Are Your Independent Contractors Really Independent?

Does your company use independent contractors in order to minimize overhead and other potential liability? What makes you so sure they are not employees? Is it because they signed an agreement indicating that they are not employees? Is it because you issue them a Form 1099 instead of a W-2? Is it because they are largely independent of your company's day-to-day control?

You may be surprised to learn that these criteria are not necessarily dispositive of whether a worker is an employee or an independent contractor. In fact, the determination of whether a worker is an independent contractor is one of the issues of the decade ' and became even more critical after the Department of Labor (DOL) and Internal Revenue Service (IRS) announced earlier this year that they plan to step up enforcement of companies that miscategorize employees as independent contractors to avoid compliance with tax laws and labor laws.

Why Hire Independent Contractors?

The reasons for engaging independent contractors as opposed to hiring additional employees is that independent contractors can be cheaper, and they expose employers to less liability. Independent contractors may be cheaper because companies: 1) need not pay them according to most wage and hour laws, such as overtime or minimum wage requirements; 2) need not pay or deduct so-called “employment taxes,” such as Social Security, unemployment insurance, Medicare, or federal income tax; and 3) need not spend money to defeat union organizing campaigns or to engage in collective bargaining. Further, independent contractors do not have the same rights as employees, so companies need not worry about liability pursuant to state or federal employment statutes, such as anti-discrimination statutes, the Family and Medical Leave Act (FMLA), or the Employee Retirement Income Security Act (ERISA).

Three General Approaches

So how can you determine whether a worker is an employee or an independent contractor? It depends on the statute at issue and the relevant jurisdiction. Courts interpreting most statutes take one of three approaches.

The 'Right-to-Control' Test

The first approach, which is used for purposes of the Internal Revenue Code, the National Labor Relations Act, ERISA and the ADA in most circuits, is called the “right-to-control” test. It relies on traditional common-law factors of control to determine whether a company has sufficient control over a worker for that person to be considered an employee. Common-law factors include: 1) the extent of control that the company may exercise over the details of the work; 2) whether the worker and the company believe they are creating an employment relationship; 3) the skill required in the particular occupation; 4) whether the employer or the worker supplies the instrumentalities, tools, and the workplace; 5) the duration of the work; 6) the kind of occupation, and whether, in the locality, the work is usually done under the direction of the company or by a specialist without supervision; 7) the method of payment, whether by time worked or by the job; and 8) whether or not the work is part of the regular business of the company.

The 'Economic Realities' Test

The second approach, called the “economic realities” test, uses several factors to determine as a matter of reality whether a worker is sufficiently economically dependent on the company to be considered an employee: 1) the degree of control exercised by the company; 2) the extent of the relative investments of the worker and alleged employer; 3) the degree to which the worker's opportunity for profit and loss is determined by the company; 4) the skill and initiative required for the worker to perform his or her job; and 5) the permanency of the relationship between the worker and the company. No one factor is dispositive, but these are the criteria the courts have used to measure the dependence of the worker on the company. This broader standard was first adopted by the courts in the 1940s for purposes of the Fair Labor Standards Act (FLSA), the FMLA, and the Social Security Act, which were designed to promote social welfare (as opposed to other statutes like the Internal Revenue Code).

The 'Hybrid-Economic-Realities-Common-Law' Test

The third approach is a mix of the first two, and is commonly referred to as the “hybrid-economic-realities-common-law” test. This approach, which is used by most courts in Title VII and ADEA cases, considers the “economic-realities” criterion, but places emphasis on the company's right to control the individual's work. Consequently, this middle-of-the-road approach is more restrictive than the “economic-realities” test, but more liberal than the “right-to-control” test.

Examples

Consider the following example from a recent case. An insurance company engaged several workers who were essentially senior salesmen. These workers signed contracts indicating that they were independent contractors. They were paid on commission, issued Form 1099s at the end of the year, and nothing was withheld from their paychecks. They had almost complete discretion with regard to their work schedules and day-to-day affairs, and the
company provided minimal oversight as to their work. They were required to attend very few of the company's meetings and training sessions.

Many lawyers would feel confident that these salesmen were independent contractors according to any test, but in 2008, the Fifth Circuit Court of Appeals held that they were employees using the “economic realities” standard. The court found that the company exercised sufficient control over the senior salesmen because it determined the type and price of products they could sell, as well as their sales territories, and the contracts forbid the senior salesmen from working for any other companies. The company also controlled the junior salesmen whom the senior salesmen supervised and from whom the senior salesmen derived much of their profits. The court found that the company's investment in the senior salesmen (training and sales materials) heavily outweighed the investment (if any) of the senior salesmen in their own business. The salesmen's opportunity for profit and loss was also heavily dependent on the company because it controlled the products they sold, as well as their sales leads and territories, and prohibited sales for any other company. Finally, the court found that the relationship between the senior salesmen and the company was relatively permanent because the salesmen had worked for the company for many years. See Cornerstone America v. Hopkins, 545 F.3d 338 (5th Cir. 2008).

When determining whether a particular worker is an employee, it is critical to evaluate all potentially relevant facts. Compare the facts of the case discussed above with those of a similar Fifth Circuit case that reached the opposite result. In the second case, just like the first, a salesman signed a contract indicating he was an independent contractor, and he operated largely independent of the company's day-to-day control. He was paid on commission, issued a Form 1099, and no withholdings were made. The difference between the workers in the first and second case is that the latter could call on any customers he wanted, anywhere he wanted, and his contract did not prohibit him from working for other companies. Because he was less dependent than the worker in the first case, the court found that he was an independent contractor. See Hickey v. Arkla Indus., 699 F.2d 748 (5th Cir. 1983).

It is safe to say that the workers in both cases would have been independent contractors if the court had used the more narrow “right-to-control” test or the hybrid test. Thus, in addition to knowing the detailed facts of each case, it is critical to determine what test the court in your jurisdiction will use to decide the case. If a suit involves a federal employment statute, the court will likely use one of the three tests discussed above, but courts may use different tests depending on the statute that it seeks to interpret. For example, some state wage and hour statutes have specific definitions of the employment relationship, which do not rely on the three tests discussed above.

Conclusion

Determining whether a worker is an independent contractor or an employee is more complicated than you might think. Thus, it is important not to assume you know his or her status based on the wording of a contract or any other single factor. Rather, you should consider: 1) the statute at issue; 2) the applicable jurisdiction; and 3) all the facts underlying the relationship at issue.

E. Fredrick Preis, Jr. , a member of this newsletter's Board of Editors, and Joseph Hugg are attorneys in the Labor and Employment section at the Lemle & Kelleher law firm, which represents management. Mr. Preis can be reached at [email protected], and Mr. Hugg can be reached at [email protected].

Does your company use independent contractors in order to minimize overhead and other potential liability? What makes you so sure they are not employees? Is it because they signed an agreement indicating that they are not employees? Is it because you issue them a Form 1099 instead of a W-2? Is it because they are largely independent of your company's day-to-day control?

You may be surprised to learn that these criteria are not necessarily dispositive of whether a worker is an employee or an independent contractor. In fact, the determination of whether a worker is an independent contractor is one of the issues of the decade ' and became even more critical after the Department of Labor (DOL) and Internal Revenue Service (IRS) announced earlier this year that they plan to step up enforcement of companies that miscategorize employees as independent contractors to avoid compliance with tax laws and labor laws.

Why Hire Independent Contractors?

The reasons for engaging independent contractors as opposed to hiring additional employees is that independent contractors can be cheaper, and they expose employers to less liability. Independent contractors may be cheaper because companies: 1) need not pay them according to most wage and hour laws, such as overtime or minimum wage requirements; 2) need not pay or deduct so-called “employment taxes,” such as Social Security, unemployment insurance, Medicare, or federal income tax; and 3) need not spend money to defeat union organizing campaigns or to engage in collective bargaining. Further, independent contractors do not have the same rights as employees, so companies need not worry about liability pursuant to state or federal employment statutes, such as anti-discrimination statutes, the Family and Medical Leave Act (FMLA), or the Employee Retirement Income Security Act (ERISA).

Three General Approaches

So how can you determine whether a worker is an employee or an independent contractor? It depends on the statute at issue and the relevant jurisdiction. Courts interpreting most statutes take one of three approaches.

The 'Right-to-Control' Test

The first approach, which is used for purposes of the Internal Revenue Code, the National Labor Relations Act, ERISA and the ADA in most circuits, is called the “right-to-control” test. It relies on traditional common-law factors of control to determine whether a company has sufficient control over a worker for that person to be considered an employee. Common-law factors include: 1) the extent of control that the company may exercise over the details of the work; 2) whether the worker and the company believe they are creating an employment relationship; 3) the skill required in the particular occupation; 4) whether the employer or the worker supplies the instrumentalities, tools, and the workplace; 5) the duration of the work; 6) the kind of occupation, and whether, in the locality, the work is usually done under the direction of the company or by a specialist without supervision; 7) the method of payment, whether by time worked or by the job; and 8) whether or not the work is part of the regular business of the company.

The 'Economic Realities' Test

The second approach, called the “economic realities” test, uses several factors to determine as a matter of reality whether a worker is sufficiently economically dependent on the company to be considered an employee: 1) the degree of control exercised by the company; 2) the extent of the relative investments of the worker and alleged employer; 3) the degree to which the worker's opportunity for profit and loss is determined by the company; 4) the skill and initiative required for the worker to perform his or her job; and 5) the permanency of the relationship between the worker and the company. No one factor is dispositive, but these are the criteria the courts have used to measure the dependence of the worker on the company. This broader standard was first adopted by the courts in the 1940s for purposes of the Fair Labor Standards Act (FLSA), the FMLA, and the Social Security Act, which were designed to promote social welfare (as opposed to other statutes like the Internal Revenue Code).

The 'Hybrid-Economic-Realities-Common-Law' Test

The third approach is a mix of the first two, and is commonly referred to as the “hybrid-economic-realities-common-law” test. This approach, which is used by most courts in Title VII and ADEA cases, considers the “economic-realities” criterion, but places emphasis on the company's right to control the individual's work. Consequently, this middle-of-the-road approach is more restrictive than the “economic-realities” test, but more liberal than the “right-to-control” test.

Examples

Consider the following example from a recent case. An insurance company engaged several workers who were essentially senior salesmen. These workers signed contracts indicating that they were independent contractors. They were paid on commission, issued Form 1099s at the end of the year, and nothing was withheld from their paychecks. They had almost complete discretion with regard to their work schedules and day-to-day affairs, and the
company provided minimal oversight as to their work. They were required to attend very few of the company's meetings and training sessions.

Many lawyers would feel confident that these salesmen were independent contractors according to any test, but in 2008, the Fifth Circuit Court of Appeals held that they were employees using the “economic realities” standard. The court found that the company exercised sufficient control over the senior salesmen because it determined the type and price of products they could sell, as well as their sales territories, and the contracts forbid the senior salesmen from working for any other companies. The company also controlled the junior salesmen whom the senior salesmen supervised and from whom the senior salesmen derived much of their profits. The court found that the company's investment in the senior salesmen (training and sales materials) heavily outweighed the investment (if any) of the senior salesmen in their own business. The salesmen's opportunity for profit and loss was also heavily dependent on the company because it controlled the products they sold, as well as their sales leads and territories, and prohibited sales for any other company. Finally, the court found that the relationship between the senior salesmen and the company was relatively permanent because the salesmen had worked for the company for many years. See Cornerstone America v. Hopkins , 545 F.3d 338 (5th Cir. 2008).

When determining whether a particular worker is an employee, it is critical to evaluate all potentially relevant facts. Compare the facts of the case discussed above with those of a similar Fifth Circuit case that reached the opposite result. In the second case, just like the first, a salesman signed a contract indicating he was an independent contractor, and he operated largely independent of the company's day-to-day control. He was paid on commission, issued a Form 1099, and no withholdings were made. The difference between the workers in the first and second case is that the latter could call on any customers he wanted, anywhere he wanted, and his contract did not prohibit him from working for other companies. Because he was less dependent than the worker in the first case, the court found that he was an independent contractor. See Hickey v. Arkla Indus. , 699 F.2d 748 (5th Cir. 1983).

It is safe to say that the workers in both cases would have been independent contractors if the court had used the more narrow “right-to-control” test or the hybrid test. Thus, in addition to knowing the detailed facts of each case, it is critical to determine what test the court in your jurisdiction will use to decide the case. If a suit involves a federal employment statute, the court will likely use one of the three tests discussed above, but courts may use different tests depending on the statute that it seeks to interpret. For example, some state wage and hour statutes have specific definitions of the employment relationship, which do not rely on the three tests discussed above.

Conclusion

Determining whether a worker is an independent contractor or an employee is more complicated than you might think. Thus, it is important not to assume you know his or her status based on the wording of a contract or any other single factor. Rather, you should consider: 1) the statute at issue; 2) the applicable jurisdiction; and 3) all the facts underlying the relationship at issue.

E. Fredrick Preis, Jr. , a member of this newsletter's Board of Editors, and Joseph Hugg are attorneys in the Labor and Employment section at the Lemle & Kelleher law firm, which represents management. Mr. Preis can be reached at [email protected], and Mr. Hugg can be reached at [email protected].