There are plenty of reasons that some people choose to go out on their own and work as independent contractors: flexible hours, unlimited income potential, control over income taxes, and control over the trajectory of their careers. There are also many reasons companies like to hire independent contractors, two of the most common being scalability and cost.

Some companies question when they should begin to transition from hiring independent contractors to full-time employees, but a more serious question should be, are your independent contractors already employees who have been misclassified? According to the U.S. Department of Labor (DOL), most workers are employees. The DOL issued a guidance in July of 2015 stating that the “misclassification of employees as independent contractors is found in an increasing number of workplaces in the United States…”. The guidance goes on to state that when employees are improperly classified, those workers may not receive protections common in the workplace, such as minimum wage pay, overtime compensation, unemployment insurance, and workers’ compensation. The reality is that this is another one of the situations where “it’s good until it’s not.” Thus, the problem is that employees classified as independent contractors will request to be classified as such until they realize that they are in dispute with their employer, e.g., they are terminated and request benefits normally provided to employees.

The DOL states that it receives numerous complaints from workers claiming to be misclassified. The government also receives lower tax revenues from independent contractors. Within the guidance, the DOL asserts that some companies may intentionally misclassify workers as a way to cut cost and avoid compliance with labor laws.

One such company caught up in a ten-year legal dispute wherein they had been accused of misclassifying employees is Fed-Ex. In June of 2015, the Memphis, Tennessee based LTL carrier settled with 2,300 of their drivers in California to the tune of $228 million. Drivers claimed that their classification as contractors, rather than employees, prevented them from receiving state-required benefits like overtime pay and rest breaks.

The Difference Between an Independent Contractor and an Employee

Under the Fair Labor Standards Act (FLSA), whether or not someone is economically dependent upon the employer is how courts determine whether or not they are an employee or an independent contractor. The FLSA defines employ as “to suffer or permit to work”. Per the guidance issued by the DOL, there are six factors that determine whether or not the work is truly independent business, or whether it is dependent upon the employer. They are:

1. Is the work an integral part of the employer’s business? If the work being performed is integral (integral being the key word) to the employer’s business, then it is considered likely that the worker is economically dependent upon the employer. For example, in the FedEx case, drivers perform an integral role in the business of shipping and delivering packages.
2. Does the worker’s managerial skill affect the worker’s opportunity for profit and loss? This refers to whether or not a worker’s managerial skill can affect profit and loss. Someone who is self-employed has the possibility of making a profit or facing a loss. Their managerial skill will commonly bring about opportunities for additional profit in the form of additional business from outside parties. Additionally, they could experience loss because of a reduction in opportunities for work. A self-employed worker decides whether or not to increase their business through means such as advertising, hiring employees, purchasing equipment and materials, and moving/adding locations. These are things that affect their profit and loss and are well within their control. Should a worker have no opportunity to work more hours or add more work opportunities unless it is within the control of the employer, they would not be considered a true independent contractor.

3. How does the worker’s relative investment compare to the employer’s investment? To be considered an independent contractor, a worker should be making an investment that indicates some risk for a loss. There should be some element of the business’ success or failure based upon that investment, beyond a specific job. There are some jobs wherein the worker may make an investment, yet still wouldn’t be considered an independent contractor. For example, buying tools or investing in additional training wouldn’t qualify someone as an independent contractor.
4. Does the work performed require special skill or initiative? Here, someone’s business skills, judgment, and initiative, rather than their technical skills, determine whether or not they are an independent contractor. For example, a highly skilled cake decorator working for a bakery is not an independent contractor, unless they are independently marketing and selling their services to that bakery, have the opportunity to work outside of that bakery doing the same work, and making their own decisions as far as which customer to work with, determining what supplies they need, placing their own orders, making their own work hours, etc.

5. Is the relationship between the worker and the employer permanent or indefinite? If a relationship between a worker and an employer is permanent or indefinite, it suggests that the worker is an employee. An independent contractor typically works a project for an employer without the dependency that comes with permanent employment.
6. What is the nature or degree of the employers control? In order to be considered an independent contractor, the worker “must control meaningful aspects of the work performed”. Meaning that it must be obvious that this person is controlling and conducting their own business. They must control their hours, the way they dress, the clients they choose to work with, etc. Control over employees suggests that they are employees, rather than independent contractors.

Penalties for Non-Compliance

There is a concerted effort among certain government agencies like the IRS (Internal Revenue Service) and DIR (Department of Industrial Relations) to bring a stop to the misclassification of employees. Employers can incur fairly hefty penalties for non-compliance. For instance, an employer can find themselves paying the IRS back taxes up to as much as 41.5% of the contractors’ wages, going back three years. If it is found that the misclassifications were done intentionally, employers can find themselves with a criminal conviction including time in jail, and fines as high as $500,000.

The Department of Labor (DOL) will also require employers to pay back wages for up to three years, and levy additional fines for faulty recordkeeping. The company will also incur an audit wherein the DOL will be looking to find other wage and hour violations, which could mean additional penalties.

Each state is different, and stage insurance agencies as well as their DOL may seek back payments on unemployment insurance and workers’ compensation premiums. States can also charge penalties for faulty recordkeeping.

What Employers Can Do

Under the FLSA’s definition of “employee”, most workers are considered employees. Companies should be analyzing their work force carefully to determine these factors. Consider each, and ask whether or not their workers truly match the definition of independent contractor or employee. The biggest question to answer is always that economic dependence. Employers should consider an independent audit of their workers with independent contractor status to determine whether or not they are classified correctly.

The good news is that most applicant tracking systems can be used to attract and manage applicants whether employee or independent contractor. The Applicant Manager or TAM can help you differentiate the recruiting process so that it is clear to applicants what the relationship is from day one. For more information, click on the contact button below.