Blog, News and Links

Dangers of Classifying Employees as Independent Contractors

Businesses quite naturally seek to reduce expenses, streamline operations and reinvest returns. This is especially true for a UK company establishing itself in America, where expenses involved with a foreign presence must be vigilantly monitored.  One tempting way of reducing expenses is to characterise as independent contractors individuals who might otherwise more resemble employees.  Not only does this save on expenses associated with workers’ compensation, unemployment insurance, disability insurance and social security, but also the administrative burden of complying with those matters and others that may be imposed under state regulations.  The danger with this approach is that it may invite serious penalties, both federal and state, far in excess of what might have been saved.  In recent years the US federal government has become more aggressive in uncovering and penalising companies it finds guilty of misclassification of employees.

In 2011, the United States General Accounting Office estimated that over $2.7 billion per year was lost to the federal government as a result of companies misclassifying as independent contractors workers more properly considered employees.  To address this, the Department of Labor’s 2011 budget contained a specific line item dedicating $25 million to hire investigators to further what it terms its “Misclassification Initiative”.

Not only do federal agencies such as the IRS and the DOL have an interest in misclassification, but private parties may often as well.  One need look no further than a 2008 case of Western Company of Texas, where 200 workers, who had been classified as independent contractors, sued en masse for unpaid overtime and were awarded $600,000 after the Department of Labor found them not to be independent contractors, but employees with rights to overtime pay.

With the increased risk of both government scrutiny and private litigation,  UK companies doing business in the USA must be aware of how the federal and state governments distiguish independent contractors from employees.  While different federal agencies and state laws have slighty different or nuanced approaches to addressing the misclassification  issue, the inquiry in all cases generally examines whether control of work sits with the worker or the company.  The more that control sits with a worker, the liklier it is that he or she is an independent contractor; the more it sits with the company, the  closer he or she is to an employee.

Worker status depends much upon the nature of work being done — whether it involves  provision of services or use of equipment; whether it’s site specific or capable of being performed in many places; whether it involves unique skills or is usually integral to any business (think of accounts receivable).  In all cases, however, there will be a multitude  of considerations, no single one of which will be dispositive.  All facets of the relationship are considered and a determination is made upon the relative weight of the evidence.

Very generally, employees are more likely to have frequent supervision from business managers; receive training from the business; perform core (as opposed to specialised) business functions; have non-contractual, open-ended relationships with the company; work mostly or exclusively for the company; have defined schedules set by the company; be paid the same amounts at regular intervals; work on company premises; have very little personal financial risk in the work performed; and, will work on an “at-will” basis.

Independent contractors, on the other hand, bring their own skills to the job and work under less supervision; the training they have pre-dates their work with the company; their skills are specialised or outside the ordinary operations of the company; they work pursuant to a contract to which the company is a party; the company provides a portion, but not the entirety, of their income; they set their own schedules; get paid in accordance with work performed, which may from time-to-time vary; work on other sites or at an office run and owned by the worker and apart form the company; have invested in and therefore have a personal stake in their own business; and, may have breach of contract claims against a company that dismisses them or refuses payment unjustly.

One of the best methods of avoiding a charge of misclassification is to have a well-drafted contract between the company and its independent contractor which recites much of the above with specific reference to the independent contractor.  In addition, it should mention the expectations attendant to invoicing and payment, various forms of insurance to be carried by the contractor and tax and regulatory responsibilites of the contractor.  When analyzing the weight of evidence, a written and signed contract usually proves itself a substantial consideration.

An excellent review of the differences between an employee and an independent contractor can be found at The California Legal Aid Society’s Employment Law Center at  Be sure to note section 5 which mentions the penalities for misclassification:  $5000 to $25,000 for each violation!