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    The Costs of Worker Misclassification: Part 3

    Outside Publication

    In part one of this series, we discussed how independent contractor misclassification has arisen and its costly consequences. Part two addressed the current landscape of the crackdown by regulators, legislators, plaintiffs’ class action lawyers and union organizers. This third and final part of this series discusses three alternatives to minimize or avoid future misclassification exposure.

    Despite the media attention that has been focused on the issue of independent contractor misclassification in recent years, including articles in newspapers and trade publications, most companies have yet to diagnose their state of compliance or determine their potential exposure for independent contractor misclassification liability. Fewer still have enhanced or updated their workforce models in a manner sufficient to meaningfully minimize or eliminate the risks of costly government regulatory and enforcement actions and class action litigation.

    For companies that would like to continue their current workforce strategies, instead of being required to reclassify every independent contractor as an employee under government or court compulsion, there is every incentive to restructure, re-document and re-implement their business models or reclassify or redistribute contingent workers currently treated as independent contractors.

    Virtually all newly enacted state laws, as well as proposed federal legislation, permit the continued use of independent contractors, provided the workers are properly classified. Nonetheless, some lawyers and legal commentators routinely advise businesses to cease using independent contractors or to reclassify them as employees to avoid the potential for misclassification liability. There are, however, a number of proven alternatives that permit companies to maintain their use of independent contractors while minimizing or avoiding future misclassification liability.

    Those alternatives include restructuring, redocumenting and reimplementing the independent contractor relationship; reclassifying independent contractors (either voluntarily or through a government program); and/or redistributing independent contractors through a workforce management or staffing company.

    Bona Fide Restructuring and Redocumentation

    Businesses that are concerned about the potential for misclassification liability often recognize that, at best, their independent contractors probably fall within a legal gray area, where some facts favor contractor status while others indicate employee status. As noted above, it is a basic precept of independent contractor law that the tests used to determine whether a worker is an independent contractor or an employee differ from law to law.

    The first step that is typically recommended by most lawyers and consultants to companies concerned about misclassification liability is to diagnose whether the company’s independent contractors are properly classified. That step, however, is wholly unnecessary for any business that wishes to consider a bona fide restructuring of its independent contractor relationships.

    Once a company has determined that it wishes to consider the restructuring alternative, it may then be beneficial to perform a comprehensive analysis on the company’s anticipated level of compliance after restructuring. Some businesses have conducted that review and assessment using IC Diagnostics, a process that examines whether the position would likely pass the applicable independent contractor tests under governing state and federal laws. All of the factors used by courts and administrative agencies — far more than 48 — are examined to determine worker status, with each of the factors weighted to reflect its relative importance in assessing compliance with applicable laws.

    A compliance analysis should then measure the company’s anticipated compliance with each of the applicable independent contractor laws. For example, the IC Diagnostics process uses a scale that is calibrated to provide assessments of alternative ways to minimize misclassification liability. Even for businesses that operate in those states that have strict tests for determining independent contractor status, this process can provide an assessment of how much restructuring is needed and, once implemented, how each alternative will minimize or eliminate future misclassification liability.

    Where bona fide restructuring is considered a sound alternative, the business can proceed to the next step in the process: redocumenting the restructured independent contractor relationship. This should be a comprehensive undertaking; it should embody the entire relationship between the independent contractors in question and the business. Redocumentation should also be accomplished in a manner designed to further enhance independent contractor compliance, consistent with applicable laws. Proprietary practice tools can be used to ensure that the redocumentation of the independent contractor relationship is thorough and state of the art.

    Many independent contractors work without an agreement or, worse, work under agreements that do not reflect the true relationship between the contractor and company. A contract that misstates the true relationship between the parties, such as one that states that a worker is not subject to the supervision of the company even though he or she is regularly supervised by a superior at the company or given regular evaluations, is generally of little or no benefit.

    Similarly, a contract that recites that a worker is an independent contractor offers no protection if the factors used by a court or government agency to determine the worker’s status demonstrate sufficient direction and control to create an employment relationship. Even agreements drafted for companies by otherwise talented lawyers include language that a plaintiffs’ class action lawyer may use to support his or her argument that the business has retained a right to direct and control the manner and means by which the worker performs the agreed-upon services. That is exactly what transpired in the recent FedEx Ground decisions by the Ninth Circuit and Kansas Supreme Court.

    After the restructured relationship is memorialized in a written independent contractor agreement, the final step is implementing the restructured relationship. Companies must ensure that what is set forth in the contractor agreement will be implemented in the field and that it does not include empty recitals or misstatements of the relationship. Equally important, businesses must avoid exercising direction and control, which is often unintended yet has the potential to undermine an otherwise enhanced state of independent contractor compliance.

    Other aspects of the reimplementation process may include reviewing and revising company operating manuals and procedures, documenting the implementation of certain provisions in the updated contractor agreement and putting safeguards in place to ensure conformity with the restructured independent contractor relationship.

    The Ninth Circuit and the Kansas Supreme Court both commented in their 2014 FedEx Ground decisions that the company did not implement its independent contractor relationships in a manner that complied with applicable laws.

    There are no "quick and dirty" ways to enhance independent contractor compliance. The use of form or model independent contractor agreements, sometimes called templates, tends to cause businesses to overlook the need to restructure and to implement a sustainable independent contractor model that will withstand legal scrutiny and serve a company’s unique business model.

    On the other hand, bona fide restructuring, redocumentation and reimplementation need not be a prohibitive undertaking and, once completed within a reasonably short period of time, can place a business in an enhanced and sustained state of compliance. That itself may substantially minimize the likelihood that a regulator or class action lawyer will seek to challenge a company’s compliance with independent contractor laws.

    There are, of course, some situations where a business is unable to attain compliance with independent contractor laws. There are at least two alternatives to restructuring that such businesses may wish to consider: reclassification and redistribution. These alternatives may also be used by companies that have properly classified a group of workers if the business nonetheless wishes to minimize or cease its use of independent contractors in the future.

    Reclassification: Government Program or Voluntary Action

    Businesses that are at greater risk for misclassification liability are more likely to have to defend their classification of workers as independent contractors. More companies are receiving notices from state unemployment agencies that question whether a former worker classified as an independent contractor should be reclassified as an employee, thereby exposing the company to the risk of liability for any prior misclassification. Some businesses also have received notices from state labor commissioners and workers’ compensation agencies inquiring whether an entire group of workers are independent contractors or employees, and some have received tax audit notices — even companies whose compliance with independent contractor laws should be beyond dispute.

    Regardless of whether a company may survive a legal challenge to its independent contractor relationships, it may wish to consider reclassification. This step is likely to be far less painful and costly than being compelled by a government agency to reclassify and ordered to make payment of back taxes, unpaid Social Security and Medicare contributions and unpaid unemployment insurance and workers’ compensation premiums, along with applicable penalties and interest, if there is a finding of misclassification in the future.

    The costs of compelled and voluntary reclassification are often weighed against the savings derived from continuing a business structured, in whole or in part, on an independent contractor model. This is a business decision that is premised on a host of competing considerations — far too many to mention here.

    Reclassification can be undertaken in one of two ways: (1) under a government-sponsored reclassification program; or (2) voluntarily, without government involvement.

    As noted in part two of this series, in September 2011, the IRS announced its Voluntary Classification Settlement Program ("VCSP"), which allows a business to voluntarily reclassify workers who currently receive Forms 1099 from the company by making what is referred to by the IRS as a "minimal payment covering past payroll tax obligations."[1] That payment to the IRS would be "10 percent of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year, determined under the reduced rates of Section 3509 of the Internal Revenue Code," according to the IRS announcement. Participation in the VCSP would also eliminate interest and penalties on the liability and, most importantly, exempt companies from an employment tax audit for worker misclassification in prior years.[2]

    Although the VCSP appears to be an attractive form of "amnesty," there have been only a scant number of participants, for obvious reasons. First, it does not provide any form of reduced penalties or interest with respect to the array of other federal and state laws that are implicated by reclassification, including state tax, unemployment and workers’ compensation laws, as well as federal wage-and-hour laws. Second, although the program evidently contains a provision that there is no admission that the taxpayer erroneously classified its workers as independent contractors, the likely takeaway by the workers themselves, their lawyers (if any) and other federal and state agencies that may become involved is that the company would not have entered the program if it had been classifying its independent contractors correctly.[3]

    For these and other reasons, businesses interested in reclassification are more likely to do so voluntarily without entering the VCSP. Voluntary reclassification, however, should be implemented in a manner that does not create unfair inferences of past noncompliance. On one hand, some workers that have been paid on a 1099 basis might welcome their reclassification but may also fail to understand why they were not treated as employees from the beginning of their relationship with the company. On the other hand, other workers who are accustomed to being compensated on a 1099 basis may object strenuously to becoming an employee and losing the tax advantages of self-employment, including tax deductions for legitimate business expenses. In addition, reclassification of workers from 1099 to W-2 status may require some businesses to engage in an array of administrative changes to comply with federal and state tax, employee benefits and labor laws. The timing of those changes can be important.

    Reclassification does not require that all workers previously excluded from an employee benefit plan be included in the future. Exclusion would be permissible if the governing documentation for the company’s plans is drafted properly and the exclusion does not violate applicable tax or Employee Retirement Income Security Act rules or any rules associated with the Affordable Care Act.

    Redistribution of Independent Contractors: Using a Workforce Management or Staffing Company

    Where voluntary reclassification is not a practical or viable alternative, another choice is to use a knowledgeable and reputable workforce management or staffing company. This alternative cannot completely eliminate all potential liability for misclassification, but using a responsible workforce organization may dramatically reduce the risk of such liability, as well as the likelihood of a lawsuit challenging the classification of a group of workers paid on a 1099 basis.[4]

    Workforce management and staffing organizations are not payroll companies; when they hire or retain some or all of a company’s independent contractors, they may either treat them as 1099 contractors or as W-2 employees.

    If the talent is treated as independent contractors, a knowledgeable workforce solutions company will take its own steps to maximize compliance with state and federal workforce, tax and benefit laws while facilitating the engagement of a company’s valuable contingent workforce. If a staffing company instead treats the workers as employees, the staffing company will withhold income taxes, make Medicare and Social Security contributions, pay workers’ compensation and unemployment insurance premiums, and can provide an array of benefits to the former independent contractors, including health insurance under a plan maintained by the staffing or workforce management company. If the workforce solutions firm treats the workers as independent contractors, it is imperative to select a firm that is knowledgeable about independent contractor compliance issues, otherwise the workforce solutions or outsourcing company can offer little or no protection from misclassification liability.[5]

    Although using a knowledgeable and experienced outsourcing company may substantially lessen the risk of future misclassification liability, it is not a panacea. For example, a business that contracts with a leasing workforce management organization may still have to account for the independent contractors or employees it has retained or hired in the company’s benefit plan language and discrimination testing.

    Conclusion

    The use of independent contractors is still a viable means to supplement a company’s workforce or to structure a business model in almost all states. Further, no bill introduced in Congress has proposed a prohibition on the use of independent contractors. All a business is required to do is classify independent contractors correctly or, conversely, not misclassify employees as independent contractors. Even companies in industries beset by multimillion-dollar independent contractor misclassification judgments, such as the adult entertainment and cable installation industries, can take steps to enhance independent contractor compliance and effectively avoid or defend against class actions.[6]

    Lax enforcement of labor and tax laws in the past, as they apply to independent contractors, has placed most businesses in a position in which misclassification liability has become a genuine risk — if steps are not undertaken to reduce or eliminate this exposure using any of the alternatives discussed above. Some companies, in fact, may choose to use not just one, but perhaps two or even all three of these alternatives for different groups of independent contractors. In view of the current and pending legislative, regulatory and judicial landscape, there is only one undesirable alternative: inaction.

    [1] See IRS Announcement 2011-64, available at http://www.irs.gov/pub/irs-drop/a-11-64.pdf. See also IRS' New Voluntary Classification Program Adds Another Choice for Companies Concerned About Their 1099ers (Sept. 23, 2011).

    [2] See IRS' New Voluntary Classification Program Adds Another Means to Minimize Independent Contractor Misclassification Liability (Sept. 22, 2011), http://independentcontractorcompliance.com/2011/09/22/irs%e2%80%99s-new-voluntary-classification-settlement-program-adds-additional-choice-for-companies-concerned-about-independent-contractor-misclassification-liability/.

    [3] See IRS Confirms Valid Use of Independent Contractors (Feb. 28, 2012), http://independentcontractorcompliance.com/2012/02/28/irs-confirms-valid-use-of-independent-contractors/. The effectiveness of the program was also questioned by the Treasury Inspector General for Tax Administration ("TIGTA") in a report issued on Sept. 24, 2014. See Press Release, Treasury Inspector Gen. for Tax Administration, TIGTA: Better Worker Identification Data Are Needed For the Voluntary Classification Settlement Program (Sept. 24, 2014), available at http://www.treasury.gov/tigta/press/press_tigta-2014-22.htm.

    [4] The IRS and Congress have long accepted the concept of leased employees. See, e.g., I.R.C. Section 414(n) (referring to "leased employees" in determining if an employee retirement benefit plan satisfies the nondiscrimination mandates of the tax laws).

    [5] See, e.g., New California Law Imposes Costly Risks to Companies Using Independent Contractors Supplied by Staffing and Recruiting Firms — But Risks Can Be Minimized (Oct. 1, 2014), http://independentcontractorcompliance.com/2014/10/01/new-california-law-imposes-costly-risks-to-companies-using-independent-contractors-supplied-by-staffing-and-recruiting-firms-but-risks-can-be-minimized/ (discussing the recent California law that imposes responsibility on companies using staffing and recruiting firms that fail to adhere to independent contractor laws); D.C. Act 20-426 (Sept. 19, 2014) (a District of Columbia law that make companies jointly and severally liable for their staffing companies’ violations of the D.C. wage-and-hour laws), available at http://lims.dccouncil.us/Download/31203/B20-0671-SignedAct.pdf. Other government regulators have also begun to utilize the joint employer doctrine, which could be used to expose a client company to misclassification liability. See, e.g., National Labor Relations Board, McDonald’s Fact Sheet, http://www.nlrb.gov/news-outreach/fact-sheets/mcdonalds-fact-sheet.

    [6] See Even an Exotic Dance Club (a.k.a. Strip Joint) Can Comply with Independent Contractor Laws — And Avoid or Defend Against Class Actions (Feb. 8, 2015), http://independentcontractorcompliance.com/2015/02/08/even-an-exotic-dance-club-a-k-a-strip-joint-can-comply-with-independent-contractor-laws/; Cable Company Pays $1.075 Million to Settle Misclassification Case with U.S. Department of Labor for Cable, Telephone, and Internet Installers (May 14, 2013), http://independentcontractorcompliance.com/2013/05/14/cable-company-pays-1-075-million-to-settle-misclassification-case-with-u-s-department-of-labor-for-cable-telephone-and-internet-installers/.

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