Businesses across the country are continuing to cut costs by replacing employees with independent contractors to save costs. Some savings are certain - employers don’t pay employment taxes to the IRS or employee benefits to their workers. However, many hidden costs can reduce these savings or even erase them entirely. This article focuses on seven legal myths, which can mislead businesses to believe they are saving costs by blinding them to costly legal risks when they hire workers as independent contractors

instead of employees.  These myths result from being uninformed about the legal differences between employees and independent contractors. Shattering these myths is the best way to learn how these distinctions affect your business’s legal compliance and why companies need to include these risks in any cost-cutting calculations.

Myth #1:  Employers Should Use the IRS’s “20 Common Law Factors Test” to Determine Worker Status as Employee or Independent Contractor

Reality:  The IRS no longer applies its long-standing, much-publicized and frequently used ”20-Common Law Factors Test” to determine a worker’s status as employee or independent contractor. The IRS has replaced this test with a new approach focusing on three categories to determine if a worker is an employee or independent contractor: Behavioral Control, Financial Control, and Type of Relationship.  Companies relying on the “20 Common Law Factors Test” today risk costly fines and penalties determinations of worker misclassification by IRS auditors.

The IRS is specifically targeting companies that have lain off employees to save costs then hired independent contractors to perform the same work (even if you rehire the same person as a contractor. Their incentive is the same as that of businesses being audited -- the huge amounts of money not being paid in employment taxes. In short, employers’ savings becomes Uncle Sam’s losses, and Uncle Sam wants his money back!  The answer lies in recognizing this risk and making sure that you are classifying your workforce properly, complying with the agency’s new tests.

Myth #2: Employers Can Avoid Costly Worker Misclassification Risks By Complying with the IRS Worker Status Test

Reality: The overwhelming focus on the IRS’s worker status tests by business and legal advisors has led many employers to the believe they can avoid legal risks of worker misclassification entirely by pleasing Uncle Sam. However, the IRS’s worker status test only applies when businesses need to determine a worker status for employment tax purposes.  Precious little information is provided about the many other federal (and state) laws governing the workforce, yet each has its own tests to determine worker status and all differ from the new IRS approach. Four examples are:

• Employee benefits: A 12-factor test determines whether a worker is an employee or independent contractor under ERISA, the federal law governing employee benefits;
• Immigration: the Immigration Reform and Control Act (IRCA) applies a 7-factor test to determine worker status.
• Employment discrimination: the Equal Employment Opportunity Commission (EEOC) applies a test based on the “right to control the means and manner of worker’s performance” federal employment discrimination law enforcement
• Wage and hour laws: the Fair Labor Standards Act (FLSA) applies an “economic realities” test including six factors to determine whether the worker is economically dependent on the business to which the services are provided.

While it is important to learn the worker status rules under the various laws and regulations governing the workplace, just knowing that “all worker status tests are not the same” is an important first step in reducing legal risks

Myth #3: You Can Avoid Costly Worker Misclassification Liability by Complying with Federal Statutes and Regulations Governing the Workforce

Reality: Even if your company complies with lengthy list of laws and regulations governing the workforce you still risk liability for worker misclassification for misclassifying workers as independent contractors who our Courts and the IRS consider to be “common law employees”.

Many high-profile worker misclassification lawsuits, whose staggering costs to employers made national headlines such as Vizcaino v. Microsoft (settled for $97 million in June, 2001), Herner v. Time Warner, (settled for $5.5 million in November, 2000), Clark v. King County, (settled for $18.6 Million settlement in June, 2000) and Logan v. King County (settled for $24 million in December, 1997) were based on courts’ findings that plaintiffs were common law employees.

The IRS defines a common law employee as “any individual who, under common law, would have the status of an employee . . . a person who performs services for an employer who has the right to control and direct the results of the work and the way in which it is done. For example, the employer provides the employee's tools, materials, and workplace, and can fire the employee.”  Compared to independent contractors, “Common-law employees are not self-employed and cannot set up retirement plans for income from their work…”

Our Courts and the IRS will find that workers are employees if they meet the common law employee criteria, whether they are hired as independent contractors, free-lancers, temporary or other “contingent” workers.

Myth #4: An Employment Contract Expressly Stating that a Worker is Independent Contractor Means that the Worker is an Independent Contractor

Reality:  In a series of recent cases, several Federal Appeals Courts across the country have ignored or rejected employment contracts that expressly designated workers as independent contractors. These and other courts have considered written contracts less important than the actual working relationships, control of worker performance and other factors when worker status is at issue.  A few recent cases illustrate why relying on an employment contracts and written agreements to determine worker status is risky business:

• In the landmark case of Vizcaino v. Microsoft case the 9^th Circuit Court of Appeals held that Microsoft’s “permatemp” workers were common law employees despite the fact that they signed written agreements acknowledging that they were independent contractors;
• In Baystate Affiliated Staffing v. Herner the 1^st Circuit Court of Appeals rejected staffing agency argument that temporary workers who signed employment agreements stating they were independent contractors. The Court held that the workers were employees, therefore entitled to receive overtime pay as required by the FLSA, and the staffing agencies (and their business clients) were liable for violating the Fair Labor Standards Act (FLSA);
• In Yak v. Brussels (June, 2001) the 2^nd Circuit Court of Appeals held that a worker who signed an employment contract stating that she was an independent contractor and waiving her rights to employee benefits was an employee. The Court ruled that: 1) plaintiff’s worker status must be based on control of work and not an employment contract and 2) ERISA requirements governing employee benefits must override the terms of an employment contract.  It based its ruling on the principle that “the terms of a contract cannot override either issues of control in an employment relationship to determine worker status or the legal requirements under ERISA”;
•  In December 2001 the EEOC filed a $2 billion lawsuit against Allstate Insurance Company after its life insurance agents  signed written agreements to convert from employee to contractor status as part of a company-wide restructuring program.                    The agency recently charged Allstate with “coercive and intimidating practices” when it forced its agents to sign written statements agreeing to the change of status from employee to independent contractor.

Myth #5:  Hiring CEO’s, CFO’s and Officers as Independent Contractors Rather Than Employees Is an Acceptable, Routine, Legal Business Practice

Reality: While hiring corporate chief executives, as independent contractors may be a common, routine and legal business practice, it carries its own legal risks for creditors, employees and shareholders.  Our current corporate accountability crisis is exposing these risks every day. Consider the Enron case. When Enron hired Stephen Cooper as its new CEO his contract designated him as an independent contractor, not a full-time employee. SEC investigators knew the independent contractor status would limit the new CEO’s fiduciary responsibility to the company and its creditors would have freed Cooper from fiduciary responsibility to the company and its creditors. They characterized the designation as  “inappropriate” and (joined by the Florida State Board of Administration, an Enron creditor and shareholder) scolded the company for its independent contractor designation. The SEC forced Enron to change Cooper’s contract status to “full- time employee” to promote corporate responsibility. With stories of corporate CEO responsibility dominating our daily headlines, this raises the inevitable question of how many other corporate executives are protected by contracts that designate them as “independent contractors” rather than “full-time employees”?  (emphasis added).

Myth #6: All Contractors Are The Same When It Comes to Legal Compliance

Reality: All contractors are NOT the same. The IRS considers independent contractors to be self-employed. Each is a business owner with the right to choose from various forms of business entity, including a corporation. An independent contractor’s business entity can affect the potential liability of any company that hires or manages that person when legal disputes arise. Recognizing that all contractors are not the same can help reduce the costs of future potential legal disputes in contractor workforce management.

Myth #7: Workers Compensation Policies Protect Employers from Liability for Work-Related Injuries Suffered by Employees, but Not Independent Contractors

Reality: This is true, however the risks of potentially costly legal consequences also need to be considered. Because independent contractors aren’t covered by an employer’s workers compensation plan, hiring independent contractors (or converting employees to independent contractor status) can open the door to personal injury lawsuits when contractors suffer work-related injuries. Because they are not employees, independent contractors who are injured on the job can bring a personal injury lawsuit alleging negligence, defective machinery or equipment, or other grounds for liability just like any other business customer or client. Employers need to recognize the real costs of losing the protective shield that workers compensation provides against such lawsuits.

Conclusion – Education is the Best Defense

As businesses struggle to balance reduced revenue growth against the goal of profitability, laying off employees and hiring independent contractors are the most obvious and convenient short-term cost-cutting fixes. This article has identified 7 illustrative areas of legal risk, which employers need to recognize and include in their business planning before they are faced with unexpected, costly legal surprises down the road. The best remedy for managers needing to cut costs is education – learning the real legal risks in contractor workforce management and the potentially high costs of ignoring these costs in their business planning.

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BIOGRAPHY

Ron Wainrib, Esq. is founder, president and owner of Ronald E. Wainrib & Associates, Inc., a Massachusetts corporation providing legal education and information services to business, legal professionals, and consumers since 1991. He has devoted his 35-year professional career to legal research, writing, education, and advocacy.

He has written, edited, and published legal information and educational material focusing on new developments in labor, employment, and employee benefits law for legal, business and consumer audiences.

Ron received his J.D. from the State University of New York at Buffalo, his M.P.A. from the University of Hartford, and his B.A. from SUNY at Stony Brook.

He has published many articles on legal issues in contingent workforce management, an is editor and publisher of the Contingent Employment Law Manual © 2010, annual updates, Contingent Workforce Forms Book, annual updates, and Contingent Employment Case Law Supplement © 2010, annual updates.  He has ghost-written several legal books and articles, and authored “The Grant Authority” © 2008, a self-help reference book for grant seekers.

Ron has worked with leaders of law, business, government, and industry in the Boston area, nationally and internationally. He served as Director of Continuing Legal Education (CLE) for the Boston Bar Association; Associate/researcher/ghostwriter for a prominent Boston trial law firm; Consultant to local and national continuing education firms; and Owner of his own CLE company, the Metro West Center for Continuing Education.  Thousands of professionals, executives, and small business owners have benefited from his professional education services and publications.

Employee misclassification, independent contractor, temporary employment, discrimination, sexual harassment, fair labor standards act, wrongful termination, family and medical leave, and employee benefits are some of the workplace legal issues he has covered in his seminars, research, publications, and web site, www.contingentlaw.com.

Articles to further review on the topic

Independent Contractor (Self-Employed) or Employee? Still Confused?

Independent Contractor (Self-Employed) or Employee? Information to avoid Misclassification

You Need to Understand the Fair Labor Standards Act Part 3 - Are You a Joint Employer?

You Need to Understand the Fair Labor Standards Act Part 2 - What Is Work Under The FLSA?

You Need to Understand the Fair Labor Standards Act Part 1 - The Basics

But I Signed An Independent Contractor Agreement

Term Limits for Contingent Workers: Urban Legend or Necessary Fix?

7 Costly Legal Myths in Contractor Workforce Management

DOL cracks down! Are your classifications FLSA-compliant?

U.S. Department of Labor Emphasizes Enforcement of Fair Labor Standards Act Classifications: Are Your Employees Correctly Classified?

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