Independent Contractor or Employee?

Classify Workers Correctly or Risk Sanctions

The practice of using independent contractors as part of a company’s business model, if used correctly, can provide flexibility and cost savings. In today’s weak economy, the practice of using independent contractors has been on the rise. While the use of independent contractors is not alone illegal, those businesses that use independent contractors in order to avoid paying payroll taxes or to avoid their obligations under the Fair Labor Standards Act could be illegal and subject a business to significant
financial liability.

Recently a number of states have entered into memorandums of agreement with the Department of Labor to share information and coordinate enforcement efforts to combat what the government perceives as a growing problem of employers misclassifying workers as independent contractors. Louisiana became the 13th state to enter into such an agreement. (California, Colorado, Connecticut, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Missouri, Montana, Utah and Washington have all signed similar agreements.) In 2011 the Wage and Hour Division of the DOL collected more than $5 million in back wages for minimum wage and overtime violations under the Fair Labor Standards Act. Additionally, U.S. Secretary of Labor Hilda Solis entered into an agreement with the Internal Revenue Service to improve efforts to eliminate the use of independent contractors as a business practice.

These coordinated efforts to attack the use of independent contractors is the result of a report released recently by the General Accounting Office (GAO) titled “Employee Misclassification-Improved Coordination, Outreach and Targeting Could Better Ensure Detection and Prevention.” In this report the GAO described the impact of misclassifying workers as independent contractors on various agencies and factors:

  1. Misclassified workers who are not paid properly for overtime
  2. Federal programs such as Social Security and Medicare are impacted
  3. State programs such as unemployment insurance and workers’ compensation are affected.

Further, the GAO estimated that the cost to the federal government for the misclassification of employees was in excess of $2.72 billion in 2006.

The coordination between federal agencies as well as the cooperation between the federal government and the states should serve as a wake-up call to companies to re-examine their use of independent contractors and insure they are in compliance with the relevant state and federal laws. In order to minimize a company’s exposure to an attack on its use of independent contractors in its business, employers who engage independent contractors should consider the following steps:

  1. Conduct an audit of the company’s classification of independent contractors to assess whether any should be treated as employees. Before engaging in this audit employers should determine whether they wish to keep the result of the audit confidential by using an attorney to conduct the audit. Employers should also be aware of the fact that there are a variety of different tests for determining whether a worker is an independent contractor under federal and state law. Further complicating this analysis is the fact that there are also different standards used among different federal agencies. For example, the DOL uses an “economic realities” test whereas the IRS uses a “right to control” test. As a result, it is highly recommended that you consult with an expert on the issues of independent contractor status in making this determination
  2. Have all written independent contractor agreements reviewed — and if needed revised — by your attorney. The agreements should specify the task and expected results, and provide the contractor with wide discretion in accomplishing the contracted task. If a company does not have written agreements, strong consideration should be given to instituting written agreements.
  3. Employers should teach the independent contractor concept to every manager who has any contact with the contractors. This education helps supervisors understand how their relationships should differ between employees and independent contractors. Additionally, these supervisors could be used as witnesses in defense of an employer’s use of independent contractors if it is ever challenged by an agency or court.
  4. Insure that contractors are treated correctly for federal tax purposes and that they are not listed on the payroll with employees. Independent contractors should receive an IRS form 1099 for their earnings rather than a W-2.

In this difficult economy, the IRS and state agencies are looking for any tax dollars left on the table by investigating whether employers are misclassifying employees as independent contractors. The Department of Labor is aggressively pursuing employers who avoid the overtime and minimum wage requirements of the Fair Labor Standards Act by misclassifying workers as independent contractors. For employers who use a large force of independent contractors, penalties and back pay could be significant if those contractors are determined to be employers under the Fair Labor Standards Act, the Internal Revenue Code and various state unemployment and workers compensation codes.

Employers should take proactive steps now to ensure that their independent contractors are properly classified and make any needed changes before a federal or state agency contacts them about their use of independent contractors.


Jimmy Patterson JIMMY PATTERSON is a shareholder with Ogletree Deakins in Nashville. He works exclusively for employers on traditional labor issues as well as advising employees on employment related matters. His practice includes the counseling and representation of employers before the National Labor Relations Board, the Equal Employment Opportunity Commission, the Department of Labor, and numerous other Federal and State agencies. He received his law degree from the Cumberland School of Law at Samford University in 1992, and his bachelor’s from Rhodes College in 1989.