Small employers in particular, but not exclusively, too often fall into the trap of classifying individuals who work for them as independent contractors when that classification does not actually align with the work being performed.  Federal and state labor laws and tax laws dictate whether an individual worker is appropriately classified as an employee or an independent contractor.  Organizations that get that wrong face a multitude of legal challenges.

What Are the Risks?

Misclassifying a worker as an independent contractor can easily subject an organization to legal challenges and administrative sanctions by at least four government entities:

• The state unemployment insurance board will require retroactive filing of regular payroll withholding reports (in New York State, these are the quarterly NYS-45 forms) and retroactive payment of contributions, plus penalties and interest;
• The state workers’ compensation board will require securing workers’ compensation coverage and retroactive fines and penalties for not having the policy in place sooner;
• The state tax department may require refiling of state tax returns for the relevant period and payment of withholdings with penalties and interest; and
• The Internal Revenue Service may require refiling of federal tax returns for the business for the relevant period and payment of Social Security and Medicare contributions, as well as withholdings for the relevant period, all with penalties and interest.

In states like New York that require employers to maintain short-term disability insurance and/or payments into a paid family leave insurance fund, organizations are likely to face additional fines and penalties for failing to maintain that coverage during the relevant period.

How Does the Government Know?

It only takes one inadvertent disclosure by an individual to initiate a legal mess for an organization.  Most of the situations for which our firm has been retained arose from an individual filing a claim for benefits and listing an organization (let’s refer to that as “Selected Org”) as a current or former employer.  This has included:

• times when an individual worked as a contractor, left Selected Org, was hired as an employee by another organization, was terminated by that new employer, and then provided recent employment history that listed both the new employer and Selected Org on the individual’s application for unemployment insurance benefits;
• times when an individual was still working for Selected Org as a contractor, but filed for unemployment benefits on the advice of a friend after Selected Org scaled back the individual’s hours; and
• times when an individual was working for Selected Org as a contractor and filed for disability or paid family leave benefits.

The claim by one individual may trigger an audit, requiring disclosure of all other individuals and entities classified as contractors who have done work for the same organization.  An audit may also be initiated by an individual whistleblower report.  In either case, the issue of potentially misclassifying one individual prompts a far broader inquiry and production of reams of contracts, tax filings and payment records.  In New York, work sharing arrangements, at least within the state Department of Labor, mean that an employer facing a worker classification inquiry by the Unemployment Insurance Board should anticipate that it will trigger an inquiry by the Workers Compensation Board, and vice versa.

What If the Individual Had Asked to Be Classified as a Contractor?

Worker classification cannot be a matter of personal preference.  Individuals may want to be classified as independent contractors because they believe in doing so they can reduce their tax liability.  They may like the perceived flexibility and independence of considering themselves a separate business, as that classification may bring with it some control over hours worked, types of work assigned, or work location.  The individual may even be the one to propose the arrangement and offer a simple form independent contractor agreement.

Just because a piece of paper – signed by both the individual and the organization – says that the individual is an independent contractor does not make it so as a legal matter.  The government may not recognize that arrangement, and the contract alone will not preclude the individual from filing for and successfully receiving government benefits as an employee.

When Does the Government Consider Someone a Contractor?

There is no universal test to determine a worker’s classification.  The federal and state law tests differ, the test varies among different states, and even within the same state the factors considered by the state tax department may not be the same as those considered by the state labor department.

Fundamentally, all the tests arise from the common law concept of whether the organization controls the manner and means by which the individual is doing the work, and the relationship between the work being provided by the individual and the core functions of the organization’s business.  For example, a lawyer providing legal advice to a retail store is likely an independent contractor – the lawyer acts independently, outside the premises of the retail store, offering services to a wide range of other clients, and legal services are not core to the retailer’s business.  A cashier, on the other hand, is likely operating under the aegis of the store owner or manager and is providing services in recording sales and receiving payment from customers, that are essential to a retail operation, such that the cashier should be classified as an employee.  These examples are at the extremes, but they frame the parameters of the analysis.

Employment status also does not depend on the number of hours worked or the duration of the work.  The government tests may dictate classification of an individual as an employee even if work is only performed on a part-time or casual basis.

Organizations should audit their existing arrangements with their workers, and assess whether they can clearly support an independent contractor classification.  When in doubt, the organization should get legal advice.

By Tracey I. Levy