Avoiding independent contractor misclassification issues

State and federal agencies have differing definitions, but there are common elements

Working as a contractor, or hiring contractors, provides the flexibility that many workers and companies desire. In some scenarios, the independent contractor status works well. However, employers can face significant and very costly problems from the misclassification of workers as independent contractors instead of employees.

Because independent contractors are considered to be in business for themselves, the IRS does not consider them to be “employees.” As a result, companies do not have to pay state or federal payroll taxes for independent contractors, and can avoid providing the usual employee benefits, such as worker’s compensation, retirement benefits and health insurance. In addition, laws intended to protect the rights of employees, which form the basis of employment litigation (i.e., wage claims, whistleblower actions, discrimination and wrongful termination actions), are not available to independent contractors.

But a business that misclassifies an “employee” as an “independent contractor” can be liable for payment of back wages (including overtime pay), reimbursement for out-of-pocket expenses that would have been covered by a benefit program if the worker had been properly classified, back taxes, as well as the possibility of criminal and other civil penalties and liabilities.

What makes this area of employment law especially difficult is that there is no universal definition to determine whether a worker must be classified as an “employee” rather than an “independent contractor.” The answer to this question generally turns on which government agency is asking the question, or which employment law is under review.

For example, the U.S. Department of Labor (USDOL) has one test for “employee” status, and the IRS has another. At the state level, NH Department of Employment Security (NHES) and the NH Department of Labor (NHDOL) each have different tests. Given the same facts, one agency or statute might classify a worker to be an employee, while another may find the same worker is eligible to be an independent contractor.

Common elements for classification

In properly classifying working relationships, employers in New Hampshire should be aware of four separate “independent contractor” legal tests: the IRS test; the NHES test; the NHDOL test and the USDOL test. The specific elements of each test can be found on the applicable agency websites.

While the competing tests can be frustrating for companies seeking clear legal guidance in their decision-making, the various tests share a number of common elements. Businesses seeking to classify a worker as a contractor may start with a reference to the following elements, although each legal test must ultimately be viewed separately in reference to each worker:

• Financial considerations: In all of the tests, this factor focuses on the workers’ opportunity for economic success or failure in performing the work. If a worker has no opportunity for profit or loss, and does not have any financial investment in materials, equipment, rental space or employees, then this suggests an employment relationship.
• Degree of control or direction: This factor focuses on the degree of control that a business exercises over the worker in areas such as the worker’s schedule, attendance and supervision of work performance and training. If workers can establish their own work hours or decline work, this may suggest a contractor relationship. If the business sets the work hours, and supervises and directs the work performed, this suggests an employment relationship.
• Duration of relationship: This factor examines whether a work relationship is ongoing and indefinite in duration, which suggests an employment relationship, or whether the relationship is short-term or sporadic, and non-exclusive, which suggests a contractor relationship.
• Independently established trade or profession-high level of skill required: This factor considers whether the worker is in an independently and established trade or profession, outside the scope of the hiring business, and whether the worker relies upon the use of specialized skills to perform the work. Employee status is indicated where the worker performs functions that are integral to the hiring business and does not use specialized skills in performing the work. Where the worker brings specialized skills to the work relationship and uses these skills for other business as well, then a contractor relationship is indicated.

Implications for employers

Employers must realize that in deciding whether an individual is an employee or an independent contractor, the existence of an independent contractor agreement, by itself, does not determine a worker’s status. There are multiple distinct tests, as referenced above, which dictate whether a worker can qualify as an “independent contractor.” During an agency audit or litigation, the actual facts will trump mere labels. Because there is no single test, employers are encouraged to audit their existing employment classifications to guard against the possible risk of costly litigation and damages for a misclassification of the “independent contractor” relationship.

Attorney Peg O’Brien, director and vice chair of McLane Middleton’s Employment Law Group, can be reached at 603-628-1490 or margaret.obrien@mclane.com.