A slippery slope

Misclassifying employees as independent contractors and labor-only contracts pose challenges to contractors


Professional roofing contractors are facing two significant challenges as they seek to be competitive in the marketplace. Reputable roofing contractors, who historically have used independent contractors in certain situations and have correctly differentiated independent contractors from employees, find they are being targeted unfairly by investigators because of legislation and enforcement activities aimed at contractors who misclassify workers. At the same time, contractors report they are losing jobs to competitors who hire "labor-only" subcontractors.

The misclassification issue most often arises when an individual is hired to perform services as an independent contractor. Companies that misclassify workers as independent contractors gain a significant and unfair advantage over competitors who treat workers as employees because treating individuals as independent contractors offers significant cost savings.

The law

Employers are required to pay the employer portion of payroll taxes for Social Security and Medicare per the Federal Insurance Contributions Act (FICA) and make contributions to federal or state unemployment insurance funds per the Federal Unemployment Tax Act (FUTA).

Employers also are required to purchase workers' compensation insurance and comply with wage and hour laws under the Fair Labor Standards Act (FLSA) and state statutes covering such subjects as minimum wage, overtime, premium time and travel time as well as federal and state statutes applicable to employer-employee relationships such as the Family and Medical Leave Act. In addition, employers provide various job benefits that may include group health insurance and retirement contributions. None of these expenses apply to independent contractors.

A business can save an estimated 30 to 40 percent by misclassifying workers as independent contractors. Published estimates indicate there are more than 10 million workers classified as independent contractors, and that number significantly has increased since 2000.

Companies must issue Form 1099-MISC by Jan. 31 to each worker who is classified as an independent contractor and was paid $600 or more during the previous year, as well as file a copy of the 1099 with the Internal Revenue Service (IRS) by Feb. 28. Employers are to issue W-2 forms to each employee by Jan. 31. However, these actions do not legally make an individual an independent contractor, which requires a more extensive analysis.

If a company treats an individual as an independent contractor and a government audit or lawsuit subsequently determines the individual should have been classified as an employee, the financial consequences for the company can be devastating because, in addition to back taxes and interest, fines and penalties in several states are calculated on a per individual, per day basis.

Labor-only subcontractors

There has been much discussion in the construction industry regarding labor-only subcontractors. It is important to distinguish between a legitimate labor-only subcontractor who is operating a business properly by treating workers as employees versus a labor-only subcontractor who either misclassifies workers as independent contractors or operates in the underground economy by making cash payments and flouting legal requirements.

Using a legitimate labor-only subcontractor is legal and may be a worthwhile way to tackle all or part of a job in certain situations. For instance, if you have contracted for a large job that includes tile work for which you don't have experienced installers and the specialty subcontractor you would like to use lacks the capital to purchase the materials, retaining a qualified and experienced labor-only subcontractor to install the tiles would make good business sense.

Similarly, if you were loaded with work and facing tight deadlines and liquidated damages, retaining a labor-only subcontractor to do a job might be the only way to meet job deadlines without incurring overtime and premium time expenses.

If you retain a labor-only subcontractor, you will want to be sure you are not running afoul of your contract with your customer, which might prohibit subcontracting without express permission and violate your licensed applicator or approved contractor agreement if a manufacturer's warranty is required and the warranty is to cover the work performed by your subcontractor.

You also should check with your insurance adviser to ascertain whether your commercial general liability (CGL) insurance policy will extend to the work of your subcontractor because some CGL policies exclude claims arising from the operations of independent contractors.

When retaining a labor-only subcontractor, you will want to be sure you are working with one who is treating and paying its workers as employees; making the required tax and unemployment insurance withholdings; maintaining workers' compensation, CGL and other insurance you may require; and complying with wage and hour regulations.

Retaining a subcontractor that does not treat its workers as employees will put you at greater risk of mechanic's liens, payment bond claims, and audits from state and federal agencies. The likelihood a subcontractor is conducting its business illegally by misclassifying workers or paying workers off the books is presumably greater when retaining a labor-only subcontractor.

Government efforts

In most states, retaining individuals as labor-only subcontractors and paying them on a piece-rate or per-job basis no longer is a viable business model. More restrictive state legislation, new criteria to distinguish between independent contractors and employees, and more aggressive enforcement have severely limited the circumstances in which an individual will be recognized as an independent contractor.

As is all too often the case, a contractor who conducts business legitimately is an easier target to locate and pursue for an audit and enforcement action than a company that operates in the underground economy. A company that issues 1099s is much easier to identify than a company that pays workers in cash and does not issue W-2s or 1099s.

The IRS has entered into a formal memorandum of understanding with the Department of Labor (DOL) to improve compliance with laws and regulations through sharing information and collaboration. Eleven states also became signatories to the IRS and DOL memorandum of understanding in 2011. The purpose of this joint initiative is to reduce misclassification of employees, obtain additional payroll tax revenue and improve compliance with federal labor laws, particularly wage and hour regulations. In addition, several states have entered into cooperative agreements with the IRS and between state agencies to identify and obtain records of construction contractors and other businesses in fields considered to have high rates of misclassification.

Tests

There is no standard legal test applied to determine whether a worker should be classified as an employee or independent contractor. Different statutes have different definitions of who is an employee. States and agencies of the federal government and state governments apply different tests depending on state law and the statute or regulation being enforced. It is possible an individual may be considered an employee under one law and an independent contractor under another law.

Although there are multiple tests to distinguish between employees and independent contractors, the most common and most critical factor in all tests is the degree of control a company has over an individual. As more control over the worker or the service performed exists, the greater the likelihood the worker is to be classified an employee. If the hiring company does not have authority to regulate the conduct of an individual or the service, independent contractor status is proper.

The most common tests used to determine misclassification are the common law test, IRS 20-factor test, economic realities test and ABC test. These tests have much in common with one another, but some are more rigorous than others. The evaluation under each test is fact-intensive.

Under the common law test that historically has been applied in many court decisions, if a hiring company exercises control or has the right of control over an individual's job performance and how the job is performed, the individual will be considered an employee.

The IRS 20-factor test has been used by the IRS to determine whether a hiring contractor should be required to pay FICA and FUTA employer payroll taxes. In 1999, the IRS issued a memorandum indicating it would be focusing on three factors: behavioral control (the right to direct and control performance); financial control (the right to direct and control the business aspects of a worker's activities); and the relationship of the parties (whether the relationship is temporary or indefinite).

The economic realities test, also known as the FLSA test, determines whether workers are subject to FLSA regulations. The economic realities test focuses on whether a worker is economically dependent on the hiring company or in business for himself or herself.

The test that most severely limits the use of independent contractors is known as the ABC test. Colorado, Connecticut, Illinois, Louisiana, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Tennessee, Utah, Vermont, Washington and West Virginia are among the states that have adopted the ABC test for at least certain state regulations. For a worker to be classified as an independent contractor, the worker must meet all three parts of the ABC test as follows:

  • Part A: The worker must be free from direction and control in the performance of the service as a matter of contract and in fact. If the person hiring the worker retains the right to exercise direction and control, even if that right is not exercised, the worker does not qualify as an independent contractor.
  • Part B: The company classifying the worker as an independent contractor must prove the worker's services are performed either outside the usual course of the company's business or outside all the company's places of business.
  • Part C: The worker customarily is engaged in an independently established business, trade, occupation or profession of the same nature as the service being provided. Having a business license, business liability insurance, letterhead and cards, advertisements, client references, state sales tax registration and federal ID number would tend to show compliance with Part C.

The states

States have become aggressive in their efforts to reduce misclassification of employees, particularly in industries such as construction that are considered to have high incidences of misclassification. States have enacted new and stronger statutes, and state agencies have been undertaking audits to detect misclassification of employees because of the significant loss of tax income and contributions to state unemployment compensation funds resulting from misclassification. Many states have established interagency task forces charged with identifying employers who misclassify workers and have begun implementing measures recommended by the task forces.

Numerous states, including Colorado, Delaware, Illinois, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Oregon, Pennsylvania, Tennessee and Texas, have enacted new legislation in recent years intended to combat misclassification of employees. Delaware, Illinois, Nebraska, New Jersey, New York, Pennsylvania and Tennessee have enacted legislation focused specifically on misclassifications in the construction industry. Many states have signed agreements with DOL's Wage and Hour Division to cross-report violations and coordinate enforcement.

State legislation

An increasingly common approach among states is to create a legal presumption by statute that any person performing labor or services for a fee is an employee. Several states take the approach that an individual worker is presumed to be an employee unless the hiring contractor can satisfy all three prongs of the ABC test. California, Delaware and Maryland, for example, take the approach that if an individual performs work or a service in the same field as the hiring contractor, there is a presumption the worker is an employee.

California enacted legislation in 2011 prohibiting the willful misclassification of individuals as independent contractors. The legislation creates civil penalties between $5,000 and $25,000 per violation. Workers who did not receive minimum wages or overtime pay or were not provided meal periods and rest breaks as required under California law can file a wage claim with California's Division of Labor Standards Enforcement.

Connecticut's Employment Misclassification Act increases civil penalties for employers who misclassify workers from $300 per violation to $300 per day for each violation; the civil penalty for one misclassified worker for one year could be $109,500. The legislation also made misclassification a felony if done with the intent to harm the state.

Under Illinois' Employee Classification Act, which is aimed directly at the construction industry, any individual "performing services" for a construction contractor is deemed to be an employee of the contractor. In 2013, the Illinois Department of Employment Security found nearly 20,000 workers in the state had been misclassified as independent contractors and assessed unemployment insurance contributions and penalties on more than $250 million in unreported taxable wages. Illinois conducted 3,635 misclassification audits in 2013.

New York enacted its Construction Industry Fair Play Act to attack misclassification in the construction industry. Studies cited in connection with passage of the act indicated misclassification in the construction industry was 15 percent higher than other industries. In New York City alone, 50,000 construction workers were estimated to be either misclassified as independent contractors or paid off the books.

New York's Construction Industry Fair Play Act makes all individual workers employees of construction contractors unless an individual is free from direction and control when performing the job; the work is not part of the usual work performed by the business that hired the individual; and the individual has an independently established business.

Pennsylvania's Workplace Misclassification Act requires construction contractors to satisfy a rigid test to use individual independent contractors and makes it a criminal offense for employers in the construction industry to misclassify employees. Displeased with the state's enforcement efforts, a state senator introduced legislation in August authorizing county district attorneys to investigate and prosecute violations by construction contractors.

What to do?

If you find you are competing against labor-only or other contractors who are not treating workers as employees and not complying with employment law, develop a plan to combat them.

Although there is no simple solution, you should consider informing prospective customers of your concerns and push them to take steps to receive and compare proposals from reputable contractors. Your customers might consider a robust pre-job qualification process and require affidavits from construction companies affirming they will use employees who are authorized to work and who will be compensated in accordance with federal and state requirements. Such steps may cause unscrupulous contractors to back off from the job and will help owners and general contractors identify legitimate contractors.

Because state governments are keenly interested in eliminating misclassification of employees and have difficulty locating contractors who are operating illegally, you also may want to inform state labor agencies of a contractor who you have good reason to believe is misclassifying employees.

If you retain individuals whom you have historically treated as independent contractors or are considering retaining an individual as an independent contractor, make a thorough assessment to determine whether your classification is proper under current law. Rather than risking an audit by a regulatory agency and the potential assessment of hefty fines, consider having a well-qualified person conduct an audit of your current or planned independent contractor relationships.

Stephen M. Phillips is a partner with Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.




For articles related to this topic, see:
"Increasing pressure," October 2009 issue
"Pitfalls of temporary employment," November 2008 issue
"Worthy reminders," August 2006 issue
"Illegal immigrant or independent contractor?" August 2005 issue

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