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Employers Beware! Government Agencies Are Out To Bust You For Misclassifying Your Employees As Independent Contractors

Categories: Employment, Article

Don't missclassify employees as independent contractors

Both federal and state labor authorities are hot on the trail of companies who hire employees and call them "independent contractors."  The United States Department of Labor (DOL) has entered into a Memorandum of Understanding with a number of states, including Arizona, mandating the enforcement of laws pertaining to properly classifying employees as employees.  The DOL and these states have made this issue an enforcement priority and may soon be asking questions at your place of business.

What is an Independent Contractor?

An independent contractor is hired on a contract basis to do work that is typically independent, unsupervised and limited in time, scope and duration.  An employee is hired on an at-will or contract basis to do work that is typically supervised, regular and ongoing and is only generally limited in scope by the kind of work she is hired to do.  Payments to independent contractors are reported on 1099s.  Payments to employees are reported on W-2s.   

Companies may think that hiring independent contractors rather than employees saves them money.  If you hire an independent contractor, you avoid having to withhold FICA and state and federal income taxes and paying for workers' compensation, health insurance and other benefits that are otherwise available to your employees.  

Employee or Contractor?

The only problem is you likely can't get away with it.  You can't call an employee an independent contractor if the employee is not really an independent contractor – if it looks like a duck, etc.  If you do, and any one of a number of government agencies finds out, you could be liable for years of unpaid payroll withholdings, insurance benefits and even on-the-job injuries that should have been covered by workers' compensation.  One government agency talks to the other, and, if found guilty by one, you can bet the others will be in quick pursuit.  Before you know it, you're dealing with the DOL, the IRS, the Arizona Department of Economic Security and some government agencies you've never even heard of.

Of course, not all independent contractors are really employees. There are many people who own their own business, who are truly independent and who market their services to multiple clients or customers.  They are legitimate independent contractors.  An "outside" IT professional, for example, is likely to be an independent contractor if she owns her own business, serves other clients and works on your computers only if and when her services are needed.  That same IT professional, however, may be an "inside" employee if she has only one client (you), works regular hours (either full or part-time) and is paid an hourly wage or salary for being there to work on your computers.  That is usually an easy call to make.  In many other cases, however, it is not so easy to tell if someone is an independent contractor or really an employee.   

Take exotic dancers.  Strip clubs in Phoenix and elsewhere around the country are being sued by exotic dancers for alleged violations of the Fair Labor Standards Act (FLSA), a federal law that requires employers to pay their employees minimum wages and overtime pay.  These dancers claim that strip club owners have misclassified them as independent contractors and that, because they are really employees, the owners have violated the FLSA and similar state laws by failing to pay them as employees entitled to minimum wages and overtime pay. So what makes them employees and not independent contractors?   

There are various "tests" that courts and government agencies use to determine whether someone is an employee or an independent contractor.  Each test is somewhat different, but all of them share a common goal of protecting the rights of workers who look like, but are not treated like, employees. 

Arizona's "Right to Control" Test

AZ Right to Control Test

Arizona courts and state agencies use a "right to control test."  This test, found in A.R.S. ¶23-902, examines: (1) whether an employer "procures work to be done for the employer by a contractor over whose work the employer retains supervision or control," and (2) whether "the work is a part or process in the trade or business of the employer." A.R.S. ¶23-902(B).  If these criteria are met, the person doing the work is an employee.  Conversely, if someone is "not subject to the rule or control of the business for which the work is done, but is engaged only in the performance of a definite job or piece of work, and is subordinate to that business only in effecting a result in accordance with that business design," the person doing the work is an independent contractor.  A.R.S. ¶23-902(C). 

Courts consider the "totality of the circumstances of the work and various indicia of control between the parties" to apply this test.  Reed v. Indus. Comm'n, 23 Ariz.App. 591, 593, 534 P.2d 1090, 1092 (1075).  The "indicia of control between the parties," or factors that agencies and courts consider when applying the test, include:

  1. The duration of the employment;
  2. The method of payment;
  3. Who furnishes necessary equipment;
  4. The right to hire and fire;
  5. Who bears responsibility for workmen's compensation insurance;
  6. The extent to which the employer may exercise control over the details of the work; and
  7. Whether the work was performed in the usual and regular course of the employer's business.

Read, 534 P.2d at 1092, citing Home Ins. Co. v. Indus. Comm'n, 123 Ariz. 348, 350, 599 P.2d 801, 803 (1979).  It is important to remember that it is the existence of theright to control, not the actual control of, a worker's activities that determines the issue.  Scott v. Rhyan, 78 Ariz. 80, 82, 275 P.2d 891, 892 (1954).[1]

The FLSA "Economic Reality" Test

FLSA Economic Reality Test

Federal courts and government agencies use what they call the "economic reality" test to determine employee status under the FLSA.  See Goldberg v. Whitaker House Co-op., Inc., 366 U.S. 28, 33 (1961) (the "economic reality" of an employment relationship, rather than "technical concepts," determines whether someone is an employee under the FLSA); Hale v. State of Ariz., 993 F.2d 1387, 1393-94 (9th Cir. 1993) (same).  The stated goal of this test is to determine the economic reality of the parties' relationship.  The Ninth Circuit Court of Appeals, which decides federal case appeals filed in Arizona, has applied six factors to make that determination:

  1. The degree of the alleged employer's right to control the manner in which the work is to be performed;
  2. The alleged employee's opportunity for profit or loss depending upon his managerial skill;
  3. The alleged employee's investment in equipment or materials required for his task, or his employment of helpers;
  4. Whether the service rendered requires a special skill;
  5. The degree of permanence of the working relationship; and
  6. Whether the service rendered is an integral part of the alleged employer's business

Collinge v. IntelliQuick Delivery, Inc., 2015 WL 1292444, 2-3 (D.Ariz. 2015), citingReal v. Driscoll Strawberry Associates, Inc., 603 F.2d 748, 754 (9th Cir. 1979).  These six factors mimic the Arizona right to control test factors.

Federal courts have said that the most important factor in the economic reality test is the crux of the Arizona right to control test – the right of an employer to control the work.  See Maddock v. KB Homes, Inc., 631 F.Supp.2d 1226, 1234 (C.D.Cal. 2007). According to the Ninth Circuit Court of Appeals, the economic reality test is "broader than the right-to-control test, covering 'situations where the worker is not directed or controlled by the employer but, nevertheless, as a matter of economic reality, depends on the employer.'" Slayman v. FedEx Ground Package Sys., Inc. 765 F.3d 1033, 1047 (9th Cir. 2014).  In both theory and practice, however, either test likely leads to the same result.  See, e.g., Slayman, 765 F.3d at 1047 (applying Oregon's version of the economic reality test to determine that Fed Ex drivers are employees, rather than independent contractors, entitled to overtime pay), Alexander v. FedEx Ground Package Sys., Inc., 765 F.3d 981, 997 (9th Cir. 2014) (applying California's right to control test to reach the same result); Collinge v. IntelliQuick Delivery, Inc.,supra, 2015 WL 1292444, 2-3 (applying the economic reality test to determine class certification issues with regard to IntelliQuick delivery drivers).

The Title VII Common Law Agency Test

Federal courts and government agencies use what they call a common law agency test to determine employee status under Title VII, a collection of federal laws that protect employees from discrimination, harassment and retaliation on the basis of sex, race, religion, disability and other protected classes.  See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323 (1992); Murray v. Principal Fin. Grp., Inc., 613 F.3d 943, 945 (9th Cir. 2010).  This common law agency test has 12 factors:

  1. The skill required;
  2. The source of the instrumentalities and tools;
  3. The location of the work;
  4. The duration of the relationship between the parties;
  5. Whether the hiring party has the right to assign additional projects to the hired party;
  6. The extent of the hired party's discretion over when and how long to work;
  7. The method of payment;
  8. The hired party's role in hiring and paying assistants;
  9. Whether the work is part of the regular business of the hiring party;
  10. Whether the hiring party is in business;
  11. The provision of employee benefits; and
  12. The tax treatment of the hired party.

Murray, 613 F.3d at 945-46.  Here again, these factors mimic the Arizona right to control test factors – although we have now jumped from six or seven factors to 12 factors – and the most important factor is the right of an employer to control the work.  See Drottz v. Park Electrochemical Corp., 2012 WL 1344729, 5 (D.Ariz. 2012) (commenting that the Title VII common law agency test factors all point to the employer having "complete control over the manner and means of Plaintiff's work").

The IRS 20-Factors Test

Federal courts and government agencies use the multi-factor test published by the Internal Revenue Service (IRS) to determine employee status for income tax and payroll withholding purposes.  See IRS Rev.Rul. 87-41 (1987); United States v. Kahre, 737 F.3d 554, 580-81 (9th Cir. 2013), cert. den.¸ 135 S. Ct. 59 (2014).  As we can expect from our favorite government bureaucracy, we have now jumped from six or seven factors to 12 factors to the following "non-exhaustive" 20 factors:

  1. Whether the employer has the right to control how the work results are achieved, and if there are instructions regarding when, where, and how to work;
  2. Whether the employee has been trained to perform services in a particular manner;
  3. Whether the services are integrated into business operations, showing the employee is subject to direction and control;
  4. Whether the services are rendered personally, showing the employer is interested in the methods as well as the results;
  5. Whether the employer or the worker hires, supervises, and pays the assistants;
  6. Whether the employee has a continuing relationship with the employer, even if work is performed at irregular intervals;
  7. Whether the employee has set hours of work established by the employer;
  8. Whether the employee ordinarily devotes full time service to the employer or the employer may have a priority on the employee's time;
  9. Whether the work is performed on the premises of the employer or at a location determined by the employer;
  10. Whether the employee is required to perform services in the order or  sequence set by an employer;
  11. Whether the employee must submit reports to the employer;
  12. Whether the employee is paid by the hour, week, or month; or instead, paid as an independent contractor by the job or on a straight commission;
  13. Whether the employee's business and travel expenses are generally paid by the employer and are subject to the employer's regulation and control;
  14. Whether the employee is furnished with significant tools, materials, and other equipment;
  15. Whether the independent contractor has a significant investment in the facilities she uses in performing the services for someone else;
  16. Whether the independent contractor can make a profit or suffer a loss;
  17. Whether the independent contractor is free to provide her services to two or more unrelated persons or firms at the same time;
  18. Whether the independent contractor makes her services available to the general public;
  19. Whether the employee can be fired, or whether the independent contractor cannot be fired so long as she produces a result that meets the specifications of the contract; and
  20. Whether the employee has the right to quit her job at any time without incurring liability.

Walker v. Apfel, 1999 WL 1000436, 2, n. 1(N.D.Cal. 1999) (omitted factor added);see Rev. Rul. 87–41; 40 T.A.C. §821.5 (1998).  Once again, these factors mimic the Arizona right to control test factors, though in a far more expansive and detailed way, and, once again, the primary concern is the right of an employer to control the work. See United States v. Kahre, 737 F.3d 554, 580-81 (9th Cir. 2013). cert. denied, 135 S. Ct. 59 (2014) (when the IRS 20-factor test is applied, the relationship of employer and employee generally  exists when "the person or persons for whom the services are performed have the right to control and direct the individual who performs the services . . . .").

Conclusion

The exotic dancers who have sued strip clubs claim they are employees rather than independent contractors because they have to follow the owners' rules that seem to make them look like employees. They are "hired and fired," they are economically dependent on their continued employment, they are disciplined, their works hours and performances are scheduled, they are supervised and instructed about when, where, and how they perform their work, and their dancing is an integral part of the owner's business.  Many state and federal courts that have addressed this hot topic have agreed and have found them to be employees who are entitled to employee wages and benefits.  See, e.g., Hart v. Rick's Cabaret Int'l, Inc., 967 F.Supp.2d 901, 912-13 (S.D.N.Y. 2013) (citing cases).  The Hart Court recently awarded nearly $11 million in unpaid minimum wages to a class of dancers.  Even exotic dancers have a right to earn a decent living. 

Whether it is dancers or truck drivers or IT professionals, the last thing you need is for the government to investigate the employment status of your independent contractors.  Given the DOL's current mandate, the risk of that happening has never been greater, and the potential for multiple-agency consequences if you are caught have never been higher.  You should manage that risk and those potential consequences by hiring competent legal counsel to review your employee/contractor records before the government does.


About the author: David N. Farren is an attorney at the Phoenix law firm of Jaburg Wilk and works in employment law, antitrust, and commercial litigation. 


[1] It can be helpful to have a written contact with someone to prove that they are an independent contractor.  See, e.g., A.R.S. ¶23-902(D) (a contract that contains certain provisions may create a rebuttable presumption that someone is an independent contractor for workers' compensation purposes). A contract is not conclusive evidence of independent contractor status, however, and courts will apply the right to control test factors to determine whether an independent contractor is really an employee regardless of what the contract says.