Are you liable for misclassifying your employees as independent contractors?

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This article was prepared by employment law attorney Denise M. Blommel.  Denise is admitted to practice in the state and federal courts of Arizona and Nevada.  Her practice centers on the employer-employee relationship. For more information about her expertise and employment services, check out her website at www.azlaborlaw.com.

The misclassification of employees as independent contractors is a huge issue right now.  The IRS and Department of Labor have been very public in their efforts to increase investigations and enforcement of the proper classifications. So, how can you differentiate an employee from an independent contractor?  Courts and governmental agencies look to the totality of the circumstances as to whether a worker is an independent contractor or an employee.  From a labor and employment perspective (as I cannot give a tax viewpoint as I do not practice tax law), there are two main criteria for determining whether a worker is an employee: (1) Right to Control (an employer has no right to control the method of the independent contractor’s work) and (2) Economic Realities (an independent contractor is not totally dependent upon the employer for his/her livelihood).

Under both the federal Fair Labor Standards Act (FLSA) and Arizona’s Minimum Wage Act, the emphasis on determining the appropriate worker classification is upon Economic Realities test.  These same criteria also apply in the Legal Arizona Workers Act (aka Employer Sanctions Law).  The Economic Realities test include the following:

Is the worker dependent on employer? (if yes, then an employee)
Are the worker’s services an integral part of business?  (if yes, then an employee)
What is the permanency of the relationship?  (more permanent – more employee)
What is the amount of the worker’s investment in his business?  (more investment in worker’s business – more an independent contractor)
Does the employer have any right of control the work?  (if employer controls work – then an employee)
Does the worker have opportunities to make a profit and loss?  (If yes, looks like a contractor)
What is the level of the of the worker’s skill?  (more skill – more a contractor)

The Department of Economic Security (DES) uses both Right to Control and Economic Realities in its criteria for differentiating between independent contractors (who are not entitled to unemployment compensation) and employees (who are entitled to unemployment compensation).  For example, the DES’ rules indicate the following as indicia of control:

Authority by the employer over the individual’s assistants (employee)
Compliance by the individual with instructions by the business (employee)
The worker providing regular oral or written reports (employee)
The place of doing the work (at employer’s location – employee)
Whether the work is being performed personally (employee)
The establishment of a work sequence (employee)
The employer’s right to discharge, set hours of work, training (employee)
Whether the worker is devoting full time to the employer (employee)
Whether the employer is furnishing tools and materials (employee if employer provides tools)
Whether the employer is reimbursing expenses (employee if there is reimbursement)

Other criteria used by DES include:

The worker’s availability to the public
Compensation on a job rather than hourly or salary basis
The worker’s realization of a profit or loss
Legal obligation to complete the work
Significant investment in tools and equipment for performing the work
Simultaneous contracts

Misclassification of workers as independent contractors can cause businesses severe financial distress when the government steps in to enforce the appropriate classification.  The employer is responsible to withhold federal income tax and the employee’s share of employment taxes for all employees and will be liable to cover these taxes if the worker was misclassified.  Additionally, employees are entitled to overtime pay according to the FLSA and the employer may be responsible for back pay and overtime payments for the time frame of the misclassification.

Furthermore, if an “independent contractor” who is really an employee is injured on the job, the employer is liable.  Under Arizona law, the injured worker can either sue the business directly in tort for personal injury or file a “No Insurance” worker compensation claim with the Industrial Commission of Arizona (“ICA”).  The ICA processes these “No Insurance “claims and charges the uninsured employer for all the benefits it pays plus interest and penalties.  A business can lose everything if this happens. Additionally, the failure to carry worker compensation insurance also is a felony.

If the worker should have been classified as an employee for Title VII/ADEA/ADA purposes, the worker has the right to file a charge of discrimination.  EEOC, like many other governmental agencies, places a heavy burden of proof upon the employer to demonstrate that a worker is a contractor rather than an employee.

In all circumstances, if a business engages the services of an independent contractor, it should always use a written contract.  Arizona’s worker compensation law gives a great template for what belongs in a written agreement so that a worker’s independent contractor status will be presumed.  The agreement must be written, signed, dated, and there can be no duress.  The business must have no authority to supervise or control the worker.  The agreement must disclose that the worker has no worker compensation benefits.  The worker cannot be required to exclusively work for the business and cannot combine business operations with the employer.  The business cannot provide required licenses and cannot pay the contractor by a wage or salary.  The contractor must be paid by the name on the contract.  The employer cannot dictate the time of performance or provide tools.  There are also restrictions upon termination of the relationship.  These criteria reflect the traditional “Right to Control” tests.

If your business wants to ensure compliance, simply reviewing the IRS criteria is not enough; a business must also be aware of its obligations under labor and employment laws and take ongoing steps to education yourself on the various requirements and keep your business compliant.   The above information is not legal advice for your business – it is designed to provide you with education for your entrepreneurial ventures.

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