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Seven Costly Myths About Managing Contract Workers

Businesses can be led to believe they are saving costs by classifying workers as independent contractors instead of employees. Ultimately, this could be costly.

September 18, 2003
Businesses across the country are continuing to cut costs by replacingemployees with independent contractors. Some savings are certain--employers don’tpay employment taxes to the IRS or employee benefits to their workers. However,many hidden costs can reduce these savings or even erase them entirely.

    This article focuses on seven legal myths, myths that can lead businesses tobelieve they are saving money by blinding them to the costly legal risks ofhiring workers as independent contractors instead of employees. These mythsresult from being uninformed about the legal differences between employees andindependent contractors. Shattering these myths is the best way to learn howthese distinctions affect your business’s legal compliance and why companiesshould include these risks in any cost-cutting calculations.

    Myth #1: Employers should use the IRS’s 20 Common-Law Factors Test todetermine worker status as employee or independent contractor.

    Reality: The IRS no longer applies its long-standing, much-publicized, andfrequently used 20 Common-Law Factors Test to determine a worker’s status asemployee or independent contractor. The IRS has replaced this test with a newapproach that focuses on three categories to determine if a worker is anemployee or independent contractor: Behavioral Control, Financial Control, andType of Relationship. Companies relying on the 20 Common-Law Factors Test todayrisk costly fines and penalties for worker misclassification by IRS auditors.

    The IRS is specifically targeting companies that have laid off employees tosave costs and then hired independent contractors to perform the same work.Their incentive is the same as that of businesses being audited--the hugeamounts of money not being paid in employment taxes. In short, employers’savings become Uncle Sam’s losses, and Uncle Sam wants his money back! Theanswer lies in recognizing this risk and making sure that you are classifyingyour workforce properly, complying with the agency’s new tests.

    Myth #2: Employers can avoid costly worker misclassification risks bycomplying with the IRS worker-status test.

    Reality: The overwhelming focus on the IRS’s worker-status test by businessand legal advisers has led many employers to believe they can avoid legal risksof worker misclassification entirely by pleasing Uncle Sam. However, the IRS’sworker-status test applies only when businesses need to determine worker statusfor employment-tax purposes. Precious little information is provided about themany other federal (and state) laws governing the workforce, yet each has itsown test to determine worker status, and all differ from the new IRS approach.Four examples are:

    Employee benefits: A 12-factor test determines whether a worker is anemployee or independent contractor under ERISA, the federal law governingemployee benefits.

    Immigration: The Immigration Reform and Control Act (IRCA) applies aseven-factor test to determine worker status.

    Employment discrimination: The Equal Employment Opportunity Commission (EEOC)applies a test based on the "right to control the means and manner of aworker's performance" in federal employment discrimination cases.

    Wage and hour laws: The Fair Labor Standards Act (FLSA) applies an “economicrealities” test, including six factors to determine whether the worker iseconomically dependent on the business to which the services are provided.

    While it is important to learn the worker-status rules under the various lawsand regulations governing the workplace, just knowing that all worker-statustests are not the same is an important first step in reducing legal risks.

    Myth #3: You can avoid costly worker-misclassification liability by complyingwith federal statutes and regulations governing the workforce.

    Reality: Even if your company complies with lengthy lists of laws andregulations governing the workforce, you still risk liability by misclassifyingas independent contractors any workers who are considered to be "common-lawemployees" by our courts and the IRS.

    Many high-profile worker-misclassification lawsuits, whose staggering coststo employers made national headlines, were based on courts’ findings thatplaintiffs were common-law employees.

    The IRS defines a common-law employee as “any individual who, under commonlaw, would have the status of an employee . . . a person who performs servicesfor an employer who has the right to control and direct the results of the workand the way in which it is done. For example, the employer provides theemployee's tools, materials, and workplace, and can fire the employee.” Unlikeindependent contractors, “common-law employees are not self-employed andcannot set up retirement plans for income from their work.”

    Courts and the IRS will find that workers are employees if they meet thecommon-law-employee criteria, whether they are hired as independent contractors,freelancers, or temporary or other “contingent” workers.

    Myth #4: An employment contract expressly stating that a worker is anindependent contractor means that the worker is an independent contractor.

    Reality: In a series of recent cases, several appeals courts across thecountry have ignored or rejected employment contracts that expressly designatedworkers as independent contractors. These and other courts have consideredwritten contracts less important than the actual working relationships, controlof worker performance, and other factors when worker status is at issue.

    In the landmark case Vizcaino v. Microsoft, the Ninth U.S.Circuit Court of Appeals held that Microsoft’s “permatemp” workers werecommon-law employees despite the fact that they had signed written agreementsacknowledging that they were independent contractors.

    Myth #5: Hiring CEOs, CFOs, and officers as independent contractors ratherthan employees is an acceptable, routine, legal business practice.

    Reality: While hiring corporate chief executives as independent contractorsmay be a common, routine, and legal business practice, it carries its own legalrisks for creditors, employees, and shareholders. The currentcorporate-accountability crisis is exposing these risks every day. Consider theEnron case. When Enron hired Stephen Cooper as its new CEO, his contractdesignated him an independent contractor, not a full-time employee. SECinvestigators knew that the independent-contractor status would limit the newCEO’s fiduciary responsibility to the company and its creditors. This wouldhave freed Cooper from fiduciary responsibility to the company and itscreditors. They characterized the designation as “inappropriate” and (joinedby the Florida State Board of Administration, an Enron creditor and shareholder)scolded the company for its independent-contractor designation. The SEC forcedEnron to change Cooper’s contract status to “full-time employee” topromote corporate responsibility.

    Myth #6: All contractors are the same when it comes to legal compliance.

    Reality: All contractors are not the same. The IRS considersindependent contractors to be self-employed. Each is a business owner with theright to choose from various forms of business entity, including a corporation.An independent contractor’s business entity can affect the potential liabilityof any company that hires or manages that person when legal disputes arise.Recognizing that all contractors are not the same can help reduce the cost offuture potential legal disputes in contractor-workforce management.

    Myth #7: Workers’ compensation policies protect employers from liabilityfor work-related injuries suffered by employees, but not independentcontractors.

    Reality: This is true, and therefore the risks of potentially costly legalconsequences also must be considered. Because independent contractors aren’tcovered by an employer’s workers’ compensation plan, hiring independentcontractors (or converting employees to independent-contractor status) can openthe door to personal-injury lawsuits when contractors suffer work-relatedinjuries.

    Because they are not employees, independent contractors who are injured onthe job can bring a personal-injury lawsuit alleging negligence, defectivemachinery or equipment, or other grounds for liability, just like any businesscustomer or client. Employers must recognize the real costs of losing theprotective shield that workers’ compensation provides against such lawsuits.

   The information contained in this article is intended to provide usefulinformation on the topic covered, but should not be construed as legal advice ora legal option. Also remember that state laws may differ from federal laws.