Employee Or Independent Contractor

Reclassification of employees can create devastating tax liabilities, major employee benefit problems, and other collateral consequences. Care in making a proper classification for various purposes is very important.

- a. Why Classification Makes a Big Difference. Businesses need peo­ple to perform work for them, but how the worker is classi­fied, or reclassi­fied, could make a dramatic monetary difference to the business.

- i. Tax and Benefit Matters. If the worker is deemed to be an independent contractor for all purposes, the business is not liable for the 7.65% FICA (Social Security and Medicare) tax and the 6.2% FUTA (unemployment) tax which apply to employees. No withholding of state or federal income tax or the employee's share of FICA tax would be required, saving administra­tive burdens and costs. The state law requirement of providing workers compensation insurance may be eliminated. Also, the worker would generally not be entitled to employee benefits of various kinds such as retirement plans, health insurance, vacation, and other fringe benefits. The Employee Retirement Income Security Act of 1974 (ERISA; 29 USC § 1001 et seq.) protects employees, not independent contractors. These possible savings have led some businesses to be aggressive in classifying workers as independent contractors. The tax savings and reductions in worker benefits have also led the Internal Revenue Service and state regulators to be aggressive in the opposite direction of classifying workers as employees. The gray areas of the law have thus led to a number of conflicts.

- ii. Other Labor Law Matters. The Fair Labor Standards Act (FLSA) requires minimum and overtime wages for certain employees but does not apply to independent contractors. State wage and hour laws and workers compensation laws apply to employees only. Antidiscrimination rules apply to employees under Title VII of the Civil Rights Act, the Age Discrimination in Employment Act (ADEA) and the Americans with Disabilities Act (ADA). The National Labor Relations Act (NLRA) protects employees= rights to organize for collective bargaining. The protections of the Family and Medical Leave Act (FMLA) apply to employees only. On the other hand, independent contractors generally have better protection for their works under the Copyright Act.

- b. Adverse Results of Reclassification. Some of the conflicts over worker classification have proven very costly to businesses.

- i. Tax and Benefit Matters. If a worker is reclassified by the Service from independent contractor to employee, the business could be required to pay the income tax that was not withheld, the business's share of FICA taxes that the business did not pay and the employee's share which the business did not withhold, the FUTA tax that was not paid, interest, and a number of penalties. If a significant group of workers are reclassified, the business could become insolvent.

- (1) The penalties include penalties for failure to pay or withhold tax and failure to file information returns. The principal civil penalties include: Internal Revenue Code (AIRC@) '' 6651(a) (late filing return, failure to pay tax), 6656 (failure to deposit employment taxes), 6662 (negligent or inten­tional disregard of rules or substantial understatement), and 6663 (fraud). In addition, criminal penalties could apply in some situations.

- (2) The principals of the business could be held personally liable for the failure to withhold and pay what are sometimes called the Atrust fund@ taxes: income tax withholding and the employee's portion of FICA tax. IRC ' 6672. Others may be liable under IRC ' 6701 for aiding and abetting an understatement of tax liability.

- (3) If workers are misclassified it could have the effect of disqualifying qualified pension or profit sharing plans. If a worker who is really an independent contractor is wrongly included in a plan as an employee, this could affect its qualified status; also, if a worker who is really an employee is excluded from a plan as an independent contractor, the plan may fail to qualify, for example, by failing to meet the minimum participation standards of IRC ' 410.

- (4) The results of a dispute involving a reclassification of workers in the gray areas of the law can be truly awful. The gray area is very large indeed, and involves complex and confusing rules. It is too easy for a business which is trying in good faith to comply with the law to either make an error or to act properly but nevertheless be forced into an expensive defense of its position.

- ii. Other Labor Law Matters. If a worker is misclassified as an independent contractor under the FLSA, the employer may be liable for minimum and overtime wages, liquidated damages in an equal amount, and further penalties for severe or willful violations. Similarly, misclassification under other employment-related laws will often change dramatically the rules and protections applicable to the parties.

- iii. Collateral Matters. Some industries, such as health care, have regulatory regimes which treat certain rules as applying or as not applying depending on whether a person is an employee or not. For example, full or part time physicians treated as common law employees for purposes of Federal Insurance Contributions Act (Social Security) taxes (26 USC ' 3121(d)(2), may qualifying for certain exceptions to referral prohibitions under federal law which use the standards of 26 USC ' 3121 (d)(2) as the basis for its definition of employee. If overall the physician is not deemed to be an employee, some of the factors described below may well prove to be Antikickback law (Medicare Fraud and Abuse Amendments of 1977; 42 USC ' 1320a-7b(b)) violations outside the employment safe harbor or to be Stark anti self referral law (Ethics in Patient Referrals Act of 1989; 42 USC '' 1395nn, 1395q) violations outside the employment exception.

- c. Classification Rules. A quick look at the rules demonstrates why they can be a trap.

- i. Tax and Benefit Matters. To classify a worker for federal tax purposes, the three analytical steps described below should be taken. Keep in mind, however, that workers compensation and other state regulatory schemes will also have their own classifications which will vary from program to program and from state to state, and which are not necessarily consistent with the federal tax rules. It is helpful to use the three-step analysis described below. The basic standard for these purposes where a specific statutory definition does not apply is a common-law control rule, a rule which originally developed to determine employer liability in tort cases.

- (2) Economic Reality. An economic reality test (looking to Acircumstances of the whole activity@) is used under the Social Security Act (benefits) (U.S. v. Silk, 331 U.S. 704 (1947)) and Family and Medical Leave Act (FMLA; 29 USC § 2601, et seq.) (Siko v. Kassab, Archbold & O=Brien, 1948 W.L. 464900 (E.D. Pa) (following Fair Labor Standards Act (FLSA) cases)) and the FLSA (relating to wages and hours) (29 USC '' 203(e)(i), 203(d) and 203(g); Rutherford Food Corp. v. McComb, 331 U.S. 722 (1947)). The economic reality analysis is broader than the control analysis. It is possible to be an employee under the economic reality test but not under the control test. A 1968 Department of Labor (DOL) Opinion Letter (W&H Opinion Letter No. 832, June 25, 1968; see also W&H Opinion Letter No. 1029, Sept. 12, 1969) states that where six factors are present, the worker is likely an employee:

- (a) worker=s limited investment in equipment and facilities;

- (b) close supervision and high degree of control by company;

- (c) worker=s limited opportunity for profit;

- (d) small degree of worker=s independent initiative, judgment, and foresight needed in open market competition for success of the operation;

- (e) high degree of permanence of the work relationship;

- (f) the broad extent to which the services are an integral part of the company=s business;

- (g) in addition to the six factors mentioned by the DOL, some courts look to how dependent the worker is on the company for continued work.

- (3) Hybrid. A hybrid of the control and of the economic reality test is often used under Title VII of the Civil Rights Act of 1964 (42 USC § 2000e et seq.) (analysis of economic reality while focusing on employer=s right to control) and the Age Discrimination in Employment Act (ADEA (1967); 29 USC § 621 et seq. ) (EEOC v. Zippo Mfg. Co., 713 F.2d 32 (3rd Cir. 1983)).