Independent contractors: New employment counseling department sheds light on the pitfalls of misclassification | Obermayer Rebmann Maxwell & Hippel LLP


Employers are often faced with a sudden need for additional temporary coverage for one or more areas of their business. Perhaps a mission-critical but discreet project is waiting to be completed: you need the manpower, but only until the project is complete. Perhaps you would like to draw on the institutional knowledge and technical expertise of an employee who is about to retire even after the end of full-time employment. Your first thought might be to hire these services on an independent contractor basis.

At first glance, it seems like a promise of profit: Your organization can take advantage of the labor it needs at a price that doesn’t include payroll taxes, unemployment insurance premiums, overtime, office space, the tools needed for the job, or other ancillary costs of a permanent employee. Independent contractors would be individually responsible for all of these costs.

Additionally, Independent contractors do not have all the statutory rights of employees. Independent contractors cannot claim unpaid wages or unpaid overtime under the Fair Labor Standards Act or similar state wage payment laws. You also cannot bring claims of discrimination under Title VII or its various state and local equivalents.

Even better, Independent contractors may be hired for a limited period.

But don’t let the potential cost savings fool you into the hidden risks of misclassifying an employee as an independent contractor. These liabilities can be costly, cumbersome, or both, and can arise in a variety of circumstances. For example, an employee you paid as an independent contractor could be claiming unemployment benefits claiming they were misclassified and are actually an employee. Or your state Department of Labor may conduct a spot check of your workforce and find that you mistakenly classified employees as independent contractors. Current independent contractors could file unpaid overtime lawsuits for misclassification. These are just some of the circumstances in which a misclassification, accidental or otherwise, can give rise to significant liability.

When an independent contractor successfully argues that they were in fact an employee, misclassification can be a costly mistake.

Your organization may be held liable for the employer’s share of payroll taxes for the duration of the person’s engagement. There may be times when you owe unpaid unemployment insurance premiums or workers’ compensation premiums. You could be held liable for unpaid overtime, leaving the misclassified worker entitled to the overtime itself, liquidated damages equal to the unpaid overtime, plus fees for the worker’s attorney to handle the matter. In short, the penalties for misclassification—whether intentional or unintentional—can far outweigh any cost savings.

To complicate matters further, recent trends have shown renewed government pressure to more narrowly define the status of independent contractors. In the past, courts have used somewhat ambiguous multi-factor tests to determine the line between an employee and an independent contractor.

in the PennsylvaniaFor example, in most cases, courts use a ten-step test to assess independent contractor status. The Pennsylvania Supreme Court has introduced a somewhat simplified six-part “economic reality” test specific to unpaid wages and unpaid overtime. The economic reality test assesses certain factors – such as B. the level of control over the contractor’s work, whether the contractor provides its own tools for the job, the degree of permanence of the employment relationship, and the extent to which the work is an integral part of the employer’s business – to determine whether an employee is truly independent or dependent on the employer for their livelihood. These convoluted tests lead to unpredictable results and sometimes come to opposite conclusions when the underlying facts change only slightly.

Faced with this unpredictability, all levels of government have begun to reassess the classification of workers. As tax authorities, governments are motivated to ensure steady tax revenues with as little effort as possible. Making employers responsible for payroll taxes and government insurance premiums, such as unemployment or workers’ compensation, greatly reduces the effort tax authorities have to expend to collect taxes. Think of it this way: it’s much easier to collect taxes from a single company with a hundred employees than it is to collect taxes from that company and one hundred individual workers classified as independent contractors.

Not surprisingly, governments have moved to simpler – and much narrower – definitions of independent contractors. At the federal level, the Department of Labor (DOL) recently issued a proposed rule that would make it more difficult for employers to prove that employees are independent contractors. The proposed rule would overturn a rule in the Trump administration that applies a five-factor test of “economic reality,” which focuses primarily on two factors: the level of control a worker has over the work being done and who Opportunities for the employee to gain or lose. Rather than the “economic reality” test, the DOL’s updated rule would require a fact-rich assessment of six broad criteria with no emphasis on any particular factor. As a result, it may become more difficult to defend an employee’s classification as an independent contractor.

The new proposed DOL rule, which would apply to the federal Wage and Hour Act, has yet to go through the administrative process where it will likely evolve. The proposed regulation will not be final until mid-2023 at the earliest.

Meanwhile, state-level legislators have lobbied for – and in some cases enacted – the much stricter regulations “ABC” test. To properly classify a worker as an independent contractor under the “ABC” test, the worker must:

  1. must be free from control or direction of their work;
  2. must perform work outside of the usual course of business of the employer; and
  3. must be engaged in what is commonly considered a independently formed trade, profession, occupation or business.

The employer must meet all three points to pass the test.

From a practical standpoint, the second or “B” pen presents the greatest difficulty for employers looking for independent contractors. This prong requires that the work performed by an independent contractor be unrelated to the employer’s business. For example, a restaurant would be permitted to act as an independent contractor and engage an accountant for tax preparation purposes. But this restaurant would not be able to hire a chef as an independent contractor, even for a one off event.

At least thirteen states have adopted some form of the “ABC” test, including New Jersey, California, Massachusetts and West Virginia. More states, including Pennsylvania, appear poised to introduce the ABC test in the near future.

Given the changing legal landscape and the potentially significant liability if an employee is misclassified as an independent contractor, employers should consult an attorney before attempting to classify an employee as an independent contractor.

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