Consequences For Misclassifying Workers As Independent Contractors

Posted on May 11, 2022

Sometimes, at first blush, it may seem beneficial to treat workers as independent contractors rather than employees.  In general, when dealing with independent contractors employers do not make matching contributions for Social Security and Medicare (“FICA”) payments and do not have to pay overtime. Workers sometimes desire to be treated as independent contractors so that no taxes and other withholdings are made from payments received for work performed. While treating workers as independent contractors can therefore seem like a “win-win” situation, employers are responsible for correctly classifying workers as either employees or independent contractors. Failure to properly classify and treat workers as employees can result in multiple liabilities such as for back payment of required contributions, failure to properly withhold income taxes and unpaid overtime.

Oftentimes, employers are quick to characterize workers as independent contractors without understanding or considering the tests used by courts and/or government agencies when a potential misclassification issue has been raised and the many consequences that can arise from failing to get it right.  The tests to be applied vary based on the agency involved and/or the law governing the event or transaction under which a worker’s status becomes an issue.

For example, worker misclassification issues may trigger minimum wage and overtime issues governed by the Fair Labor Standards Act (“FLSA”). Only employees are entitled to FLSA protections.  When analyzing such claims, courts have consistently applied an “economic reality test” to determine if a worker is an employee or independent contractor. This test examines whether an individual is economically dependent upon the employer’s business or is really in business for himself. The more dependent the individual is on the company, the more likely it is that he or she should be classified as an employee. This is a fact intensive inquiry and courts ultimately decide the issue based on the “totality of the circumstances”, but are often guided by several considerations:  (1) the degree of control exercised by the alleged employer; (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 alleged employer; (4) the skill and initiative required in performing the job; and (5) the permanency of the relationship.  Importantly, an agreement between the employer and worker as to the worker’s status is alone not sufficient as a matter of economic reality to establish an independent contractor relationship.

The Department of Labor, the federal agency which oversees and enforces the FLSA, uses a modified version the economic reality test which also considers whether the services provided by the worker are an integral part of the employer’s business.  But, again, the determination of status is based on the totality of the circumstances.

The IRS employs yet a different analysis for independent contractor status which  focuses on the amount of control and independence between the business and the worker, including behavioral control, financial control, and the nature of the relationship itself.  The IRS has outlined some 17 different factors to be considered in evaluating a worker’s relationship. Even when the factors are considered, the IRS acknowledges that whether a person is an employee for federal income withholding requirements is often a difficult determination to make.

Different still, each state has developed its own tests for evaluating a worker’s status for various situations.  One such situation arises when a putative independent contractor injures someone.  The injured person may claim that the worker was really an employee of the business and attempt to hold the business/employer liable for the injuries. The business/employer’s responsibility and liability may depend on the worker’s status.

In Texas, the evaluation of a worker’s status often depends on the extent the employer had a right to control the work of the “independent” contractor. Courts often examine such factors as, (i) the extent of control which, by the agreement, the business may exercise over the details of the work; (ii) whether the one employed is engaged in a distinct occupation or business; (iii) whether the employer or the worker supplies the instrumentalities, tools, and the place of work for the person doing the work; and (iv) whether the parties believe they are creating the relationship of employer and employee.

Employers who misclassify workers as independent contractors face a myriad of potential penalties and/or liabilities. As briefly mentioned above, employees are subject to the minimum wage, overtime, and recordkeeping obligations of the FLSA. Misclassified workers may be entitled to up to three years of back wages, and an equal amount in liquated damages for some violations.  Similarly, if the IRS determines an employer-employee relationship exists, it could require the company to pay unpaid FICA matching payments.  Also, if the worker did not pay his/her federal taxes, the IRS may hold the employer responsible for any unpaid taxes that were not withheld from the worker’s wages, and impose other fines and penalties, including a fifty dollar fine for each W-2 Form the employer failed to file for the relevant employees; a penalty of up to $1,000 per misclassified worker; and a potential one-year prison sentence if the misclassification was intentional to avoid tax requirements.

In addition to federal liabilities, states also have potential claims against employers who misclassify workers.  For example, aside from the general issue of liability for worker mishaps, under the Texas Unemployment Compensation Act, employers pay unemployment taxes for each employee but not independent contractors. Employers who misclassify its employees as independent contractors may be subject to fines, increased taxes, and interest charges for failure to pay unemployment taxes on the misclassified workers.  Additionally, because workers compensation premiums are based, in part, on the number of hours worked by employees, businesses who misclassify workers may be subject to increased and/or back-due premiums.

The above summary of worker misclassification issues is not exhaustive and only touches on the most commonly occurring situations.  There are many more federal and state laws each with their own nuance as to how to resolve worker misclassification issues. Employers with workers in locations outside of Texas should be cognizant of the various tests and other penalties that may apply in those jurisdictions.

Disclaimer: This information is made available for educational purposes only, as well as to give general information and a general understanding of the law, not to provide specific legal advice. For more information concerning this topic, please contact Keith Sieczkowski, Sandra White or Emily Arnold, employment lawyers with Branscomb Law, at ksieczkowski@branscomblaw.com, swhite@branscomblw.com, or earnold@branscomblaw.com