Litigation over Independent Contractor Misclassification Grows

The latest “lawsuit du jour” in California is taking aim at employers that misclassify workers as independent contractors, according to Betsy Johnson, an Epstein, Becker & Green attorney in Los Angeles.

At a Jan. 27 National Press Club briefing in Washington, D.C., Johnson said classification challenges are on the rise in other states as well, including Illinois, Massachusetts, Michigan, New Jersey and New York. She told attendees that they should “expect to see a lot more activity, especially if federal legislation” on independent contractor misclassification passes.

Johnson predicted that states will take a harder look at independent contractor classifications, particularly since some studies suggest there is much untapped state tax revenue where individuals have been misclassified. A 2000 Department of Labor (DOL) study found that 30 percent of firms misclassify their employees as independent contractors. And a 2007 study by the Industrial and Labor Relations School of Cornell University estimated that in New York alone, the average unemployment insurance taxable wages underreported from 2002-2005 due to misclassification of workers as independent contractors was $4.28 billion.

Take steps now to defend your companies, Johnson recommended, noting that many employers struggle to defend themselves from challenges to their classifications because of inadequate record-keeping for their independent contractors.

Record-Keeping Challenges

Johnson has two class actions pending in California on independent contractor classification. She said that these kinds of class actions are similar to wage and hour challenges of employers’ classification of workers as exempt or nonexempt. So, employers face similar difficulties defending themselves when their independent contractor classifications are challenged.

In wage and hour litigation, employers often don’t have time sheet records for employees classified as exempt, because employers don’t need the records if the employees truly are exempt. The record-keeping often is scantier for workers classified as independent contractors, according to Johnson. There typically won’t be an I-9 for them, she noted, adding that there also often wouldn’t have been any background checks either. In California, the challenges “can go back four years,” Johnson said. “It can be difficult to go back and recreate the paper trail.”

In the past, litigation over the misclassification of independent contractors typically has arisen when those classified as independent contractors seek to recover unemployment compensation or workers’ compensation benefits. To recover the benefits, they maintain that they should have been classified as employees.

The Internal Revenue Service (IRS) has been cooperating with state agencies to fight the misclassification of independent contractors. Johnson said the IRS has entered information-sharing agreements with at least 30 states and she expects that number to increase.

Proposed Federal Legislation

Under proposed federal legislation, the Independent Contractor Proper Classification Act (S. 2044), the IRS’ role in fighting misclassification would grow. Johnson said the legislation would let the IRS issue new regulations on independent contractor status and conduct more audits. The IRS would share that information with the DOL, which could lead to more DOL audits. The legislation would let workers ask the IRS for opinions of their status to see if they were properly classified, and require employers to inform those classified as independent contractors that they have to file taxes and are exempt from employment laws, wage and hour laws, and unemployment compensation and workers’ compensation statutes. Employers also would have to inform employees about their right to seek a classification determination from the IRS.

In addition, the Internal Revenue Code would be amended to change the safe harbor definition of independent contractor and remove industry standards as a reasonable basis for designating someone as an independent contractor. The legislation also would prohibit retaliation against those who were misclassified.

Johnson added that, if enacted, the Employee Misclassification Prevention Act (S. 3648) would increase the potential liability if the IRS reclassified the workers as employees. This bill also would require that at least 25 percent of the DOL Wage and Hour Division’s audits focus on potential misclassifications of workers as independent contractors. And it would amend the Fair Labor Standards Act to require employers to keep records of independent contractors.
The bills floundered in the 110th Congress, but Johnson expects them to return, noting that President Obama sponsored both. If enacted, the legislation would dramatically change how independent contractor classification challenges arise, she predicted, observing that two federal agencies “would be tasked with going out to find and root out the problem.”

Protective Action

Johnson recommended that employers take action to limit their potential legal exposure, suggesting that they conduct internal audits to ensure their classifications of independent contractors are correct. “At a minimum, have an independent contractor agreement,” she said.

Make sure supervisors who work side by side with independent contractors don’t treat them like employees, she added.

The definition of who is an independent contractor can vary not only between different states but by different state agencies within the same state. For example, in California, she said the Employee Development Department has a different definition of “independent contractor” than the California Division of Workers’ Compensation. And the California Labor Standards Enforcement Division has a different definition from the California Franchise Tax Board.
Johnson is left resorting to the “duck test” to distinguish true independent contractors from misclassified ones. If someone “walks like an employee and quacks like an employee, the chances are that agencies will treat them like an employee,” she remarked.