Use of Independent Contractors: Risks, Benefits, and Increasing Defensibility of Independent Contractor Status

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1 Use of Independent Contractors: Risks, Benefits, and Increasing Defensibility of Independent Contractor Status By: Kevin Hishta, Esq. and Maggie Hanrahan, Esq. Ogletree, Deakins, Nash, Smoak & Stewart, P.C. 1 April 10, 2012 Implementing a carefully-structured independent contractor business model can provide companies with numerous business advantages. However, given the current economic and political climate, independent contractor relationships have been facing and continue to face increased scrutiny. The liabilities associated with a misclassification finding can be significant. Therefore, if a company wishes to use an independent contractor business model for any individuals with whom it contracts, it must structure this independent contractor relationship very carefully, building in the appropriate recommended provisions, to minimize the risks of any such liability. This Memorandum will discuss: (A) some of the general benefits and risks associated with using an independent contractor model; and (B) various recommended options and considerations for minimizing exposure to independent contractor misclassification liability. Also attached to this Memorandum is an Independent Contractor Checklist, which provides additional practical guidance in this area. I. DISCUSSION A. Benefits and Risks of Implementing An Independent Contractor Model 1. General Benefits Associated with Implementing an Independent Contractor Model Today s business environment, with its ever increasing price tag for labor, resources, materials and benefits, combined with expanding competition, has forced business owners to search for ways to reduce operating expenses while remaining productive, efficient and 1 This paper has been written by the authors to inform in-house counsel of important information in these areas of law. The information contained herein is not intended as specific legal advice Ogletree, Deakins, Nash, Smoak & Stewart P.C. Any reproduction of these materials in any form or incorporation of its contents into any information retrieval system or any use without the express written consent of Ogletree, Deakins, Nash, Smoak & Stewart, P.C. is prohibited. Please direct all inquiries to Margaret Santen Hanrahan or Kevin Hishta at Ogletree, Deakins, Nash, Smoak & Stewart, P.C., 191 Peachtree St., NE, Suite 4800, Atlanta, GA (404)

2 competitive. Moving away from the traditional employee model and implementing an independent contractor model for some aspect of their business has been one way companies have been able to reduce their direct labor costs without sacrificing market share, productivity or efficiency. The cost savings produced by an independent contractor model may include many of the following: (1) Reduction in employer contributions for state unemployment taxes and reduction in Social Security and federal unemployment taxes; (2) Elimination of discretionary fringe benefit costs such as health insurance, retirement contributions and vacation pay; (3) Reduced cost for workers compensation insurance; (4) Savings on initial training costs as independent contractors should already possess the necessary skills; (5) Greater operational flexibility and increased efficiency; (6) Potential for minimized exposure to legal risks for a wide array of state and federal labor and employment laws and regulations; and (7) Reduced capital expenditures as independent contractors frequently (and should) own the equipment necessary to do the job. As discussed below, however, implementing an independent contractor model is not without risk. There is no question, however, that a properly implemented independent contractor model can help reduce costs without loss of productivity. 2. General Risks Associated with Implementing an Independent Contractor Model a. Misclassification Litigation and Federal/State Investigative Initiatives Conversely, given the current economic and political climate, and the significant enforcement efforts in this area, the risks associated with implementing an independent contractor business model can be significant. These risks can include, for example: (1) Federal and state Department of Labor wage and hour investigations, testing the independent contractor classification, and seeking unpaid overtime compensation if employee status is found; (2) Private individual and collective lawsuits under the Fair Labor Standards Act ( FLSA ) and state wage and hour laws seeking a finding of employee status, the recovery of unpaid overtime, liquidated damages, treble damages (under some state laws), and attorneys fees; 2

3 (3) Investigations and assessments/fines by federal and state taxing authorities, including the Internal Revenue Service ( IRS ), federal and state Departments of Labor, and other entities for unpaid payroll taxes, and unemployment compensation contributions if employee status found; (4) Class action or individual lawsuits under other employment laws, such as Title VII, ADEA, ADA, FMLA, ERISA, 2 etc., alleging misclassification and entitlement to the benefits/protections typically afforded to employees; and (5) Class actions or individual lawsuits under other state law theories, such as unjust enrichment, fraud, rescission, and improper wage deductions. b. Federal Legislative Initiatives Moreover, given the current enforcement efforts in this area, these risks are even more imminent. More specifically, the DOL budget for FY 2013 specifically allocates $14 million to be used to combat misclassification, including $10 million for grants to states to identify misclassification of employees as independent contractors and $3.8 million for enforcement by the Wage and Hour Division of the Department of Labor. The FY 2012 budget likewise designated several million dollars for misclassification efforts. This budget helps to fund the Department of Labor s five-year initiative, launched in 2010, to identify and deter employee misclassification. Under this initiative, the Department of Labor has committed to working closely with the Department of Treasury to conduct targeted wage/hour investigations in industries with the most substantial independent contractor abuses. The initiative also includes offering training for investigators on the detection of misclassified workers, targeted efforts to recoup unpaid taxes, and several financial incentives and rewards for states with the most success in targeting misclassification. In fact, the Wage and Hour Division has even opened 13 new enforcement offices and expanded six of its existing offices nationwide to help increase enforcement. Further, since at least 2007, there have been several federal legislative efforts to pass legislation aimed at curbing independent contractor misclassification. The federal bills have focused primarily on: (1) eliminating the current Safe Harbor provision in the Internal Revenue Code, currently available for companies who (in pertinent part) have a reasonable basis for classifying individuals as independent contractors; and (2) making independent contractor misclassification an independent violation of the FLSA by imposing various additional recordkeeping requirements, among others. The Employee Misclassification Prevention Act, introduced in 2011, sought to do the latter namely, make misclassification an independent violation of the FLSA and increase penalties for any violations of the FLSA that result from misclassification (i.e., treble damages instead of liquidated damages). The more recent federal legislative efforts aimed at targeting misclassification take a slightly different approach. For example, on March 1, 2012, Senator Kerry introduced another piece of legislation entitled the Fair Playing Field Act of 2012 (S. 2145) to allegedly address 2 The risks of benefits claims, however, can be greatly minimized by the use of appropriate carve-out language for independent contractors in a company s benefits plans. More specifically, benefits plans should, when defining employee, specifically exclude (for example) any individuals: (1) not on the company s normal payroll; or (2) who are or have been for the period in question treated as an independent contractor, whether or not later reclassified for the same period as an employee by a state, federal or local administrative agency or tribunal or court. 3

4 the uncertainty as to the proper classification of workers. This legislation would require the Secretary of Treasury to issue guidance, including regulations, to clarify which employees qualify as independent contractors for federal employment tax purposes. This would assist companies in determining whether they could take advantage of the Safe Harbor provision in Section 530 of the Revenue Act of The bill would also require companies to provide a written statement to independent contractors informing them of: (1) their federal tax obligations, (2) what labor and employment protections do not apply to them; and (3) their rights to seek a determination of their status from the IRS. Various categories of workers, such as engineers, computer programmers and systems analysts, would be exempt from this bill. An identical bill has been introduced by Representative Jim McDermott in the House (H.R. 4123). The most recent bill, entitled The Rebuild America Act, which was introduced in the Senate in the last week of March and first week of April 2012, attaches a misclassification provision to close the loopholes to prevent worker misclassification. The details of such initiative, however, have not yet been released. This Act also includes provisions to: (1) increase the minimize wage by more than $2 an hour, (2) provide funding for state and local governments to hire teachers and first responders; and (3) implement another of other miscellaneous initiatives to assist the Middle Class. None of these bills have been passed to date. However, we believe that this independent contractor misclassification issue will continue to be a huge legislative initiative and that some variation of legislation targeting misclassification will pass at some point, particular as President Obama was a co-sponsor of one such bill as a Senator and has openly supported others as President. c. State Legislative and Other Enforcement Initiatives In addition to the federal legislative efforts, numerous states have either passed misclassification legislation or have introduced such legislation. This legislation mostly targets key industries known to use independent contractors, such as the construction industry and trucking/transportation industries, and often creates a presumption of employee status for contractors in such industries. 3 New Jersey has just introduced such a bill, entitled the Truck Operator Contractor Act, which seeks to define parcel delivery owner-operators as employees of the companies they provide services for, rather than independent contractors. Interestingly, this New Jersey bill also allows labor unions to bring a civil action on behalf of an individual or group of individuals for violation of the Act and misclassification. Other state statutes create the presumption of employee status unless the worker satisfies the stringent ABC test typically used by the state unemployment offices. Ohio, Virginia and North Carolina, for example, have all introduced such bills in State Attorney General and Department of Labor investigations, along with other Inter- Agency Task Force initiatives, 4 are also being used to combat misclassification. In Massachusetts, for example, the Attorney General s office just reached a $3 million settlement 3 Pennsylvania, Delaware and Maine, for example, all passed laws in 2011 that create such presumptions in these industries. California, Kansas, New York, and New Jersey all introduced such bills in Several other states passed and/or introduced similar misclassification legislation prior to Georgia, however, has not introduced any such legislation to date. 4 To further these Inter-Agency initiatives, several states have entered into formal Memoranda of Understanding with the Internal Revenue Service and state Department of Labor to share information regarding misclassification. 4

5 with a package-delivery company to settle claims of misclassification. The Connecticut Department of Labor, for example, also issued 23 stop work orders against subcontractors working on a $26 million HUD project after finding that the firms misclassified their workers and failed to have appropriate workers compensation insurance. B. Options for Minimizing Risks of Liability 1. Recommended Factors and Considerations to Strengthen Defensibility of Independent Contractor Relationship It is impossible to determine with certainty how any court or agency may rule when assessing the enforceability/defensibility of any one independent contractor model. However, there are numerous steps any company using independent contractors can and should take to enhance the enforceability of their independent contractor models and minimize their risks of any misclassification liability. Many of these recommended steps have been factors courts have focused on when upholding independent contractor status in recent cases. Specifically, we recommend that the following factors/business considerations be built into any independent contractor model, to the extent possible, to minimize the risks of misclassification liability: (1) Only contract with individuals who are incorporated into a separate legal entity; (2) Ensure the contractor s relationship with the company is not established for a high degree of permanence by establishing an expiration date in the contract not to exceed one year at the highest; (3) Allow the contractor to hire employees to assist him/her with the services and/or perform the services in his/her place without prior approval of the company; (4) Allow the contractor to own multiple routes or trucks (if applicable); (5) Allow the contractor to negotiate contract terms (e.g., rates); (6) Require payment by the job not time worked and avoid paying any set salary; (7) Allow the contractor to work elsewhere, have his/her own clients, and advertise his/her own services to others through the use of his/her own business cards or other advertising materials; (8) Allow the contractor to control the economic aspects of his/her job by, for example: (a) requiring significant investment in all equipment necessary to perform the job and no reimbursement of operating expenses or company-provided subsidies, privileges, goods, services or facilities at a discount or free (i.e., such as providing an office or office equipment for the contractor to use); and 5

6 (b) providing opportunity for profit or loss based on managerial skill by allowing contractor to make his/her services available to the market, accept or refuse work for the company at his/her discretion, and hire employees to perform work with him/her or in his/her place; (9) Avoid any semblance of control over manner and means in which services are performed, such as: (a) (b) (c) (d) (e) (f) specific work hours or mandated work at company offices; designated break/lunch periods; specific techniques; training programs; grooming standards; and mandated dress code or use of business cards with the company s logo. (10) No use of conventional discipline for contractors (rather, breach of contractual obligations may result in contract termination); (11) Allow the contractor to own or obtain an equity interest in the business; (12) Not include contractors in employee meetings; and (13) Build in an equity ownership interest that can be sold to others without prior company approval for profit or loss. It is imperative that these and other factors/business considerations be incorporated into a carefully-drafted independent contractor agreement to increase the chances of the independent contractor model being upheld. 2. Other Options for Minimizing Risks of Liability In addition to the considerations discussed above, there are several other legal options companies can utilize to minimize the risk of independent contractor misclassification liability. The most pertinent options include: (a) obtaining an opinion letter on the independent contractor status of the individual in question from counsel; (b) requesting an SS-8 determination from the IRS on the proper status of such individuals; and (c) petitioning for acceptance into the Voluntary Classification Settlement Program ( VCSP ) offered by the IRS. All such options, along with the pros and cons of each, are discussed below. 6

7 a. Opinion Letter on Independent Contractor Status The first option that may be available is to obtain a formal opinion letter confirming the independent contractor status of the individual in question from outside counsel. This opinion letter would be based on applicable judicial precedent and would analyze the position at issue in light of such precedent. This approach would assist the company in arguing that it has a reasonable basis for classifying the individual as an independent contractor for purposes of the Safe Harbor provision contained in the Internal Revenue Code (assuming it can establish the other elements of the Safe Harbor provision for the position in question, such as substantive reporting consistency). See I.R.C. 530(a)(2)(A) (containing Safe Harbor provision). While it is possible that the IRS would not find such a private-letter opinion sufficient to establish this reasonable basis, having such a letter could help minimize the company s liability in other areas as well. For example, an opinion letter from outside counsel confirming independent contractor status of any particular individual would assist the company in minimizing damages in any misclassification actions for overtime or minimum wage violations under the FLSA. Under the FLSA, good faith reliance on advice of counsel is a defense to the imposition of liquidated damages. b. Request for SS-8 Determination Another, although risky, approach is petitioning the IRS for a formal determination of the individual s status (i.e., employee vs. independent contractor). This step should only be pursued for individuals the company (and outside counsel) is confident are correctly classified as independent contractors. The IRS allows private parties both individuals and companies to petition for this type of determination through the use of a Form SS-8. This Form SS-8 asks for information about the relationship between the parties, including (for example) for a description of: (1) the type of work performed; (2) who provides supplies or materials; (3) who determines the worker s daily return, including hours worked, manner of performing work, etc.; and (4) whether the worker has the opportunity for profit or loss, among others. The party requesting this determination from the IRS is responsible for submitting a completed Form SS-8 to the IRS for their determination. The IRS will then respond to the request, indicating whether the individual is properly classified as an independent contractor or should be classified as an employee. A favorable SS-8 determination finding independent contractor status has several advantages. First, it establishes a reasonable basis for treating the individual as an independent contractor going forward under the IRS Safe Harbor provision for employment tax purposes. See I.R.C. 530(a)(2)(A) ( For purposes of paragraph (1), a taxpayer shall in any case be treated as having a reasonable basis for not treating an individual as an employee for a period if the taxpayer s treatment of such individual for such period was in reasonable reliance on... (A)... a letter ruling to the taxpayer). Further, having an SS-8 determination in favor of independent contractor status provides a defense to any action by the Georgia Department of Labor for the payment of state unemployment taxes. See O.C.G.A (f)(2) (providing alternate basis for exemption from tax liability when a company has received an SS-8 determination establishing independent contractor status). 7

8 However, from a practical standpoint, it is very difficult to get a favorable SS-8 determination from the IRS. And, more often than not (or reportedly at least 75% of the time) the IRS finds employee and not independent contractor status. Moreover, if the company receives an unfavorable determination, it is then on the IRS radar screen for audit and assessment purposes. Further, this misclassification could also be brought to the Department of Labor s attention under any information-sharing agreements. 5 Consequently, as noted above, we would not advise that companies pursue this option unless completely confident about the independent contractor status of the individual in question. c. Participation in the VCSP The VCSP is a recent program developed by the IRS that permits companies to voluntarily reclassify workers from independent contractors to employees for federal employment tax purposes. To participate in the VCSP program, however, the company must meet the following eligibility criteria: (1) The company must have consistently treated the workers at issue as nonemployees and filed the required Form 1099s for all such workers for the past three years; (2) The company cannot currently be under an audit by the IRS; and (3) The company (or any member of a consolidated group such as parent company or other subsidiary) cannot currently be under audit concerning classification of the workers by the Department of Labor or a state government agency. If previously audited by the IRS or Department of Labor regarding classification of the workers, the company will only be eligible if the company has complied with the results of that audit. Further, the company must enter into a closing agreement with the IRS as a part of this VCSP. The benefits of the VCSP are that the company: (1) will only have to pay 10% of the employment tax liability that may have been due on compensation paid to the workers for the most recent tax year under the reduced rates of Section 3509 of the Internal Revenue Code; (2) will not be liable for any penalties or interest on the liability; and (3) will not be subject to an employment tax audit with respect to the worker s classification for prior years. By way of example, the Section 3509 tax rates for 2011, for compensation paid up to the Social Security wage base, is 10.28% and 10.68% in Therefore, if you paid workers subject to the VCSP $1.5 million in 2010 (and all such workers were compensated at or below the Social Security wage base) 6, the employment taxes applicable would be $160,200 (10.68% of $1.5 million). The liability under the VCSP would be $16,200 (or 10% of 160,200). See Voluntary Classification Settlement Program (VCSP) Frequently Asked Questions, available on the IRS website, for further elaboration. 5 Specifically, the DOL and IRS have entered into a Memorandum of Understanding ( MOU ) whereby they have agreed to share information and coordinate law enforcement efforts to ensure all workers are properly classified. 6 You must look to the amounts paid to workers in the most recent completed tax year at the time the application is filed. 8

9 However, there are several risks to the VCSP as well. First, companies who wish to participate in the VCSP must apply to the IRS for participation. And, according to the IRS own materials on the VCSP, the IRS retains the discretion whether to accept a taxpayer s application for the program. There are no published guidelines, however, that discuss when this discretion will and will not be exercised. As such, if the company submits an application for participation in the VCSP that the IRS denies, the company will not only be denied the benefits of the program and but will have also identified itself to the IRS as having workers it believes are misclassified. The IRS has indicated that rejection of an application will not automatically trigger an audit. However, even the IRS own materials acknowledge that the taxpayer could be audited for other reasons. And, given how new the VCSP program is, the exact consequences of a rejected application remain unknown. Further, while the IRS has indicated that it will not share VCSP applicant information with the Department of Labor, it is unclear exactly how the IRS is defining applicant information, how the MOU between the Department of Labor and IRS discussed in footnote 5 above will come into play in such situations, and whether there are any other reporting obligations between the entities, as the MOU establishes, that may lead to subsequent misclassification investigations. Importantly, the IRS does not guarantee that applicant information will remain confidential from the allegedly misclassified independent contractors themselves, who could pursue misclassification litigation on their own. In addition, the program only applies to employment taxes and does not apply to workers compensation, unemployment, or the reclassification of workers on the employer s retirement and welfare plans. This means that, if the benefits plans do not have the requisite carve-out language discussed in footnote 2 above, corrective contributions on behalf of the misclassified workers may be required as a result of participation in the VCSP. Further, companies who are selected for participation in the VCSP must agree to extend the statute of limitations on employment taxes from three to six years for the first three calendar years after the agreement is signed. Importantly, this extended statute of limitations extends beyond employee misclassification issues and allows the IRS to review the company s entire employment tax compliance for all employees during the extended period. II. CONCLUSION As the discussion above establishes, navigating through the independent contractor mine field can be difficult and can, if handled incorrectly, result in significant liability. Both Kevin Hishta and Maggie Hanrahan with Ogletree Deakins have extensive experience in assisting companies with independent contractor-related issues and would be happy to help assist with any related issues. Please feel free to contact Kevin and Maggie at (404) or via at Kevin.Hishta@odnss.com or Maggie.Hanrahan@odnss.com. 9