LEGAL SERIES

Misclassification of Employees - The "Independent Contractor" Versus "Employee"

In light of recent economic shortfalls, employers are looking to reduce costs to improve their bottom-lines. One of the primary ways that most businesses cut costs is by hiring "independent contractors," eliminating the need to provide employee benefits and to avoid payroll taxes. However, such categorization of hired help may land the employer in a legal mess.

1. The Good and the Ugly

a. The Good

When you hire someone as an "independent contractor," your goal is to avoid all of the responsibilities that come with having a regular "employee." These include: workers' compensation insurance, state employment tax, wage withholding, pension plans, health insurance, vacation, sick pay and other fringe benefits. If you do it right, employers also avoid having to pay for office space and equipment for independent contractors because they will work in their own space.

Employers may also experience greater efficiency because the independent contractor is an expert that needs little input to cause a profit.And, if the need for the contractor decreases, the employer can just cease the relationship. Finally, employers reduce their exposure to lawsuits by hiring independent contractors who are not protected by the same state and federal laws as employees. Unlike employees, independent contractors are not protected by wage and hour laws under the FLSA or discrimination and retaliation laws under Title VII of the Civil Rights Act of 1964, as amended. See 29 U.S.C. §§ 203, 206; 42 U.S.C. §§ 2000e, 2000e-2. Therefore, by hiring independent contractors, employers reduce the risk of claims against them for violating such rights that are exclusive to employees.

b. The Ugly
While there are many benefits to hiring independent contractors, in a true independent contractor situation, there are significant drawbacks to consider as well. Employers will have less control over their workers because independent contractors enjoy a certain level of autonomy in deciding how best to complete the task for which they are hired. Independent contractors have the ultimate control over whether they will work for an employer in a given situation and may even work for one of the employers' competitors. There is no automatic guarantee protecting an employer's confidential information when they hire an independent contractor.

However, requiring independent contractors to sign a non-disclosure agreement may ensure penalties will be imposed upon them if they violate the agreement. Employers also do not have the freedom to fire an independent contractor for any reason at any time as they do with employees. Rather, an employer's right to terminate an independent contractor’s services is limited by the terms of the written agreement. A violation of the agreement could result in the employer facing liability damages. Moreover, because independent contractors are not covered by worker's compensation insurance, if they are injured on the job, they may be able to sue the employer and recover damages.

To avoid some of the pitfalls of hiring an independent contractor, employers should have a comprehensive written agreement signed by the worker prior to the commencement of work. The agreement should provide a description of the services the independent contractor has been engaged to perform, set the duration of the services and establish clear details of the relationship between the parties. The agreement should also contain provisions that hold the independent contractor responsible for his own expenditures, require indemnification to the company for claims that arise out of the independent contractor’s acts or omissions and prohibit the independent contractor from impairing the reputation of the employer or competing with the employer. Without a written agreement, an employer may become exposed to a tremendous amount of risk that could have been avoided.

2. Independent Contractor v. Employee

Under the Fair Labor Standards Act (FLSA), an employee is defined as "any individual employed by an employer." 29 USC § 203 (e)(1). The FLSA also specifies that “to employ” includes arrangements in which one party "suffers or permits" another party to work. 29 USC § 203(g). The determination of employment status under the FLSA is guided by the economic reality of the relationship. Hopkins v. Cornerstone America, 545 F.3d 338, 343 (5th 2008) citing Herman v. Express Sixty-Minutes Delivery Services, Inc., 161 F.3d 299, 303 (5th Cir. 1998).

Courts focus on whether, as a matter of economic reality, an individual is economically dependent on the employer to which he renders his services, or is in business for himself. To determine whether a worker qualifies as an employee, courts generally consider the following five non-exhaustive factors:

1. The degree of control exercised by the alleged employer;
   

2. The extent of the relative investments of the worker and alleged employer;
   

3. The degree to which the worker’s opportunity for profit and loss is determined by the alleged employer;
   

4. The skill and initiative required in performing the job; and
   

5. The permanency of the relationship.

Courts have also inquired into whether the alleged employer has the power to hire and fire the employee, supervises and controls the employee’s work schedule or conditions of employment, determines the rate and method of payment and maintains the employees’ records. See Watson v. Graves, 909 F.2d 1549, 1553 (5th Cir. 1990).

Employers should consider all of these factors when hiring an independent contractor to ensure the worker is classified and treated appropriately.

Similar to the FLSA, under Title VII and the Americans with Disabilities Act (ADA), an employee is defined as "an individual employed by an employer." 42 U.S.C. § 2000e(f); 42 U.S.C. § 12111(4).

To determine whether an employment relationship exists within the meaning of Title VII, the 5th Circuit Court of Appeals has applied a hybrid economic realities/common law test. See Muhammad v. Dallas City Cmty. Supervision & Corr. Dept., 479 F.3d 377, 380 (5th Cir. 2007). The focus of this test is on whether the alleged employer has the right to hire, fire, supervise and set the work schedule of the employee. The economic realities portion of the test focuses on "whether the employer paid the employee’s salary, withheld taxes, provided benefits and set the terms and conditions of employment." Courts will then look to state common law upon consideration of the employee’s duties required by the position.

Under the ADA, on the other hand, because the determination of what constitutes an employer/employee relationship is not evident from the statute, courts have held that the common-law test is the proper test. See Johnson v. City of Saline, 151 F.3d 564, 568 (6th Cir. 1998). This test requires the consideration of many factors including, but not limited to, the following:

• the employer's right to control how the product/task is accomplished;
  

• the duration of the relationship;
  

• the skill required;
  

• the employer's right to assign additional projects; and
  

• method of payment.
  

These are just a few factors employers must evaluate when determining whether the individual they have hired classifies as an independent contractor or an employee who would therefore be protected by the provisions of the ADA.

3. Legal Consequences of Misclassification

a. Overtime Wage Claims

The consequences of misclassifying employees as independent contractors can be extensive. One of the greatest risks employers face is the potential for very significant claims for overtime wages. In Hopkins, the Fifth Circuit found that sales leaders, whose primary responsibility was recruiting, training and managing a team of subordinate sales agents, were employees – not independent contractors. Hopkins, 545 F.3d at 346.

This ruling allowed the group of sales leaders to proceed with their collective action against their employer for overtime wages. Id. The complainants in this case were actually "sales agents" who agreed to work as independent contractors with payment on a commission basis and who were promoted to management-level positions called "sales leaders." Id.

The Court focused its opinion largely on the fact that the employer had a substantial amount of control over the sales leaders’ ability to earn income and precluded the sales leaders from being involved in or owning any other businesses while working for the employer. The Court, using the economic realities approach, found that because the employer controlled the meaningful aspects of the business model, the sales leaders could not plausibly be considered separate economic entities that would render them independent contractors.

The Hopkins case also illustrates that employers may be at risk of incurring FLSA claims brought by individuals they have properly classified as independent contractors for other purposes. One of the class action members claiming he was an employee under the FLSA had previously asserted in his pleadings and during his deposition regarding a sexual harassment case under the Texas Commission on Human Rights Act that he was an independent contractor. Hopkins, 545 F.3d at 347. However, the Court in Hopkins held that it is legally possible to be an employee for purposes of the FLSA and an independent contractor for purposes under other statutes. Id., citing Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 318, 326 (noting the FLSA "stretches the meaning of 'employee' to cover some parties who might not qualify as such under strict application of traditional agency law principles.")

b. Other Possible Claims

Employees misclassified as independent contractors may bring a variety of claims against an employer – other than those for overtime pay under the FLSA. For example, if determined an employee was misclassified by the employer, the employee may seek to recover retirement benefits, medical coverage for injuries they sustained on the employer’s property, the right to stock options and claims for unemployment benefits. See e.g., Kristi Kessler & Patricia Bartis, Independent Contractor Classification can be a Tricky Issue, BUSINESS JOURNAL, Jan. 10, 2003. Employers will also experience a shift in liability from the independent contractor (now employee) to the employer for injuries to others, damage to property and for harassment charges.

Other consequences employers may face if a worker is deemed misclassified by a court ruling include liability for back payroll taxes, litigation costs and out of court settlement costs to make the issue disappear. See Id. Employers may also be confronted with unwelcome attention and embarrassment for their mistake, and for the cost of correcting it.