During a recent conversation with a local retailer, I asked him how many employees he had in his shop. He assumed a Cheshire grin…
“Employees? Why bother?” he asked rhetorically. “I just use independent contractors. It simplifies everything.”
“Really?” I prompted. He did not catch the sarcasm.
“Sure,” he proudly continued, “All 1099s. I don’t have to worry about workers’ comp, unemployment, withholding, overtime – anything. I figured it out last year. I don’t know why other folks still mess with employees.”
If you’re reading this and thinking my retailer friend has unlocked the secret to business success, please call me. You and my buddy are headed for trouble.
Many employers misunderstand the requirements associated with treating workers as independent contractors. They see contractors, and the flexibility the arrangement seems to offer, as an attractive alternative to employees and the obligations that come along with a formal hire. But misclassifying workers as independent contractors when they should technically be regarded as employees can cause big legal headaches, including problems under the Fair Labor Standards Act (“FLSA”), federal and state tax laws, and workers’ compensation and unemployment insurance obligations. In some cases, moreover, business owners and supervisors can be individually liable for violations and may personally be on the hook for monetary, and perhaps criminal, sanctions.
Economic realities determine the relationship
Whether a worker is classified as an employee or contractor is not simply a matter of what the company (and/or the worker) wants or designates the classification to be. It’s not enough that there is a written contract between the parties or that the company and the worker agree to a contractor relationship. Instead, courts and enforcement agencies (such as the Department of Labor or the Internal Revenue Service) look to the “economic realities” of the relationship to determine whether the worker is, in reality, an employee or 1099 contractor.
There are several variations on the economic realities test, but six common criteria show up in most versions. No single criterion is determinative – the elements together create a sliding-scale accounting for the totality of the relationship.
- The degree and nature of control that the company has over the manner in which the worker performs the work. The more closely the company oversees the worker, such as dictating how, when, and where the worker completes his tasks, the more likely the worker should be considered an employee.
- The chance that the worker has for profit or loss depending on his skill. If several workers all performing the same task each receive similar compensation and the worker does not share in the risk or reward of the business’s profit, the more likely the worker should be considered an employee.
- The worker’s own investment in the equipment or materials needed to complete the work. If the company provides the worker’s tools, resources, equipment, materials, etc., the more likely the worker should be considered an employee.
- Whether the service at issue requires a special skill. The more common the task to be performed, for instance customer service, office administration, or manual labor, the more likely the worker should be considered an employee.
- Whether the relationship is permanent. The more indefinite the period for which the worker is engaged and the less the work resembles “project work,” the more likely the worker should be considered an employee.
- The extent to which the worker’s services are an integral part of the company’s business. If a worker is doing the business of the company, and not something incidental to its operations, such as painting the company’s offices, fixing the company’s computers, or performing an audit of the company’s financials, the more likely the worker should be considered an employee.
As you can see, applying these criteria to most of the workers in the retail shop I was visiting, it is more likely than not that the owner had improperly classified his employees as contractors. The young man operating the cash register, for example, is told specifically when to work and how to complete the transactions, does not share in the risk or reward of the shop’s profit, uses the business’s equipment and exercises a rather pedestrian skill set, was likely engaged on an indefinite basis, and is directly engaged in doing what the shop is in business to do – retail merchandise.
So what’s the big deal?
Lots. An employer who has misclassified employees is likely in violation of several employment laws. For instance, most employees, unlike contractors, are entitled to an overtime premium on their compensation for hours worked in excess of 40 in a week. Misclassified employees may be entitled to back overtime wages for as many as three years.
Employers are also required to take income tax, Social Security, and Medicare withholdings from employee’s checks, plus account for the employer’s share of FICA taxes; independent contractors are responsible for their own taxes and do not usually have anything withheld from their checks. If the worker has been misclassified, the employer will likely owe back taxes on the worker’s wages, as well as face penalties for failing to withhold.
Furthermore, companies who mistakenly rely on an independent contractor designation may not maintain sufficient workers’ compensation insurance coverage and are likely not properly funding their unemployment insurance obligations.
Not every independent contractor is improperly classified and contractors can, when properly engaged, provide businesses with cost-effective and flexible staffing solutions. But proper classification of workers is a fact-specific determination. Employers not familiar with the particulars of the inquiry should seek qualified employment counsel to helps avoid the headaches and big liabilities of misclassification.