Outside Publication

Company-Contractor Relationships Draw Scrutiny, The National Law Journal

April 11, 2016

Businesses relying on independent workers should review their procedures and ways to mitigate risk.

Given the increasing scrutiny of contractor relationships, companies relying on independent contractors should evaluate that practice and their options for risk mitigation.

Contractor misclassification can lead to not only costly government audits seeking unpaid taxes and wages, but also to class and collective actions advancing claims for overtime, wage deductions, unreimbursed business expenses, derivative state law claims — for example, for meal and rest breaks — and demands for penalties under new state misclassification laws.

Shortly after the 2008 financial ¬crisis, companies were slow to return to precrisis employment levels, sometimes easing their way back by relying on ¬independent contractors rather than adding full-time employees. And in recent years, emerging businesses that are part of the "gig economy" have taken the use of contractors to a whole new level as the centerpiece of their new business models.


Meanwhile, federal and state tax authorities were looking closely at business practices limiting the funds flowing to their coffers. Widespread use of independent contractors has led to reductions in payroll tax contributions, heavy business-expense deductions by the contractors that are free from the limits on employee deductions for unreimbursed expenses, and reduced contributions to workers' compensation and unemployment insurance funds.

Employee rights groups, the media and the public have increased attention on the contractor issue. From a policy standpoint, government agencies have been similarly concerned with reliance on contractors rather than on employees. Use of contractors limits job growth numbers and contractors lack the cushion of unemployment insurance.
Concerns with the absence of minimum-wage and overtime protections for contractors have fueled renewed interest from federal and state departments of labor. Many of those agencies have entered into information-sharing agreements with tax authorities due to their shared trepidation.

It is no surprise that the federal Department of Labor has been focused on independent contractors since David Weil assumed leadership of its Wage and Hour Division.
As a professor, Weil wrote regularly on what he called "fissured employment" — the prevalence of various nontraditional working relationships like franchisor/franchisee arrangements, staffing agencies and of course independent contractors. On behalf of the department, he released an administrative interpretation in July 2015, declaring: "In sum, most workers are employees under the [Fair Labor Standards Act's] broad protections."
The nonbinding administrative interpretation is only now starting to work its way through the courts so it remains to be seen how persuasive it will be with judges. But if a court defers to the department's views, the interpretation can be read to reign in the kinds of working relationships that legitimately can be classified as independent contractors.

For instance, the interpretation sets a very high bar for one of the factors identified as relevant to the contractor/employee analysis. It suggests that an individual is more likely an employee than a contractor if they invested less in their business than the larger contracting company invested in its own business. But that will almost always be the case.

The interpretation also focused on whether an independent contractor provides a service "integral" to a company's business, which the interpretation called a "compelling" factor. This analysis presents particular challenges for gig-economy companies for which independent contractors are central to the business model.

And federal law is certainly not the end of the analysis. California law differs in that it focuses on the "right" to control an independent contractor rather than "actual" control exercised.

Plaintiffs' lawyers have argued that this makes contractor misclassification class actions particularly susceptible to certification where companies rely on template contracts, which is common.

Other states, like Massachusetts, use an entirely different "ABC" test for contractor status. Unlike the balancing test under federal law, the ABC test often calls for a putative employer to prove that each of its three factors favor contractor status. If not, a worker is deemed an employee. The second "B" factor has received the most attention in litigation, as it can support a finding of employee status if a worker is not providing services outside of a company's usual business. Plaintiffs' lawyers have used this factor to turn up the heat on companies using contractors for core business functions.

Given this action among government authorities and in the courts, the time is ripe for companies to take a close look at their use of independent contractors.

The first step is often just to identify the contractors. In-house lawyers are regularly surprised to learn about the widespread use of these relationships throughout a business — often without any central approval or tracking.

Next, companies should ask what sounds like an easy question — why are these workers classified as contractors rather than employees? Time and again, companies have realized they don't have an answer other than "because it's how we've always done it" or "it's what the workers want for tax reasons."

Neither of those answers presents a compelling reason for a company to take on risk. Similarly, the cost of using contractors may be higher than hiring employees, eliminating budget cost as a justification for using contractors.

Having identified contractors and evaluated any reasons to retain contractor status, companies should bucket the relationships based on risk.

Depending on the states where contractors work, some of which may apply the ABC test or other demanding tests, and also on the nature of the contractor relationship, it may be time to reclassify some of these workers as employees in order to reduce risk. Doing so, however, requires a carefully managed process and communication plan in order to avoid stirring up litigation.


For those who will remain contractors, the contracts that delineate the parties' obligations generally can be improved to better support contractor status. And employers can consider adding to contracts an arbitration provision with a class/collective action waiver. The U.S. Supreme Court repeatedly has enforced those waivers, which cut off the greatest risk for businesses under federal and state wage-and-hour laws.

Defending an individual contractor misclassification claim in arbitration is one thing, but defending a class or collective action on behalf of dozens, hundreds or even thousands requires a considerable investment in fees and can develop into a major distraction for a business, potentially resulting in millions of dollars of liability.

Finally, companies relying on contractors should reconsider training, policies and manuals directed at independent contractors, evaluating the language of each and whether it could be argued as evidence of control supporting employee status.
Similarly, company managers who interact with independent contractors can benefit from training on proper communications with contractors so that they are not construed as exercising undue control.

The recently increased scrutiny of independent-contractor relationships may only be the beginning of this trend. Companies are well-advised to get out in front of this issue and work with counsel to attempt to limit risk before becoming a target.

Reprinted with permission from the April 11, 2016 edition of The National Law Journal© 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.