Employers everywhere have increasingly relied upon temporary, contract or other "contingent" employees as a more flexible and often less expensive alternative to hiring permanent employees. Temporary employees are excluded from most employee benefits plans, and employers are not required to pay withholding, social security, taxes, insurance or other benefits for contract employees who qualify as "independent contractors." But increasingly, employers are discovering that workers they once believed were independent contractors are instead viewed by courts as regular employees . resulting in the unsettling and expensive prospect of providing these workers with the benefits provided to regular employees, and damages for past withholding omissions.
Last October, for example, Washington State's King County agreed to pay $24 million to settle a class-action lawsuit brought by hundreds of temporary employees who claimed that the County violated its charter by not providing them with the same benefits -- including health insurance, paid sick leave, holidays, and vacations -- enjoyed by regular County employees. The settlement is the third time the County has been sued over the temporary-work issue and has had to pay settlements. Workers won a similar case against the City of Seattle in 1991.
At the heart of the King County controversy was a 1988 voter mandate requiring County workers employed more than six months to receive benefits, a mandate the County failed to follow. County officials acknowledged that settling the lawsuit was less expensive than facing a potential judgment that, by law, could have been as high as $48 million, double the amount of damages. When asked to provide a comment for this article, Ron Sims, King County Executive, stated that the County is "Working on developing strategies for stopping" the practices that lead to the lawsuit. "When the County compiled a list of the temporary workers to put them on the books, even the County Budget Office was surprised by how many of these workers there were." Mr. Sims was enthusiastic about the settlement, stating that "since the settlement, the County's labor relations are at an all-time high."
The King County case was based on this voter-mandated charter amendment, and therefore does not apply directly to other employers. Nonetheless, the staggering dollar amount of the settlement has set off alarm bells for many employers who use temporary or contract workers. Depending on the level of control exercised over "temporary" workers, those individuals may unwittingly become eligible for an employer's retirement benefit plans if they otherwise meet the plan's eligibility requirements. As demonstrated below, this alone can cause significant potential legal exposure and defense costs . even where the employer ultimately prevails.
Few cases have sent shudders through employers of all types like the Ninth Circuit Court of Appeals' decision in Vizcaino, et al. v. Microsoft Corporation, 120 F.3d 1006 (9th Cir. 1997). In Vizcaino, freelancers who worked as independent contractors were held to be employees eligible to participate in the company's benefit plans. Although decided on technical legal grounds and still on appeal, the case illustrates the importance of properly classifying individuals as either employees or independent contractors -- and the potential ramifications of misclassification.
Each of the freelancers had clearly understood that they were not entitled to employee benefits, and had signed an agreement stating that he or she was an independent contractor, responsible for his or her own taxes, withholding, social security, insurance and other benefits. The freelancers worked alongside regular employees and performed similar job functions with similar hours. In 1989 and 1990, the IRS examined the company's records and decided that, for tax purposes only, the freelancers were employees rather than independent contractors. Following the IRS review, freelance workers sued, contending that they should be considered "employees" not just for tax purposes, but for all purposes, and should be allowed to participate in the company's benefit plans.
The Ninth Circuit ruled in favor of the freelancers, affirming its previous decision that the freelancers were entitled to benefits as employees under the company's benefit plans. The court noted that the company had admitted that the freelancers were its employees under common-law rules. As such, the Court held that the freelancers were entitled to participate in some of the company's benefits plans. While the Vizcaino opinion did not address the standards for classifying individuals as either independent contractors or employees, it exemplified the significant legal exposure employers face if individuals are classified as independent contractors, but later found to be employees.
In order to avoid the types of challenges from temporary or contract workers raised in the King County and Vizcaino cases, employers must be careful to correctly classify employees. It is the circumstances of the working relationship, not a worker's title, that determines whether a worker is an "employee." The following list may be used by employers as an aid in periodically evaluating the status of temporary or contract workers.
THE I.R.S. FACTORS
A worker is an "employee" under the common law test if the employer retains a right to control the manner and method by which the work is performed. To determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. All evidence of control and independence must be considered. In any employee-independent contractor determination, all information that provides evidence of the degree of control and the degree of independence must be considered. According to recently-modified factors announced by the Internal Revenue Service, facts that provide evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties as shown below.
Behavioral control. Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of:
- Instructions the business gives the worker. An employee is generally subject to the business's instructions about when, where, and how to work. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved.
- Training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods.
Financial control. Facts that show whether the business has a right to control the business aspects of the worker's job include:
- The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business.
- The extent of the worker's investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. A significant investment is not required, however.
- The extent to which the worker makes services available to the relevant market.
- How the business pays the worker. An employee is generally paid by the hour, week, or month. An independent contractor is usually paid by the job. It is common in some professions, however, such as law, to pay independent contractors hourly.
- The extent to which the worker can realize a profit or incur a loss. An independent contractor can make a profit or loss.
Type of relationship. Facts that show the parties' type of relationship include:
- Written contracts describing the relationship the parties intended to create.
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay.
- The permanence of the relationship. If a business engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
- The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect of the employer's regular business activity, it is more likely that the employer will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it is likely that it will present the attorney's work as its own and would have the right to control or direct that work. This would indicate an employer-employee relationship.
A more detailed description of these factors can be found at the IRS's site on the World Wide Web at http://www.irs.ustreas.gov/
The potential liability for misclassification of workers is staggering. Employers often want individuals classified as independent contractors in order to save on benefits and other costs. Individuals classified as independent contractors often readily agree. They like the flexibility inherent in the independent relationship, and appreciate the ability to pay self-employment taxes on a quarterly basis. However, what was once thought to be a "victimless crime" now has the potential to cost employers millions of dollars in back wages, damages, and legal fees and costs.
To avoid such liability, employers should periodically evaluate each of the criteria for workers classified as independent contractors or temporary employees; many employers perform such evaluations every six months. The review should include keeping a written record of the classification evaluation, signed by the purported independent contractor where possible. Careful adherence to these simple precautionary measures will greatly assist in defending claims of misclassification, will help ensure compliance with tax laws and the employer's benefits plans, and will help prevent the time-consuming and costly alternative: employment litigation.