The Costs of Worker Misclassification: Part 1

Over the last half-dozen years, employers have seen a crackdown on the misclassification of employees as independent contractors. This three-part series will first address how this form of misclassification has arisen and what its consequences are for companies caught in the crackdown. The second part will detail how regulators, legislators, plaintiffs’ class action lawyers and union organizers have sought to counter businesses that are believed to engage in independent contractor misclassification. The third and final part will discuss how businesses can minimize or avoid this type of misclassification.

First, let’s briefly discuss an actual class action so that the issue of independent contractor misclassification can be viewed from a real-world perspective, including the circumstances that lead a company to classify workers as independent contractors. In a district court case, a company that was sued for misclassification made a motion for summary judgment after extensive discovery. The company argued that, as a matter of law, the undisputed facts showed that the class of workers in question were independent contractors. The court examined the evidence in the light most favorable to the plaintiffs, as it must do on a motion for summary judgment. It then granted summary judgment in favor of the company, concluding as follows:

[T]he only reasonable inference is that [the company] hasn’t retained the right to direct the manner in which [the workers] perform their work. [The company] ... offers numerous suggestions and best practices for performance of assigned tasks, but the evidence doesn’t suggest that [the company] has the authority under the [Independent Contractor] Agreement to require compliance with its suggestions. Further, other factors strongly weigh in favor of independent contractor status; in particular, the parties intended to create an independent contractor arrangement, the [workers] have the ability to hire helpers and replacement[s], they are responsible for acquiring [the tools of their trade] and can use the [tools] for other commercial purposes, they can sell their [contractual rights purchased from the company] to other qualified [contractors], and [the company] doesn’t have the right to terminate contracts at-will. Although some facts weigh in favor of employee status, after considering all the relevant factors, the court finds that the plaintiffs are independent contractors as a matter of [state] law. (Emphasis added.)

An appellate court, looking at the same facts, reached the opposite conclusion. It held that, as a matter of law, the workers were employees, not independent contractors. The appellate court examined 20 separate factors and concluded as follows:

Viewing the factors as a whole leads to the conclusion that [the company] has established an employment relationship with its [workers] but dressed that relationship in independent contractor clothing. Even where the factors should point us toward finding that the [workers] are independent businesspersons, [the company’s] control and micromanaging undermine the benefit that a [worker] should be able to reap from that arrangement.

Those who are familiar with the subject of independent contractor misclassification will recognize that this case involved FedEx Ground. The lower court decision was issued by the U.S. District Court for the Northern District of Indiana, which was assigned to handle dozens of FedEx Ground cases from around the country. The appellate court is the Kansas Supreme Court, which was asked by the Seventh Circuit to rule on this case under Kansas law. We will use FedEx as a case study for each of the three parts of this series.

Second, let’s identify the industries affected by independent contractor misclassification. We have been studying reported cases for the last five years and have described hundreds in monthly updates on independent contractor compliance and misclassification. Although businesses in virtually all industries use independent contractors, our study reveals that businesses in more than 40 industries have been specifically targeted by federal or state agencies or been the subject of class action lawsuits.

Those industries include amateur and professional athletics; aerospace and defense; automotive; banking; cable television and Internet services; car services, limousines and taxis; charities; cleaning and janitorial services; colleges, universities and other educational services; computer programming and technical consulting; construction; cosmetics/beauty products; courier services; crowdsourcing; deliveries and logistics; direct selling; entertainment; environmental services; fashion/design; financial services; food and beverage; government contracting; health care; heavy industry/manufacturing; hospitality, hotels and lodging; home products installation; insurance; landscaping; life sciences; marketing; media; mergers and acquisitions; music and video; professional services, including consulting; publishing/editing; retail and Internet sales; security; staffing; technology; telemarketing; television, radio and movie production; and trucking and transportation services.

Economic and Business Advantages to Using Independent Contractors

The use and misuse of independent contractors has increased dramatically since the mid-1990s. According to a 2006 report by the Government Accountability Office, the number of independent contractors in the U.S. workforce increased by 24.5 percent from 1995 to 2005.[1] This was due, in large part, to a combination of two factors: (1) economic and other business advantages derived from the use of independent contractors and (2) lax regulatory enforcement — a classic risk-reward calculus.

Many of the reasons for using independent contractors are well-understood by most businesses. They include the following:

• Businesses are not required to withhold taxes, make Social Security and Medicare contributions on the fees paid to independent contractors, pay unemployment taxes or provide coverage for workers’ compensation insurance.
• Independent contractors are not required to be paid the minimum wage or overtime pay.
• Employee benefit plans only cover employees, not independent contractors.
• Federal labor laws do not afford independent contractors the right to be represented by a labor union.
• Businesses can more easily expand or contract their workforces to accommodate workload fluctuations.
• The custom and practice in particular industries is to use independent contractors.
• Even in industries where there is no historical custom and practice of using independent contractors, some companies acquire business units that have historically used an independent contractor model and wish to continue to use that model to better compete in the marketplace.
• A company that needs to supplement its workforce may have either an internal hiring "freeze" in place, or managers may be discouraged by their superiors from increasing headcount or payroll costs.
• Workers who have specialized talents or technical expertise, and hence are in demand, may insist or indicate a strong preference that they be retained on an independent contractor basis.

These considerable economic and business reasons have led many companies to classify a host of workers as independent contractors, even those workers who may fall within one or more of the definitions of "employee" under the labor, tax and/or benefit laws.

In the FedEx Ground case discussed above, it is common knowledge that FedEx acquired its ground division in 1985 from a company that operated that business on an independent contractor model. The appellate court noted that FedEx’s lawyer “acknowledged at oral argument [that] the company carefully structured its drivers' operating agreements so that it could label the drivers as independent contractors in order to gain a competitive advantage" (i.e., to avoid the additional costs associated with employees). “In other words,” the appellate court noted, “this is a close case by design, not happenstance.”

Decades of Lax Enforcement and Different Legal Tests

Lax enforcement of independent contractor laws by governmental revenue and workforce agencies prevailed throughout the 1990s and well into the latter part of the 2000s. Government inattention to the issue of proper worker classification also contributed to a demonstrable lack of understanding of the legal distinctions between independent contractors and employees.

Although some businesses knowingly have misclassified employees as independent contractors, most businesses that misclassify employees have paid insufficient attention to the legal requirements or simply do not understand the laws in this area, either because they have mistaken conceptions of the laws or because they are confused by the array of different laws at the federal and state levels.

This is not the least bit surprising. Even many legal "treatises" and articles by lawyers that purport to list the various independent contractor laws fail to take into account that the tests for independent contractor status are varied. Further, the same language found in an independent contractor statute in one state is often interpreted differently by the courts and administrative agencies in another state. The 2006 GAO report addressing employee misclassification reached the conclusion that "the tests used to determine whether a worker is an independent contractor or an employee are complex, subjective and differ from law to law."[2] As varied as the tests are under federal law, some state laws are even more complex and far more varied — a veritable crazy quilt of state laws.

There is, however, one overriding constant factor in almost all of the federal and state tests for independent contractor versus employee status: whether a business has the "right to control the manner and means" by which a worker accomplishes the end product of his or her services. In determining whether a business has such a right to control, some federal and state agencies consider more than two dozen factors that may indicate whether or not the business has retained or used such control.

For example, while the IRS has articulated a three-part test, it essentially considers about 20 factors in determining independent contractor status under the “common law” test it follows. Yet, as noted in its online guide, the IRS states that "all information that provides evidence of the degree of control and the degree of independence must be considered."

Similarly, the U.S. Department of Labor considers six main factors in its so-called economic realities test, but likewise states in its online guide that “all facts relevant to the relationship between the worker and the employer must be considered.” Dr. David Weil, administrator of the wage and hour division, has recently stated publicly that the Department of Labor will issue further guidance in the next few months on determining independent contractor status, but such guidance is not expected to deviate much from the current standards as articulated on the department’s website.

About half the states have statutory tests for independent contractor status in their laws covering unemployment, workers’ compensation, overtime and minimum wage and/or wage payments and deductions. Many of those statutory laws are referred to as “ABC” tests and require a business to affirmatively prove all three prongs of the test to establish independent contractor status. These types of statutory tests are often more worker-friendly than the judge-made tests under the federal tax, wage and labor laws.

A 2009 review of the factors used by the courts and by various state and federal agencies revealed that, collectively, far more than 48 factors were being used by different decision-making bodies in determining independent contractor status — and, in the years since, dozens of additional factors have been considered. Although some commentators have called on legislatures to standardize the test for independent contractor status, it is highly unlikely that state legislative bodies and Congress will coordinate among themselves to pass a unified bill with a common definition of an independent contractor.

Rise in Intentional and Unintentional Misclassification

Businesses engage independent contractors for a variety of reasons. Many businesses utilize them to carry out an essential function of the business, such as delivering or installing goods or providing a specialized service. Another common usage is when a business connects a customer seeking a service with an individual who provides the service. This latter utilization has been the centerpiece of the on-demand or sharing economy, where independent contractors supply the services sought by customers of companies like Uber Technologies Inc., Lyft Inc., Homejoy Inc., TaskRabbit Inc., BloomThat Inc., Washio Inc. and Spoonrocket Inc.

Since mid-2007, federal and state regulators have been cracking down on independent contractor misclassification. A variety of reasons have been articulated for the crackdown, but the three main justifications that have been articulated by those favoring the crackdown are:

• to capture lost tax revenues occasioned by the failure to withhold taxes on the compensation paid to workers misclassified as independent contractors or paid in cash;
• to ensure that workers who should be legally classified as employees are protected by the full array of laws intended to safeguard them and are paid in accordance with wage laws; and
• to foster fair competition so that those companies who “play by the rules” and pay wages to workers in accord with the law are not disadvantaged by those who are misclassifying employees as independent contractors.

These reasons would resonate with any law-abiding corporate citizen when it comes to companies that knowingly misclassify workers as independent contractors or pay them cash under the table. These reasons, however, do not address one of the more prevalent types of independent contractor misclassification — the unintentional form, where legitimate companies use individuals whom they regard as legitimate independent contractors, but fail to structure, document and implement the independent contractor relationship in a manner that complies with a myriad of federal and state laws.

As stated publicly earlier this year by the Department of Labor's wage and hour administrator, although an independent contractor relationship may not be used to evade compliance with federal labor law, "[T]he use of independent contractors [is] not inherently illegal ... [and] legitimate independent contractors are an important part of our economy."[3]

So, where does FedEx Ground fall in the unintentional or intentional misclassification realm? At least one federal appellate court has ruled in favor of FedEx on the independent contractor issue,[4] and another has stated that FedEx presents a “close case.”[5] So, it is hard to place them in the category of having intentionally misclassified employees as independent contractors.

FedEx is not unlike many other businesses that have failed to properly understand how to structure, document and implement an independent contractor relationship that can survive legal scrutiny. In addition, companies that have not utilized customized solutions and opted for a one-size-fits-all or other “standardized” compliance approach are likely to find that they are usually ill-fitting, unsustainable or impractical. In any event, what may work for one company is unlikely to serve the business needs of another and might not even meaningfully enhance the company’s state of independent contractor compliance.[6]

What are the concerns for a company whose independent contractor relationships are not properly structured, documented and implemented? Those businesses, like FedEx Ground, are at risk for a host of costly misclassification consequences — even when the misclassification is unintentional.

Costly Consequences of Misclassification

Independent contractor misclassification liability can be devastating to many for-profit and nonprofit organizations and those governmental entities that rely on the use of 1099 contractors, regardless of whether the employees have been mistakenly or intentionally misclassified.

Risks include years of exposure to some of the most common forms of independent contractor misclassification liability, such as:

1. unpaid federal, state and local income tax withholdings and Social Security and Medicare contributions;
2. unpaid unemployment insurance taxes, both to the federal government and to state governments;
3. unpaid workers’ compensation premiums;
4. unpaid overtime compensation and/or minimum wages;
5. unpaid work-related expenses; and
6. unpaid sick and vacation pay.

These types of liabilities usually also include interest and/or penalties for noncompliance.

How much can these liabilities add up to? We discuss 18 administrative and judicial cases in part two of this series, and the recoveries range from the hundreds of thousands of dollars to more than $10 million, with the recent FedEx Ground settlement topping the list at $228 million for its California drivers.

Another costly liability risk arises if misclassified employees, who are otherwise entitled to coverage under Employee Retirement Income Security Act employee benefit plans, have not been provided with group health, disability and life insurance coverage, as well as contributions to a 401(k) plan or other pension and profit-sharing plan. The Microsoft Corp. case in the 1990s demonstrates how costly misclassification can be, no matter how unintended, when workers classified as independent contractors are recharacterized by the courts or regulatory agencies as employees. In addition to satisfying a very substantial payment obligation to the IRS, Microsoft paid $97 million to settle a benefits case brought by its long-term temporary workers, who were not afforded coverage under Microsoft’s stock purchase plan, plus millions more in legal fees for the workers’ class action lawyers.[7]

The Affordable Care Act gives rise to yet another form of independent contractor misclassification liability. If an employer (including all employees in the employer’s controlled group) has fewer than 50 full-time equivalent employees, but would equal or exceed that number if independent contractors were recharacterized as employees by the IRS or a court, the ACA would require that company to provide qualifying medical coverage to its employees (which includes misclassified independent contractors). Employment status is also relevant in determining whether a "large employer" is subject to the excise tax when a particular worker receives subsidized health insurance coverage offered through a state or federal exchange. A large employer is required to offer minimal essential coverage that is affordable and provides minimum value to at least 95 percent of its full-time employees (including those who are misclassified) and their dependents.

Part two of this three-part series will focus on the current landscape of independent contractor misclassification, including federal and state regulatory enforcement initiatives, legislative initiatives, class actions and union organizing. Part three will focus on steps that employers can take to minimize or eliminate independent contractor misclassification exposure.

[1] U.S. Government Accountability Office, Employment Arrangements: Improved Outreach Could Help Ensure Proper Worker Classification, GAO Report 06-656, at 47 (July 2006), available at http://www.gao.gov/new.items/d06656.pdf [hereinafter 2006 GAO Report].

[2] 2006 GAO Report at 25.

[3] See Press Release, U.S. Department of Labor, U.S. Labor Department and Wisconsin Department of Workforce Development sign agreement to reduce misclassification of employees (Jan. 20, 2015), available at http://www.dol.gov/whd/media/press/whdpressVB3.asp?pressdoc=national/20150120.xml.

[4] See FedEx Home Delivery v. National Labor Relations Board, 563 F.3d 492 (D.C. Cir. 2009).

[5] See Craig v. FedEx Ground Package Systems Inc., 686 F.3d 423, 428 (7th Cir. 2012) (which requested the Kansas Supreme Court rule on how it should decide “close cases such as this”).

[6] One approach for such companies to enhance compliance is IC Diagnostics, a process designed to create a customized, sustainable and pragmatic approach to minimize or eliminate independent contractor misclassification risk, taking into account all relevant laws governing independent contractors.

[7] See Vizcaino v. Microsoft Corp., 142 F.Supp.2d 1299 (W.D. Wash. 2001), available at http://independentcontractorcompliance.com/legal-resources/court-casesdecisions-of-significance/.