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President Obama released his budget proposal for 2011 on February 1, 2010, and included a recommendation that the U.S. Department of Labor (DOL) be given $25 million for the specific purpose of investigating and prosecuting employers who misclassify employees as independent contractors. This so-called “Misclassification Initiative” would permit the DOL to hire additional investigators and enforcement personnel. The budget also proposed legislation to shift the burden of proof to employers to demonstrate that their workers are classified correctly and to make misclassification a violation of the Fair Labor Standards Act (FLSA).

With the weakened economy and cost-cutting efforts everywhere, the temptation is great to classify workers as independent contractors rather than employees and thereby avoid the overtime, payroll tax, and benefit costs associated with employees. But the monetary consequences of misclassifying workers may outweigh the perceived advantages. Employers could face liability for unpaid overtime, minimum wage violations, lost benefits, and back payroll taxes, in addition to sanctions, penalties, and attorney fees.

There are several different tests for determining whether a worker is an independent contractor or an employee. In fact, the DOL and the Internal Revenue Service use different tests. The DOL has issued a Fact Sheet that purports to define an “employment relationship” under the FLSA: “In the application of the FLSA an employee, as distinguished from a person who is engaged in a business of his or her own, is one who, as a matter of economic reality, follows the usual path of an employee and is dependent on the business which he or she serves. The employer-employee relationship under the FLSA is tested by ‘economic reality’ rather than ‘technical concepts.’ It is not determined by the common law standards relating to master and servant.” Crystal clear, right? According to the Fact Sheet, the factors to be looked at include:

• The extent to which the services rendered are an integral part of the principal’s business;
• The permanency of the relationship;
• The amount of the alleged contractor’s investment in facilities and equipment;
• The nature and degree of control by the principal;
• The alleged contractor’s opportunities for profit and loss;
• The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor; and
• The degree of independent business organization and operation.

The Michigan Department of Energy, Labor & Economic Growth has issued a similar statement regarding misclassification and is making efforts to address the subject. The Michigan Unemployment Insurance Agency (UIA) uses listings of employers who are issuing 1099-MISC statements, obtained from the IRS, to identify employers that have potentially misclassified workers in order to recoup unpaid unemployment insurance taxes (and to “educate” employers). Other states have intensified their enforcement efforts to combat and punish worker misclassification.

In recent years, many companies have been challenged in the courts on their “employee” versus “independent contractor” classifications. For example, FedEx delivery drivers filed class action lawsuits in a number of states claiming misclassification. FedEx maintains that its drivers are small business owners who can own multiple routes and expand their businesses as they wish. In the past year, a federal multidistrict litigation judge certified eight of those class actions, in addition to 19 state actions that had previously been certified. The common legal element was each state’s use of a “right to control” test to determine a worker’s status. A California state court, noting FedEx’s control over every detail of the driver’s performance, concluded that the drivers are employees, not independent contractors; that case then settled for $27 million. But a Washington jury recently found that the same FedEx delivery driver arrangement lawfully categorized them as independent contractors. Confused?

Bear in mind that the plan for federal and state agencies cracking down on misclassification is an enforcement plan, not an education plan, and that it is unlikely that those agencies will forgive innocent confusion regarding this complex issue.

The bottom line in making classification decisions is that it is generally a question of control. In a true independent contractor relationship, the principal has a right to judge the result produced by the independent contractor — but not to direct or control the methods that produce the result. A true independent contractor has control over his or her operation, covers operating expenses, and experiences profit or loss. True independent contractors usually provide their services to more than one entity.

The risks of misclassification — for both independent contractors as well as for supposedly FLSA-exempt workers — can be very significant, particularly when collective actions are filed. The volume of litigation in this area keeps growing, in large part because misclassification cases are lucrative for plaintiffs’ lawyers. Employers should analyze the soundness of their classification decisions, and conduct audits, preferably under the umbrella of the attorney-client privilege, to locate and eliminate areas of vulnerability.

Jennifer A. Zinn

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