:: Worker Misclassification Investigations Gain Momentum

t the federal level, Senator Barack Obama (D-Ill.) has introduced S.2044, the Independent Contractor Proper Classification Act. If enacted, this legislation would limit the availability of the “safe harbor” provisions in the Revenue Act of 1978,1 permit workers to petition the IRS for a determination of their status as an independent contractor or employee, and mandate that employers post notices to employees and independent contractors informing them of their right to challenge their classification as an independent contractor. The legislation is being considered by the Senate Finance Committee.

The Risk of Using Independent Contractors, The New York Law Journal (May 15, 2008)

In the employee benefits context, classification of workers as employees or not is a critical presuppositional issue that will affect the validity of many subsequent judgments in the administration of employee benefit plans. For example, including non-employees in a qualified retirement plan violates the exclusive benefit rule and may lead to plan disqualification. On the other hand, treating those who are properly classified as employees as independent contractors presents an array of significant, potentially devastating, risks as well.

It is this latter problem that has made the headlines of late. The New York Law Journal article published today gives a succinct treatment of the risks of misclassifying employees as independent contractors.

Know The Risks

Here is a summary of risks noted by the authors:

  • liability for unpaid federal, state and local income tax withholdings
  • liability for Social Security and Medicare contributions
  • liability for unpaid unemployment insurance premiums
  • liability for unpaid Workers’ Compensation premiums
  • liability for unpaid overtime compensation and work-related expenses
  • liability for claims of benefit entitlement to pension and profit-sharing benefits, medical benefits
  • liability for incentive compensation, such as bonuses and stock options

The total bill can be ruinous for the small to medium size employer, and punishing even for the large employer. In the case of the much-publicized Fed Ex debacle, the IRS is claiming $319 million in back taxes.

Indeed, Fed Ex has been the poster child for this issue.

From the NY Law Journal article:

The transportation industry has been on high alert in the past year, not only because FedEx Ground has been assessed more than $300 million by the IRS over its classification of drivers but also because several lawsuits have challenged the industry practice of classifying drivers as independent contractors. In November 2007, the California Supreme Court affirmed a lower appellate court ruling that more than 200 drivers used by FedEx Ground in that state were employees and not independent contractors. As a result, FedEx Ground is required to reimburse its drivers in that state for work-related expenses, which together with payment of the plaintiffs’ legal fees is expected to exceed $13 million. FedEx Ground is also defending a nationwide ERISA class action involving allegations that its 20,000 drivers are common law employees and therefore entitled to employee benefits under certain of its Employee Retirement Income Security Act plans.

And then there is the risk of class action litigation – see :: Seventh Circuit Rejects FedEx’s Request To Review Class Certification.

A Foreboding Trend

Undoubtedly, some industries are both more prone to misclassify workers and more vulnerable to challenge due to the nature of the work involved. Construction, transportation and even the medical profession have proven at risk on the issue. Again from the article:

The medical profession in New York has also been thrown into disarray regarding the use of independent contractors. For years it has been assumed that physicians on the medical staffs of hospitals were independent contractors. The U.S. Court of Appeals for the Second Circuit recently ruled, however, that a lower court erred when it held that a gastroenterologist at an upstate New York hospital was an independent contractor and not an employee for purposes of her Title VII lawsuit.

For regulators and taxing authorities, the outcomes are really as valuable as tax increases. They have gained momentum as this realization has taken hold. New York and New Jersey are among the states enacting legislation directed at worker misclassification abuse. And, as noted at the outset, the Senate has begun to give the issue consideration as well.

What To Do

From the employee benefit perspective, it is vital to examine the basis for classification of workers with a view to the common law control factors as well as plan eligibility language. The problem is particularly acute when employers are part of a controlled group of entities as defined in ERISA (Title I & II). Insurance contract language must be examined with care. The effect of employee leasing or “co-employment” or any other novelty of work for hire must be assessed on a “what if” basis.

The status of a worker as an employee or not is an assumption that runs like the vagus nerve throughout the entire spectrum of benefits and compliance. Given the trend is to challenge worker classification, the prudent employer will take steps to correct past errors, document compliance and examine alternatives that reduce exposure going forward.

Note: I am not as sanguine as the authors appear to be as to how employee leasing entities can aid in resolution of the issue. See, e.g., :: PEO’s “Co-Employer Artifice” Rejected As “Contrary To Reality”

Examination of indemnification provisions in contracting for services in this context would be at the top of my list of due diligence initiatives. For technical background on the tax implications of classification, the “Who Is The Employer?” series on BenefitsLink remains one of the most accessible and thorough treatments of the subject on the web.