a. Factors that Determine Who is an Employee and Who is an Independent Contractor
As mentioned above, there is no uniform definition of “employee” under the laws of the United States, and no single standard or test exists to determine conclusively wheth-er a worker should properly be classified as an independent contractor or employee. Classification issues may and frequently do arise in the U.S. under an intricate patchwork of federal and state laws and legal principles relating to taxation, employee benefits, employee wages and work hours, collective bargaining, workplace safety and health, employment discrimination and other employment-related matters. As discussed below, courts and government agencies have developed different and often divergent classification standards. The outcome of any classification analysis, therefore, is highly context-dependent.
Navigating the manifold standards and expectations under federal and state laws in the day-to-day implementation of an independent contractor arrangement can be a challenging task and the risk of misclassification is by no means insignificant. Enforce-ment efforts by government agencies have been stepped up markedly in recent years, while private collective and class action lawsuits abound. Any independent contractor relationship should be carefully reviewed and managed to avoid the potentially serious consequences of an adverse agency ruling or court judgment.
The Common-Law Test
The United States Supreme Court has held that when a statute does not adequately define “employee,” the term must be interpreted by reference to the common law of agency.2 The common-law test has been applied in a variety of contexts. Such contexts include claims by allegedly misclassified employees seeking participation in employ-er-provided welfare or retirement benefit plans under the federal Employee Retirement Security Act (“ERISA”); 3 claims to determine collective bargaining rights under the National Labor Relations Act (“NLRA”); 4 claims to decide whether a company is required to withhold from compensation for state unemployment compensation benefits; 5 and various other statutory and common-law claims.6
The central question to be answered under the common-law test is whether the hiring party retains the right to control the manner and means by which the work is to be ac-complished. This means that courts must focus their inquiry on whether the hiring party “has the right to control and direct the work, not only as to the result to be accomplished by the work, but also as to the manner and means by which that result is accomplished.”7 When the hiring party retains the right to control the manner and means by which the work is to be accomplished, the worker is considered an employee – even if the hiring party actually never exercises the right.8
Although the extent to which the hiring party actually supervises the “means and manner” of the worker’s performance is a core factor under the common-law misclassi-fication test, it is far from the only one. Among the numerous additional factors courts must weigh as part of their overall analysis are the following:
• the skill required;
• the source of the instrumentalities and tools;
• the location of the work;
• the duration of the relationship between the parties;
• whether the hiring party has the right to assign additional projects to the hired party;
• the extent of the hired party’s discretion over when and how long to work;
• the method of payment;
• the hired party’s role in hiring and paying assistants;
• whether the work is part of the regular business of the hiring party;
• whether the hiring party is in business;
• the provision of employee benefits; and
• the tax treatment of the hired party.9
The common-law test requires a careful balancing of all relevant factors. No one factor controls the outcome. The weight given to each may vary from case to case depending on the particular facts and circumstances. In no case, however, will the terms of any written agreement between the company and the worker by themselves prove dispositive of the outcome.
A recent federal district court decision illustrates the common-law approach. In this decision 10, the court refused to dismiss a class action lawsuit filed by insurance agents they were employees under the common-law test and therefore entitled to certain employee benefits under ERISA. The court denied the company’s motion to dismiss the case, finding that a series of factors could be interpreted to indicate employee status. These factors included the insurance company’s requirement that agents sell compa-ny products exclusively and only use company-owned hardware and software; the company’s ability to fire the agents at any time with or without cause; the company’s right to determine where agents’ offices were located and what their office hours would be; and the company’s actual monitoring of agents’ daily work and compliance with production and conduct requirements.
The IRS Right to Control Test
Perhaps the most commonly used test is a variant of the common-law test developed by the U.S. Treasury Department’s Internal Revenue Service (“IRS”) to determine whether a worker should be deemed an employee for income tax purposes. The IRS has historically applied a lengthy 20-factor test.11 In recent years, however, the agency restructured its approach and now applies a simplified “Right to Control Test,” which groups 11 factors into three broad categories.12 As with the common-law test, the critical inquiry focuses on the degree to which the business retains the right to control the manner and means by which the work is performed.
The Right to Control Test can be summarized as follows:
A) Behavioral control. Behavioral control refers to the degree to which the company retains the right to direct and control how the worker performs the task for which the worker is hired. Whether or not the business in fact exercises that right is irrelevant.13 The focus is simply on whether the company has reserved the right of control to itself. There are two behavioral control factors:
• does the business provide instructions to the individual regarding (a) when and where to perform work, (b) what tools or equipment should be used, (c) where supplies and services should be purchased, (d) whether and what assistants the worker my hire, (e) whether the work must be performed by a specified individual, and (f) in what order or sequence the work must be completed?
• does the business provide training to the worker?
Independent contractors normally use their own methods to perform work and require little to no training. Positive answers to the above questions therefore point to the existence of an employment relationship.
B) Financial control. Financial control factors are intended to capture the degree to which the business has the right to control the business aspects of the job:
• does the business pay the worker’s business expenses? Routine reimbursement of a worker’s business expenses can be indicative of an employment relationship.
• has the worker made a significant investment in the services performed? Typically, independent contractors, but not employees, have invested substantially in the work, for example by maintaining an office or other facilities where services are performed.
• does the worker make his or her services available to the general public? Independent contractors generally remain free to advertise their services and are available to work in the relevant market.
• is the worker paid a flat fee, or by the hour, week or month? Employees commonly receive a regular wage based on a certain time interval, whereas payment on a flat fee, per-job basis suggests independent contractor status.
• does the worker have the opportunity to realize a profit or loss from the work? This is ordinarily a hallmark of independent contractor status.
C) Type of relationship. As the nature of the relationship between the business and the worker can provide further evidence of control, the IRS also examines the following additional factors:
• does the worker have an opportunity to participate in certain employee welfare and pension benefits, such as health insurance, a pension plan, vacation pay, or sick pay? Benefits typically are provided only to employees.
• how permanent is the relationship? An independent contractor relationship is ordinarily of limited duration and defined by the length of the specific project for which the contractor is hired. Hiring a worker on an indefinite basis indicates intent to create an employer-employee relationship.
• are the worker’s services a key aspect of the company’s regular business? If so, an employment relationship is more likely to exist.
• do the terms of a written contract between the business and the worker show that the parties intended to create an independent contractor relationship? This factor is normally the least important, because courts must examine first and foremost the parties’ actual practice.
The Economic Realities Test
Neither the common-law test nor its IRS variant governs where federal wage-and-hour laws are concerned. In the United States, federal minimum wage and overtime pay standards are established by the Fair Labor Standards Act (“FLSA”).14 Recognizing that the FLSA was enacted to remedy low wages and long working hours, the United States Supreme Court has long held that the common-law distinctions between employees and independent contractors do not apply when determining FLSA coverage.15
Instead, courts must decide whether a worker has been properly classified as a matter of “economic reality.”16 The key question to be answered under the Economic Realities Test is this: Is the worker economically dependent on the hiring party, or is the worker truly in business for him- or herself? If economic dependence is found, the worker will be classified as an employee, even if the employer does not exercise full control of the means and manner of the worker’s performance.
Resolution of this question requires a balancing of the following factors in light of the totality of the circumstances:
• the degree of control the business exerts over the worker;
• the worker’s opportunity for profit or loss;
• the worker’s investment in the business;
• the permanence of the working relationship;
• the degree of skill required to perform the work; and
• whether the services are an integral part of the company’s business.17
Various additional factors may also be considered as part of the economic realities test, such as whether the business has the power to hire and fire employees, supervises and controls employee work schedules or conditions of employment, determines the rate and method of payment, and maintains employment records. No one factor is determi-native.18 All must be carefully weighed and take account of the factual circumstances of each particular case.
The ABC Tests
Many U.S. states have wage-and-hour laws that provide additional or greater protections beyond those set out in the FLSA. These states employ any one of a number of different tests to determine whether misclassification issues exist. The “ABC Test” represents one of the more commonly used alternatives not only to determine exempt status under state wage-and-hour laws but also to evaluate whether a worker should be deemed an employee for state unemployment tax purposes.
Although applications of the ABC Test are not uniform, it generally places the burden of establishing independent contractor status squarely on the hiring party. In its broadest form, the ABC Test provides that a worker should be considered an employee unless the business can establish that:
• the worker has been, and will continue to be, free from control or direction over the performance of the work under both the terms of the contract and in fact;
• the services are either provided outside the usual course of the business or performed outside of all the places of business of the enterprise; and
• the worker is customarily engaged in an independently established trade, occupation, profession, or business.
In most, but not all, states, all three conditions must be met. As a result, meeting independent contractor requirements can be particularly onerous where the ABC Test applies.
As the above reflects, courts and legislatures in the United States have woven a com-plex tapestry of legal standards for determining independent contractor status. Further complicating the analysis, employee status may also need to be determined under laws governing workers’ compensation insurance for individuals who suffer work-related injuries or illness; laws protecting whistleblowers or prohibiting discrimination in employment; and various other employment-related statutes. Depending on the statu-te, state agencies and courts may use variants of the common-law, IRS, economic-reali-ties and ABC tests discussed above.
Not surprisingly, application of the many different tests for determining employment status can lead to diverging results. An individual may, for example, be classified as an independent contractor for state or federal income tax purposes, yet is deemed an employee for purposes of workers’ compensation law and be qualified for such benefits. Businesses should remain mindful of the fact that each situation must be evaluated on its own merits.
Summary of Tests Used Under Key Federal Statutes
Certain Federal Laws explicitly require that a particular test be used to determine the status of a worker as an employee or independent contractor. Below is a list of which test applies to which statute.
Common Law Test
• Federal income taxes, Medicare taxes, Social Security taxes, Federal unemployment taxes
• National Labor Relations Act (NLRA)
• Employee Retirement Income Security Act of 1974 (ERISA)
• Immigration Reform and Control Act of 1986 (IRCA)
• Americans with Disabilities Act (ADA)
• Copyright laws
Economic Realities Test
• Fair Labor Standards Act of 1938 (FLSA)
• Title VII of the Civil Rights Act of 1964 (Title VII)
• Age Discrimination in Employment Act of 1967 (ADEA)
• Family and Medical Leave Act (FMLA)
• Migrant and Seasonal Agricultural Worker Protection Act
b. General Differences in Tax Treatment
There are significant tax advantages for businesses when workers are classified as independent contractors. U.S. employers must pay one-half of an employee’s required social welfare taxes for government-provided Social Security retirement and medical benefits (known as “Medicare”). Typically, these equal approximately 7.65 percent of an employee’s wages. Independent contractors, by contrast, must pay the full amount without any contribution from the hiring business. Employers must also withhold state and federal employee income taxes from an employee’s paycheck, whereas indepen-dent contractors pay these taxes on their own in the form of a self-employment tax. Finally, the amount of an employer’s contributions to federal and state unemployment insurance funds depends on the size of the employer’s workforce, but does not take into account independent contractors.
From the perspective of the individual as well, substantial financial benefits can be reaped from holding independent contractor status. Independent contractors need only make quarterly tax contributions and can thus realize benefits from the greater control the absence of mandatory withholdings from each paycheck can afford. Social welfare benefits, in turn, need to be paid only once a year and one-half of the contribution can be deducted from the individual’s income tax. Moreover, unlike employees, indepen-dent contractors are able to deduct a wide range of direct and indirect business-related expenses from their taxable income. The increased flexibility and potential for greater actual earnings therefore render independent contractor status an attractive option for many workers.
That said, the adverse tax consequences flowing from misclassification of employees as independent contractors, can be a matter of significant concern, particularly when large groups of similarly-situated workers are found to be similarly misclassified. Recent years have seen an increasing focus on aggressive enforcement actions on the part of not only the Department of the Treasury, but also other federal and state agencies. As a result of new information-sharing agreements between agencies, a finding by the IRS that a business has misclassified employees may now lead to audits and further enforcement proceedings by the Department of Labor (which enforces the FLSA), as well as potential investigations by state tax and workers’ compensation agencies. And as further discussed below, workers claiming to be misclassified may also pursue costly class action litiga-tion, with the attendant risk of potentially very large liability verdicts. A misclassification finding therefore can place the very survival of a business at risk. This underscores the need for careful assessment before entering into any independent contractor arrangement.
c. Differences in Benefit Entitlement
Most state laws require U.S. employers to provide their employees with workers’ compensation insurance, which provides compensation for wage loss, medical treatment and death benefits in the event of a work-related injury or illness. No require-ment exists to provide workers’ compensation coverage for independent contractors hired to perform services for the business. Since workers’ compensation coverage can be costly, many businesses find it financially advantageous to hire independent contractors, where appropriate, in order to lower premiums.
In 2010, the United States Congress passed the Affordable Care Act (“ACA”),19 colloquially known as “Obamacare,” which for the first time in the country’s history makes health insurance protection mandatory for most Americans. Beginning on January 1, 2015, employers with 50 or more full-time employees must offer health insurance coverage to their full-time employees.20 Under the ACA, a “full-time” employee is one who works 30 hours or more per week or 130 hours or more per month. No mandate exists for businesses to provide similar coverage to part-time employees or independent contractors. Persons falling into these categories will instead be required to obtain individual coverage in the marketplace or incur a tax penalty.
The federal Family and Medical Leave Act of 1993 (“FMLA”),21 which covers companies with at least 50 employees, allows eligible employees to take up to 12 weeks of unpaid leave in a 12-month period for certain family and medical reasons.22 These include the birth, adoption or placement for foster care of a child and incapacity due to an employ-ee’s or family member’s serious health condition. In addition, employees may take leave for certain purposes in the event a family member is called to active duty or sustains injury or illness as a result of military service. The FMLA applies only to employees and affords no benefits to independent contractors.
Various states have statutes that provide leave benefits greater than, or in addition to, the FMLA. As with the FMLA, most of these state-level statutory benefits are restricted to individuals classified as employees.
Other Employee Benefits
Generally, U.S. employers are not legally mandated to provide other types of benefits to employees. Thus, except where state law provides otherwise, businesses need not offer vacation, sick leave, disability or retirement benefits to their employees, and when em-ployers do provide such benefits, independent contractors are typically excluded. Some states offer state-funded benefits, such as disability payments, to employees. Indepen-dent contractors’ eligibility for such benefits would depend on the particular state law at issue.
The contractor/employee distinction is particularly important for employee benefit plans covered by ERISA, which can lose their tax-favored status if they cover independent contractors. Independent contractors generally are precluded from participating in a company’s tax-qualified retirement plans, because such plans can only cover employ-ees. It would be permissible for an independent contractor to participate in a company’s health plans, assuming the insurance policy allows it, but if the company were to make premium payments on behalf of the independent contractor, the payments would be includable in the contractor’s gross income. Employees, by contrast, may exclude such payments from gross income.23
Generally, a company is liable for making unemployment insurance withholdings from the compensation paid to employees (including temporary employees), but not from compensation paid to independent contractors. If a worker classified as an independent contractor subsequently makes a claim for unemployment compensation benefits, the relevant state agency will likely re-examine this classification, and the em-ployer may be held liable if the agency determines that the individual was misclassified and contributions should have been paid.
d. Differences in Protection from Termination
With the exception of the State of Montana, employment in the United States is deemed to be “at will” absent a written contract to the contrary. This means both employer and employee are free to terminate the employment relationship at any time, with or with-out notice, and for any or no reason. This basic common-law principle, however, is limited by an intricate framework of state and federal statutory and common-law rights provid-ing employees – but not independent contractors – with protection against termination decisions that arise from an unlawful motive. Unlawful motives include discrimination based on an employee’s race, color, national origin, religion, age, gender, disability and other legally protected statuses, as well as retaliation against a worker for complaining of discrimination, for blowing the whistle on alleged illegal activity, for exercising legal rights to certain employee benefits, and for a myriad of other legally protected activities.
By contrast, the duration and termination of an independent contractor arrangement is generally regulated by contract. An independent contractor relationship is, by its very definition, one that is limited in duration and that ends upon completion of the project for which the contractor was hired. The parties may by agreement specify conditions on which the agreement may be terminated at an earlier time.
e. Local Limitations on Use of Independent Contractors
There are no laws that limit the use of independent contractors to specific purposes or circumstances. Rather, the primary limitation is the risk of misclassification. Increasing-ly, states are passing laws that create a presumption of employee status for individuals performing services in certain industries, such as construction, where misclassification has historically been the most prevalent. These statutes squarely place the burden on the employer to provide evidence that a worker is sufficiently independent to qualify as an independent contractor. The statutes generally impose civil and criminal penalties on employers who knowingly or willfully misclassify employees. Among the states that have passed such laws are Pennsylvania, Delaware, Colorado, Illinois, Minnesota, New York, and Maine. Other states are considering similar legislation.
In slight contrast to the state laws discussed above placing the burden on the employer to prove that a worker qualifies as an independent contractor, Arizona passed a law, Declaration of Independent Business Status (“DIBS”), effective August 6, 2016 allowing employers contracting with independent contractors to prove the existence of such are-lationship through a signed declaration by the independent contractor. A declaration by the independent contractor is considered, under the law, a rebuttable presumption that an independent contractor relationship exists. Examples of declarations include the contractor’s acknowledgement that: he/she is paid per project and not hourly or through salary, not covered by employer health insurance or worker’s compensation, not restrict-ed to perform services for other parties, and is not dictated by employer on how to perform services. The employer is not required to include such a declaration, and lack of such does not raise a presumption that an independent contractor relationship does not exist.24 The Arizona statute stands in some tension with the 2015 DOL guidelines which advise that labels should not be a determinative factor in deciding whether an employee is a worker or independent contractor.
In addition, the terms of collective bargaining agreements may impose limitations on the use of independent contractors with respect to the work performed by the bargaining unit. A company that hires independent contractors to do work covered by a union contract could be held liable for breach of the collective bargaining agreement and may risk the filing of an unfair labor practice charge with the National Labor Relations Board, which enforces labor law in the United States.
f. Other Ramifications of Classification
The federal FLSA and similar state wage-and-hour laws afford many U.S. employees the right to be paid a minimum wage and overtime compensation for hours worked in excess of the statutory threshold.25 Some states also have laws requiring employers to provide employees with paid rest periods and unpaid meal breaks. These statutory protections are available solely to employees. As a result, a company found to have misclassified workers as independent contractors may be liable for unpaid wages and, in particular, overtime compensation due to employees for hours worked in excess of the statutory threshold.
The federal NLRA protects employee rights to form unions and to engage in collective bargaining and other concerted activity, affords remedies to employees who have been harmed by any violation, and protects employees and union members against unfair bargaining practices.26 By its express terms, the NLRA covers only employees and not independent contractors.27 Independent contractors have no statutory collective bargaining rights.
Other Statutory Protections
Employees in the United States are entitled to a broad range of additional statutory protections under federal and state laws that prohibit workplace discrimination and harassment. Many statutes also provide relief from retaliation against employees who have exercised their statutory right to complain about or report unlawful activity or to obtain certain benefits of employment provided by law. At the federal level, these statutes include Title VII of the Civil Rights Act of 1964, which protects employees from discrimination on the basis of race, color, national origin, sex and religion;28 the Age Discrimination in Employment Act of 1967, which protects employees against age discrimination;29 and the Americans with Disabilities Act of 1990, which protects employees against discrimination based on disability.30
In addition, the FMLA prohibits employers from interfering with employees’ use of statu-torily-guaranteed leave and from retaliating against employees who avail themselves of such leave.31 ERISA, in turn, makes it unlawful to discriminate against any employee for exercising any right under an employee benefit plan.32 These federal statutes are limited to employees and do not cover independent contractors.33 Note, however, that in some states, state and local employment discrimination laws have been interpreted to cover certain independent contractors. Thus, it is critically important to be cognizant of the applicable jurisdiction.
Numerous statutes also afford various types of whistleblower protections – among them the Sarbanes-Oxley Act of 2002, which protects employees of publicly-traded corpora-tions who report alleged shareholder fraud or violations of federal securities laws.34 In most (but not all) cases, whistleblower protections may be unavailable to independent contractors. Federal and state occupational safety and health laws likewise in most cases apply only to employees.
The United States recognizes the common-law doctrine of respondeat superior, under which an employer can be held liable for the negligent acts of its employees if the acts were committed in the scope of employment and in furtherance of the employer’s busi-ness. By contrast, under the common law of most states, the hiring party has – with limited exceptions – no responsibility for the negligence of an independent contrac-tor.35 Liability can arise if a third party is physically harmed by an act or omission of the contractor pursuant to orders or directions negligently given by the hiring party, or because the hiring party failed to exercise reasonable care to retain a competent and careful contractor.36 The risk of liability can be lowered significantly by hiring independent contractors, rather than employees, where permissible under applicable law.
g. Leased or Seconded Employees
One way to avoid the legal pitfalls of misclassification is to enter into an agreement with a third-party employee leasing or workplace management firm. Such an agreement typically provides that the staffing firm, not the business, is responsible for hiring, placing and terminating workers; ensuring appropriate tax payments are made and tax reporting is performed; providing workers’ compensation insurance coverage; and offering employee benefits, if available, directly to employees. Where an outside vendor has been engaged, the company’s responsibilities can be limited significantly, reducing the possibility that an employer-employee relationship will be found to exist.
There exists considerable variability in this area. Some staffing companies hire the work-ers as their own independent contractors and thus assume the risk of misclassification. Others perform the full panoply of functions traditionally associated with an employ-ment relationship, such as withholding of income taxes, payment of Medicare and Social Security contributions, payment of workers’ compensation and unemployment insurance premiums, provision of employee welfare and retirement savings benefits, performance management, and implementation of employee discipline, transfer and promotion decisions. Since companies must be well-informed about the ramifications of each arrangement, entering into an arrangement with a reputable and knowledgeable provider is of critical importance.
Using a staffing company is not a cure-all. Under various employment statutes, the client of a staffing agency is potentially considered a “joint employer” for purposes of liability, such as those prohibiting discrimination and harassment. In that case, an employee leasing arrangement will afford only limited liability protection. Additionally, some state laws regulating staff leasing companies may expressly require the staffing company and its client to agree that both will assume joint employer responsibility in specific aspects of the worker’s employment.
For example, regulations implementing the FMLA provide that “[w]here two or more businesses exercise some control over the work or working conditions of the employee,” or where the work performed “simultaneously benefits two or more employers,” a joint employment relationship may exist.37 A company will likely be considered a joint employer of employees supplied by a staffing agency and be subject to many of the requirements of the FMLA, if the company and the agency: (1) share control over the worker; (2) share the worker’s services; or (3) act in each other’s interest with regard to the worker. Indeed, some courts have found that a joint employment relationship exists for FMLA purposes anytime a staff leasing agency places employees with a client employer.38
Where employee rights to welfare and retirement benefits governed by ERISA are concerned, the specific language of the benefit plan may control whether workers are entitled to participate in a client company’s plans. Several recent court decisions hold that when workers appear to be employees under the common-law test and the language of the plan does not expressly exclude individuals on the payroll of third-party contractors, the workers may be entitled to participate in the client company’s ERISA benefit plans.39
h. Regulations of the Different Categories of Contracts
There is no regulatory scheme that governs employment contracts or independent contractor agreements. The parties are free to contract as they see fit, subject only to the provisions of the various employment laws discussed in the preceding sections. Many employees do not have written contracts, but are employed on an “at-will” basis. The details of an at-will employment relationship are often described in policies and procedures promulgated by the employer for all employees. Contractual disputes arising from independent contractor agreements are commonly resolved through litigation. Employment laws are enforced through agency actions such as audits, investigations and legal proceedings, as well as through private litigation initiated by employees claiming to be aggrieved.