Misclassifying Employees as Independent Contractors is a Gamble Employers Cannot Afford

Using independent contractors rather than employees makes sense for employers trying to reduce costs in a bad economy. The use of independent contractors can reduce the amount of money employers have to spend on health benefits, insurance premiums, unemployment and workers’ compensation, overtime, social security contributions, and administrative costs. However, employers should ensure that they correctly classify independent contractors, because misclassification could cost them much more than they are saving.

A Pennsylvania employer recently felt the effect of misclassifying employees as independent contractors. In July of 2011, an Essington auto-parts company was forced to pay more than $256,000 in back wages to misclassified delivery drivers for violating overtime pay laws. Additionally, in 2012 three federal lawsuits and a state investigation were initiated in response to claims that Marcellus Shale gas companies were misclassifying their workers as independent contractors in order to avoid paying overtime.

The slow economy has adversely affected government agencies as well. To raise revenue, state and federal agencies are cracking down on employers who misclassify employees as independent contractors. The agencies are successfully collecting unpaid taxes and levying fines, with criminal penalties applicable in some circumstances. Misclassified employees also have successfully sued their employers and recovered monetary damages for unpaid overtime, health benefits, wrongful termination, discrimination, retirement benefits and workers’ compensation. In order to avoid serious civil and criminal penalties, employers must educate themselves on how to properly classify their workers.

Each distinct Pennsylvania and federal law provides its own penalties for misclassification, and the penalties are all severe. Two of the most important Pennsylvania laws illustrate this point.

The Construction Workplace Misclassification Act (“Act 72”) was enacted in 2011, and makes it illegal to misclassify employees as independent contractors in the commercial and residential construction industry. Act 72 contains a narrow definition of independent contractor. In order to qualify, an individual must: (a) have a written contract to perform the construction services, (b) be free from control or direction over the performance of those services, and (c) be customarily engaged in an independently established trade, occupation, profession or business. Any construction business, or its officers, that misclassifies an employee as an independent contractor could face criminal prosecution, administrative fines up to $2,500 per violation (each misclassification is a separate violation), and a court-issued stop work order.

The Pennsylvania Workers’ Compensation Act also provides penalties for misclassifying workers. An employer convicted of failure to carry workers’ compensation coverage through misclassification would be guilty of a misdemeanor of the third degree. If an employer’s failure is found to be intentional, the penalty is a third degree felony. Each day’s violation constitutes a separate offense. In addition, an employer who misclassifies an employee loses the liability protections provided by the Act and is subject to common law tort and negligence claims, exposing the employer to vastly increased civil liability.

To avoid penalties, employers should review the classification of the individuals who work for them, and if necessary correct any misclassifications. Unfortunately, there is no bright-line test for determining whether an individual is an employee. Over the years state and federal courts have applied different tests, which encompass a myriad of factors. Although each situation is different, there are several factors commonly applied in each test, with the most important factor being control.

The following are a list of factors employers should consider, with affirmative answers tending to show that the individual is an employee:

1. Control: Does the employer retain the power to determine not only what work should be done by the individual, but also the manner in which the work is completed?
2. Monitoring: Does a supervisor normally direct the individual’s work (as opposed to it being completed independently)?
3. Training: Did the employer train the individual for the job (as opposed to the individual already possessing the required skills)?
4. Benefits: Does the employer provide employment related benefits to the individual, such as health benefits, a retirement plan, or a company vehicle?
5. Tools: Does the employer furnish the tools necessary to carry out the job?
6. Duration: Has the working relationship existed for an extended period of time (as opposed to the individual being hired for a discrete project)?
7. Payment: Is the individual paid on a weekly or bi-weekly basis (as opposed to being paid by the job)?
8. Hours: Is the individual required to work a set number of hours per week on a set schedule?
9. Exclusivity: Is the individual prevented from carrying out similar work for other companies (as opposed to the individual operating an independent business venture)?
10. Discipline: Does the employer have the right to discipline the individual (as opposed to terminating the agreement)?
11. Taxes: Does the employer withhold taxes on behalf of the individual, pay social security taxes, and contribute to Medicare? (Note: Employers should issue an IRS Form-1099 to independent contractors rather than a Form W-2).
12. Absence of written agreement: Did the employer fail to engage the individual under a written agreement, which includes language stating that the individual is not an employee and that the individual will not receive employment related benefits. (Note: While courts will not rely on the employer’s classification of the worker as a non-employee, a written agreement helps prove the intent of the parties).

It is important to note that courts do not require the presence of all of these factors, and the presence of a few may be enough to justify a finding of employment. If an existing work relationship does not meet this test, the employer should change its practices to eliminate any problematic areas. If the individual cannot properly be classified as an independent contractor, he or she should be treated as an employee and receive the statutorily required benefits and protections that go along with the classification.

The bottom line is that employers need to use their heads. Risk assessment and defensive planning today can prevent serious consequences in the future.