DOL and IRS: Double-Teaming to Target Independent Contractor Classification

26 July 2011 Publication

While recovering from troubling economic times, employers are often inclined to take steps to reduce overhead. One common cost-saving technique is to classify (or re-classify) workers as independent contractors, rather than employees. By "1099ing" a worker, the employer avoids payroll taxes and the need to provide employee benefits, and often the employer does not pay "contract labor" for hours worked over 40 per week, as is usually required by the Fair Labor Standards Act. The duties imposed by the FLSA apply only to "employees" of the employer, not to independent contractors. However, if the independent contractor classification is not in accordance with federal law, it can have far-reaching and expensive legal implications. Often, unpaid overtime is just a portion of the potential exposure. Unpaid benefits can add up to extraordinarily large amounts. For example:

  • Microsoft - $97 million settlement in a case brought by temporary workers who claimed they should have been entitled to benefits such as the stock purchase plan. This case stemmed from an IRS audit.
  • Time Warner - $5 million to settle the claims brought by the DOL alleging they misclassified regular, full-time temporary and leased workers as independent contractors, excluding these workers from the company's welfare and pension plans.

This year both the U.S. Department of Labor and the IRS have articulated their intent to target employer misclassification of independent contractors. Both federal agencies are concerned that misclassification deprives workers of the wage and hour protections provided by the FLSA and of other employee benefits, and also deprives the government of revenues from avoided payroll taxes.

  • The IRS hired 200 new employees solely to help recoup lost tax revenue from misclassification, planning to perform 6,000 audits over the next three years. The federal government predicts this new effort on employee misclassifications will reap at least $7 billion in federal revenue over the next ten years in fines and back taxes.
  • The DOL plans to use an additional $25 million in FY2012 for their "Misclassification Initiative" to develop data sharing activities with the IRS and other federal and state agencies, increase number and frequency of audits, establish a cross-state agency task force to target egregious employer schemes to avoid taxation through misclassification, and develop education and outreach programs.

So what is a REAL independent contractor?

True independent contractor status does not depend upon an agreement between employer and worker, but rather on the underlying nature of the work relationship. For example, some employers hire temporary workers during a busy period to perform the same duties that current employees perform but think that they are somehow "contract labor" or "contract employees." These terms, however, have no real meaning under wage and hour laws.

Unfortunately, there is no hard and fast test or rule that can easily be applied. The IRS, DOL, federal common law and Estate Courts all have articulated similar, but yet different tests to determine whether a worker is an employee or independent contractor. However, recent case law indicates that regardless of the forum, the inquiry should hinge on how much control the employer retains over the work performed, and how much economic and actual independence is retained by the worker. Some general guidelines are as follows:

An independent contractor normally:

  1. is hired to perform a discrete task,
  2. furnishes his or her own equipment,
  3. is in control over the manner the task is accomplished,
  4. has a finite end to the relationship at the completion of the discrete task, and
  5. is not wholly economically dependent upon the employer, i.e. you are not his or her only source of income.

Point of reference: like individuals should be treated alike. If an "independent contractor" is performing the same duties and job as an employee, the inconsistency is problematic. Proper classification is a fact-sensitive inquiry; no one factor is determinative. Job titles mean very little, and individualized analyses will control whether someone is an economically-dependent employee or an independent contractor.

The labor and employment lawyers at Gardere are seasoned professionals in auditing independent contractor classifications and can greatly reduce risks and exposures. This is certainly an area in which an ounce of prevention is worth a pound of cure. We can both assist you in auditing current workers and in appropriately classifying new hires going forward.

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