

Keep your ear to the legislative ground, because Section 530 is a political football. “The law has been under attack since it was passed in 1978,” says Joerg. “There have been all kinds of proposed legislation to phase it out, but so far nothing has happened.”

Help, please

Your legal risk can only grow as federal and state agencies pay more attention to worker misclassification. “What used to be a somewhat minor issue for employers has become a huge one,” says Joerg. “Any employer who uses independent contractors has to have some basic understanding of the law. There is too much risk to do it casually.”

Indeed, the entire field of employment law can be so confusing that outside help should be considered. “There are so many ramifications that I encourage all employers to consult with attorneys who have experience with independent contractor issues,” says Joerg. “A qualified attorney should look over your independent contractor agreement, if any. This need not be a long consultation, but perhaps an hour on the phone. There is a lot you can do in a short consultation to dramatically lower your risk.”

Above all, don’t ignore the issue and hope nothing happens. “I see businesses ‘play ostrich’ by sticking their heads in the sand because an issue is complex,” says Hersh.  “But that is perhaps the biggest mistake a business can make.  You need to get out in front of the issue in order to avoid problems.”

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