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Recent Decisions in Vizcaino v. Microsoft Corp. Redefine the Term "Employee"


A. Common Law Test
B. Latest Microsoft Decision
C. 1997 Microsoft Decision
D. Microsoft II is at Odds with Decisions
by Other Circuit Courts
E. Remember: The Test is Different Under
Employment Law
F. Other Developments

A. Review Worker Classifications
B. Review and Amend Your Plans
C. Never Concede Employment Status
Without the Advice of Counsel

Common Law Test Under ERISA
Common Law Test Under Tax Code


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Last summer, Microsoft's famous "temp" problem appeared headed toward a conclusion. The trial judge overseeing the class-action had issued a ruling that reduced the number of "misclassified" workers who could claim retroactive benefits against the company to a fraction of the thousands of potential claimants. However, on May 12, 1999, the United States Court of Appeals in San Francisco reversed the trial court's decision and held that as many as 15,000 temp agency workers assigned to Microsoft in specified positions are "presumptively" common law employees of Microsoft and, therefore, "presumptively" entitled to receive retroactive benefits in the company's employee stock purchase plan, in some cases going back to 1987. Vizcaino v. Microsoft Corp., 173 F.3d 713 (9th Cir. 1999) (Microsoft III). If the ruling stands, Microsoft's liability could easily reach $20 million.

This issue of Labor and Employment News looks at recent developments in the worker misclassification area and offers two strategies businesses can follow to avoid getting "Microsofted." First, businesses should be aware of and apply correctly the criteria used by the courts to determine whether workers are properly classified as employees, independent contractors, or temporary services agency workers. It is also important to understand that many of the problems that Microsoft faced in its litigation probably could have been avoided if the company's benefit plans had been drafted differently and if the company had not made a key concession early in the case.

Microsoft's example demonstrates why it is imperative for businesses to work with counsel early to review and, where appropriate, amend their benefit plans and forms of contract. The Microsoft case also shows why it is essential that, in all matters before the IRS, businesses obtain the advice of counsel and not only that of an accountant. Employers which do so will minimize the risk that a concession or settlement under tax law will have unintended consequences under employee benefits law.

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A. Common Law Test
To determine whether a worker is an employee for purposes of benefits law or tax law, courts apply the so-called multiple-factor common law test. The precise formulation of the common law test varies depending on the law being applied.

Under the federal Employee Retirement Income Security Act of 1974 ("ERISA"), which is the principal body of law governing retirement, health care, disability, and similar types of benefit plans (although not stock plans), the Supreme Court has described the common law test as one that requires courts to consider "the hiring party's right to control the manner and means by which the product is accomplished" and the 12 additional factors outlined at the end of this report. No one factor is decisive. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323-24 (1992); see Barnhart v. New York Life Ins. Co., 141 F.3d 1310, 1312-13 (9th Cir. 1998); Sharkey v. Ultramar Energy Ltd., 70 F.3d 226, 231-32 (2d Cir. 1995). The test under federal tax law also focuses on whether there is sufficient control to conclude that an employer-employee relationship exists, based on the 20 factors outlined on Pages 10-12 of this Newsletter. When evaluating relationships, IRS agents are instructed not to let formalistic aspects of an arrangement obscure its substance. Rev. Rul. 87-41, 1987-1 C.B. 296, 298-99.

Neither of these tests is very helpful to employers because application of the various factors often leads to ambiguous results, which are then subject to second-guessing by the courts and the IRS. Thus, employers often are confronted with "damned if you do, damned if you don't" decisions.

For example, in the case of independent contractors who are subsequently reclassified as employees, employers may face Microsoft-type liability for back employment taxes and retroactive employee benefits. However, in the reverse situation, where employees are reclassified as independent contractors (there is a long line of cases involving insurance agents who fought successfully to establish themselves as independent contractors for tax advantages), employers run a genuine risk that the IRS will challenge the tax-qualified status of any retirement plans in which the independent contractors may have participated. This is because the tax laws limit participation to common law employees only. Such challenges typically are resolved by settlement and payment of a penalty.

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B. Latest Microsoft Decision
For businesses that use temporary workers, and for the agencies that supply such workers, the classification problem can be particularly acute, as the Ninth Circuit's latest decision in the Microsoft case makes clear. Vizcaino v. Microsoft Corp., 173 F.3d 713 (9th Cir. 1999) (Microsoft III). There, the court held for the first time under benefits law that temp agency workers can be employees of both the agency and the client company. Of course, the concept of co- or joint-employer status has long existed under employment law. But, under benefits law, it has long been thought that workers employed by a staffing company were the employees of the staffing company and not of the client company. Indeed, a 1996 legislative change in the definition of "leased employee" under the Internal Revenue Code was intended to clarify that a worker could be performing services under the "primary direction or control" of a client company and still not be the client company's common-law employee.

The precise issue presented for decision in this latest Microsoft opinion was who, among the thousands of Microsoft's temp agency workers, was an "employee" of Microsoft. Microsoft argued that only the few hundred individuals who had been working as independent contractors until their positions were reclassified by the IRS in 1990, were employees, while the rest would have to establish individually that they were the common law employees of Microsoft and not of the temp agency that hired them.

The Ninth Circuit rejected Microsoft's "either/or" formulation and ruled that all 10,000 to 15,000 workers were presumptively Microsoft employees, even if they also were the common law employees of the temp agencies. The court's decision relied heavily on the fact that Microsoft had conceded in the trial court and in a prior appeal (for purposes unrelated to determining the scope of the class) that all "class members" were its common law employees. The court also concluded that because the IRS had determined in 1990 that positions, and not merely individuals, had been misclassified, it would be appropriate to place the burden on Microsoft to disprove that any worker occupying such a "reclassified" position was the company's common law employee. In a revealing passage, the court expressed its belief that "application [of the Darden factors] generally turns on factual variables within an employer's knowledge, thus permitting categorical judgments about the 'employee' status of claimants with similar job descriptions."

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C. 1997 Microsoft Decision
In hindsight, it appears that Microsoft's earlier decision to concede the common law employee status of some workers, even though for an unrelated purpose, was a mistake. At the time the concession was made, it appeared reasonable, as the workers previously had signed agreements acknowledging they would not receive any benefits from Microsoft and instead would be responsible for purchasing their own benefits. However, the Ninth Circuit ruled in Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997) (Microsoft II), that the individual agreements were ineffective because they were premised on a "mutual mistake." This mutual mistake was Microsoft's and the workers' mistaken belief that the workers were independent contractors rather than common law employees. Implicit in the court's focus on "mutual mistake" is the notion that, if only the parties had been aware of the workers' "true" employee status, both would have intended that the workers participate in Microsoft's 401(k) plan and its stock purchase plan. But Microsoft argued that this wasn't so, as the exclusionary language in the individual contracts so clearly showed. The Ninth Circuit rejected this argument, holding that the exclusionary language merely warned the workers about what happens when they are independent contractors, but it could not, on its own, define the relationship between the parties. This conclusion is at odds with the decisions of two other Circuit Courts of Appeals, which have held that agreements like those at issue in Microsoft were effective to preclude workers from participating in the employer's ERISA-covered retirement plans.

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D. Microsoft II is at Odds with Decisions by Other Circuit Courts
In Capital Cities/ABC, Inc. v. Ratcliff, 141 F.3d 1405, 1409-10 (10th Cir. 1998), decided after Microsoft II, a group of newspaper carriers who signed independent contractor agreements with no-benefits language nearly identical to the language signed by Microsoft's workers were reclassified by the IRS as common law employees for employment tax purposes. The Tenth Circuit Court of Appeals upheld their exclusion from the company's retirement plans, finding that the individual contracts alone were a sufficient basis for excluding the workers because the agreements reflected both parties' understanding that the workers would not receive any company benefits. In Trombetta v. Cragin Fed. Bank for Savings Employee Stock Ownership Plan, 102 F.3d 1435, 1438-39 (7th Cir. 1996), a group of loan originators who executed agreements stating they would be Cragin's "independent contractor[s] and not [its] employees for all purposes" sought to participate in Cragin's employee stock ownership plan ("ESOP").1

The Seventh Circuit Court of Appeals held that the agreements established that the loan originators were not employees and, therefore, not entitled to participate in the plan.

A decision by the Ninth Circuit itself after Microsoft II suggests that, at least in cases where there has been no concession of common law employee status before the IRS, the Ninth Circuit will give at least some weight to the terms of a contract in determining whether a worker is an independent contractor under employee benefits law. In Barnhart v. New York Life Ins. Co., 141 F.3d 1310, 1312-13 (9th Cir. 1998), an insurance agent sued New York Life, claiming that the company terminated his agency contract in violation of ERISA and the Age Discrimination in Employment Act ("ADEA"). To maintain his suit under ERISA and the ADEA, the agent was required to show that he was an employee or former employee. After applying the Darden factors to the agency contract, the court concluded that the agent was an independent contractor. The court noted that, while there were factors supporting a finding of employee status, including the fact that New York Life permitted the agent to participate in the company's life insurance, pension, and 401(k) plans and the fact that the company trained the agent during the first three of his 16 years with the company, these factors were not persuasive. What the court found persuasive was the fact that the contract "contained clear language stating that Barnhart would be considered an independent contractor, not an employee. Consistent with this, Barnhart was free to operate his business as he saw fit," was paid on a commission-only basis, claimed to be self-employed on his tax returns, and was free to sell competitors' products. Accordingly, Barnhart was found to be an independent contractor and his suit was dismissed under ERISA and the ADEA. See also Adcock v. Chrysler Corp., 166 F.3d 1290, 1292-93 (9th Cir. 1999) (applying Barnhart analysis to discrimination claim under Title VII and concluding that parties' express intention in dealership agreement that "under no circumstances is either party to be considered the agent of the other" supported determination that plaintiff was independent contractor, not employee); Sharkey v. Ultramar Energy Ltd., 70 F.3d 226, 231-32 (2d Cir. 1995) (applying Darden factors but noting that employment status not determined solely by label used in contract or by corporate form under which individual conducts business).

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E. Remember: The Test is Different Under Employment Law
Of course, this newsletter only addresses the worker classification issue under employee benefits law, and employers must keep in mind that other employment laws do not use or rely as heavily upon the common law to determine "employee" status. Thus, it is possible for a worker to be an independent contractor under benefits law but an employee under discrimination, labor, or workers' compensation law.

For example, the Fair Labor Standards Act ("FLSA"), which sets forth federal wage and hour requirements, contains the same unhelpful definition of "employee" as is found in ERISA: "any individual employed by an employer." But the FLSA goes on to define the term "employ" to mean "suffer or permit work," a definition the Supreme Court has held extends to relationships beyond those covered under the common law. Darden, 503 U.S. at 326. Because of this (seemingly slight) difference in terminology, the "economic reality" test rather than the common law test is used under the FLSA to determine whether an employer-employee relationship exists. Under the economic reality test, courts consider six factors:

(i) Which party has the right to control the means and manner of production;
(ii) The worker's opportunity for profit or loss based on his or her own managerial skills;
(iii) Which party supplies the equipment or materials used to accomplish the job;
(iv) The lack of skill required;
(v) The permanence of the relationship; and
(vi) Whether the job being performed is integral to the company's business.

Many state courts also do not adhere to the common law test when interpreting state employment laws. In California, for example, the leading state supreme court decision on worker classification held that the common law test is merely "useful" when determining employee status under California's workers' compensation statute. More meaningful, the court held, is the federal "economic reality" test and consideration of the remedial purpose of the statute at issue. S.G. Borello & Sons v. Department of Industrial Relations, 48 Cal.3d 341 (1989). The California Supreme Court also suggested that the same approach should be used when determining employee status under the state's anti-discrimination and other employment statutes.

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F. Other Developments
Despite the virtually uniform rejection outside the Ninth Circuit of claims by temps for retroactive benefits, the Ninth Circuit's decisions have kept the issue alive around the country. In October 1998, the U.S. Department of Labor filed suit against Time Warner Inc. seeking retroactive benefits on behalf of 1,000 workers, who the Labor Secretary contends were misclassified. On May 18, 1999, less than a week after the Ninth Circuit issued its decision in Microsoft III, a group of temps refiled a class action against Pacific Bell that previously had been dismissed pending the Microsoft III decision. The suit, which was filed on behalf of more than 1700 individuals who had worked at Pacific Bell as temps during the past six years, seeks retroactive retirement and other benefits, which the plaintiffs' attorney estimates to be worth approximately $30 million. And on June 24, 1999, the same attorneys representing workers in the Microsoft case filed a class action on behalf of a group of workers at Atlantic Richfield Co. seeking retroactive benefits.

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There are at least three steps employers can take to significantly reduce their exposure to liability to temps and independent contractors for retroactive benefits and to the IRS for unpaid employment taxes.

A. Review Worker Classifications
Companies that use temps through an agency should take steps to ensure that the agency, and not the client company, has the ability to control or direct the manner and means by which the product is accomplished. In that regard, where possible, the agency (not the client company) should:

  • Provide the workers with benefits,
  • Assume responsibility for paying workers,
  • Be responsible for payroll taxes,
  • Retain the right to hire, evaluate, and fire workers,
  • Be responsible for supervising, instructing and training the workers,
  • Provide agency personnel to supervise on-site workers,
  • Issue its own employee handbook covering the workers,
  • Maintain all employee records,
  • Enter into an employment agreement with each worker, and
  • Provide the tools and materials necessary to perform the services.

Client companies also should have counsel review their contracts with the agency to ensure that these issues are properly documented. Companies that engage independent contractors should always use a written agreement approved by counsel and designed to document the nature of the relationship properly. The contractor should retain as much control and direction as possible over the manner and means of production.

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B. Review and Amend Your Plans
There are at least five areas in your company's benefit plans that counsel should carefully review and, where appropriate, prepare amendments to improve:

1. Discretion to determine eligibility.
Every employee benefit plan should be drafted to confer maximum discretion upon the plan administrator to:

(i) construe the terms of the plan,
(ii) decide all questions of eligibility to participate; and
(iii) determine claims for benefits.

In most circumstances, courts are required to defer to a plan administrator's decision made under such a grant of discretionary authority. A shortcoming in this area, or a failure by the plan administrator to exercise its discretion properly, can mean the difference between a denial of benefits being upheld on review and 10,000 to 15,000 workers recovering $20 million in retroactive benefits.

2. Exclude the proper categories of workers and employees.
It is absolutely essential that plans be written to identify accurately the classes of workers or employees who should be excluded from participation, and that the appropriate legal language is used to ensure that the intended objective is likely to be accomplished.

3. Don't incorporate sections of the Code unless necessary.
Courts have held that incorporating sections of the Internal Revenue Code by reference, or including language stating that the plan is intended to be interpreted to comply with a particular section of the Code, can create substantive rights to benefits or lead to other problems where none otherwise would have existed. Accordingly, plan sponsors should have counsel evaluate whether any sections of the Code incorporated in their plans can safely be removed. Caution is advised in this area, as certain plan language is required as a condition of tax qualification.

4. Establish proper claims procedures.
The plan's benefit claims procedures should be spelled out in some detail in the plan document and in the summary plan description distributed to employees. This is true even if the plan is not covered by ERISA (as in the case of certain stock plans). When a claim is made, it is essential that the plan administrator follow the procedures fully to minimize the chance that a reviewing court will overturn the administrator's decision.

5. Special problems with non-ERISA stock plans.
The Ninth Circuit ruled in Microsoft that the company's employee stock purchase plan covered all common law employees, even those who had been retroactively classified as such, because the plan expressly provided that it was to "be construed so as to extend and limit participation in a manner consistent with the requirements of [Code Section 423]. "That section conditions favorable tax benefits on stock purchase plans being written to expressly provide that participation will be open to all common law employees. The court's reasoning is unassailable with respect to workers whose common law employee status is uncontested. However, with respect to retroactively classified workers, the court appears to have assumed (in the absence of any plan language addressing the issue) that Section 423 requires retroactive participation. The opinion does not address what the result would be if a plan were drafted to provide something like the following: participation will be limited to common law employees of the company, whose status shall be determined in the sole discretion of the plan administrator; moreover, any individual retroactively determined to be a common law employee will be permitted to participate only prospectively, unless it is determined that the administrator's decision was made in bad faith. The intent of this type of language is to preserve the plan's tax status under Code Section 423 while preventing reclassified workers from participating retroactively. Obviously, this approach has not yet been tested in the courts. However, companies interested in pursuing such an approach should consult with counsel about appropriate language and the advisability of seeking an advance private letter ruling from the IRS.

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C. Never Concede Employment Status Without the Advice of Counsel
After the Microsoft case, it should be obvious that no worker's employment status is to be conceded to the IRS (or any other federal or state government agency) without first seeking the advice of experienced counsel. Obtaining the advice of counsel will minimize the risk that a concession or settlement under the tax laws will have unintended consequences under employment or benefits law.

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Common Law Test Under ERISA
This test requires employers to consider the hiring party's right to control the manner and means by which the product is accomplished and the following additional twelve factors:

  1. The skill required
  2. The source of the instrumentalities and tools
  3. The location of the work
  4. The duration of the relationship between the parties
  5. Whether the hiring party has the right to assign additional projects to the hired party
  6. The extent of the hired party's discretion over when and how long to work
  7. The method of payment
  8. The hired party's role in hiring and paying assistants
  9. Whether the work is part of the regular business of the hiring party
  10. Whether the hiring party is in business
  11. The provision of employee benefits, and
  12. The tax treatment of the hired party.

Common Law Test Under Tax Code
Under federal tax law, the test also focuses on whether sufficient control exists to conclude that an employer-employee relationship exists, based on the 20 factors set forth below. When evaluating relationships, agents are instructed that "special scrutiny is required in applying the twenty factors to assure that formalistic aspects of an arrangement designed to achieve a particular status do not obscure the substance of the arrangement (that is, whether the person or persons for whom the services are performed exercise sufficient control over the individual for the individual to be classified as an employee)."

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The twenty factors are:

1. Instructions.
A worker who is required to comply with other persons' instructions about when, where, and how he or she is to work is ordinarily thought to be an employee.

2. Training.
Training a worker often indicates that the person or persons for whom the services are performed want the services performed in a particular method or manner.

3. Integration.
Integration of the worker's services into the business operations generally shows that the worker is subject to direction and control.

4. Services Rendered Personally.
If the services must be rendered personally, presumably the person or persons for whom the services are performed are interested in the methods used to accomplish the work as well as in the results.

5. Hiring, Supervising and Paying Assistants.
Generally, the party that hires, supervises and pays assistants will be the party that exercises control over them on the job.

6. Continuing Relationship.
A continuing relationship between the worker and the person or persons for whom the services are performed tends to indicate that an employer-employee relationship exists.

7. Set Hours of Work.
The establishment of set hours of work by the person or persons for whom the services are performed is a factor indicating control.

8. Full Time Required.
If the worker must devote substantially full time to the business of the person or persons for whom the services are performed, such person or persons have control over the amount of time the worker spends working and impliedly restrict the worker from doing other gainful work.

9. Doing Work on Employer's Premises.
If the work is performed on the premises of the person or persons for whom the services are performed, that factor suggests control over the worker, especially if the work could be done elsewhere.

10. Order or Sequence Set.
If a worker must perform services in the order or sequence set by the person or persons for whom the services are performed, that factor shows that the worker is not free to follow the worker's own pattern of work but must follow the established routines and schedules of the person or persons for whom the services are performed.

11. Oral or Written Reports.
A requirement that the worker submit regular or written reports to the person or persons for whom the services are performed indicates a degree of control.

12. Payment by Hour, Week, Month.
Payment by the hour, week, or month generally points to an employer-employee relationship, provided that this method of payment is not just a convenient way of paying a lump sum agreed upon as the cost of a job. Payment made by the job or on a straight commission generally indicates that the worker is an independent contractor.

13. Payment of Business and/or Traveling Expenses.
If the person or persons for whom the services are performed ordinarily pay the worker's business and/or traveling expenses, the worker is ordinarily an employee.

14. Furnishing of Tools and Materials.
The fact that the person or persons for whom the services are performed furnish significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship.

15. Significant Investment.
If the worker invests in facilities that are used by the worker in performing services and are not typically maintained by employees (such as the maintenance of an office rented at fair value to an unrelated party), that factor tends to indicate that the worker is an independent contractor.

16. Realization of Profit or Loss.
A worker who can realize a profit or suffer a loss as a result of the worker's services (in addition to the profit or loss ordinarily realized by employees), is generally an independent contractor, but the worker who cannot is an employee.

17. Working for More Than One Firm at a Time.
If a worker performs more than de minimis services for a multiple of unrelated persons or firms at the same time, that factor generally indicates that the worker is an independent contractor. However, a worker who performs services for more than one person may be an employee of each of the persons, especially where such persons are part of the same service arrangement.

18. Making Service Available to General Public.
The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.

19. Right to Discharge.
The right to discharge a worker is a factor indicating that the worker is an employee and the person possessing the right is an employer.

20. Right to Terminate.
If the worker has the right to end his or her relationship with the person for whom the services are performed at any time he or she wishes without incurring liability, that factor indicates an employer-employee relationship.

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The information contained in this publication is general in nature and does not constitute legal advice. The attorneys listed at the conclusion of this publication would be pleased to discuss in greater detail its contents and its application to your specific situation. Thelen Reid & Priest welcomes your comments and suggestions.

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