Preventing Legal Problems with Contractors

According to the IRS, a worker is an independent contractor "if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done." Incorrectly labeling employees as contractors can be costly. In one high profile case involving FedEx, the Ninth Circuit applied California law and determined that the company had been mislabeling its drivers as independent contractors for several years. The court highlighted FedEx's control over their drivers through, among other things, its dress, vehicle, and scheduling policies. FedEx eventually settled the case for $228 million for back pay and other employment-related costs.

The lesson from this case is that control brings with it responsibilities, regardless of a worker's title. Misclassification can carry high risks of liability especially where the incorrect labeling of one worker could change the status of other similarly-situated workers, who may eventually form a new class of plaintiffs. Read on to learn more about preventing legal problems with contractors and how you help your corporate clients avoid FedEx's costly fate.

Factors to Determine Worker Status

The specific law of your clients' jurisdiction will determine what facts to analyze in determining what level of control creates employee status. However, the IRS also provides a helpful list of factors which can help your clients, including:

Behavioral Control Facts

  • Does the business have a right to direct and control what work is accomplished and how?
  • Does the worker have to participate in instructions or other training?

Financial Control Facts

  • What's the extent of unreimbursed business expenses for a worker?
  • What's the extent of a worker's investment in the facilities or tools used for the work?
  • What extent can the worker make services available to other businesses?
  • How is the worker paid?
  • What extent can the worker realize profits or incur losses?

Relationship of the Parties Facts

  • Are there written contracts describing the intended relationship?
  • Does the business provide any employee-type benefits?
  • How permanent is the relationship?
  • Are the worker's services a key aspect of the company's regular business?

What Are Some Ways to Reduce Liability Risks?

If your clients are seeking clarification about the employee status of existing or potential workers, they can always request an advance opinion from the IRS by submitting an IRS Form SS-8. Of course, an adverse IRS determination may expose them to liability for current or former employees. A better alternative, where possible, would be voluntary reclassification where your clients confer directly with workers to clarify their status and responsibilities by formal agreement which should, of course, contain a waiver and release for any past mislabeling.

Another way for your clients to significantly reduce their liability risks is by hiring contractors from a staffing company. This provides the benefits of contractor status with another company being responsible for employee-related legal obligations. However, because responsibility follows control, your clients should still be cautious in their interactions with workers from staffing agencies.

Even if the IRS determines that a previously labeled contractor is actually an employee, it will not assess back employment taxes if the employer qualifies for the safe harbor exception. It's important to first note that this exception only applies to past due federal employment taxes and would not absolve any past due state taxes or obligations. That being said, an employer can qualify for safe harbor if:

  1. It consistently treated the worker as a non-employee for employment tax purposes,
  2. It filed all previous returns consistent with non-employee status, and
  3. It had a reasonable basis for treating the workers as non-employees (i.e. it relied on court decisions, IRS rulings, a past IRS audit, or industry practice).

Other Important Considerations

If your client has made the business decision to hire contractors instead of employees due to the reduced costs and responsibilities involved, they will have to decide exactly how far to integrate the contractors into their business operations. Contractors are free to simultaneously work for other companies, including competitors, so your clients should be cautious about their level of access to business operations. It will likely be necessary to incorporate confidentiality and non-disclosure and non-compete provisions into their contracts.

For more information on labor and employment law and how you can better protect your corporate clients, see the articles in FindLaw's Corporate Counsel section.