New England Biz Law Update
Many businesses use independent contractors to augment their regular workforce. However, businesses cannot always avoid employer obligations simply by designating certain workers as independent contractors.
The Internal Revenue Service often examines independent contractor relationships to determine whether, in fact, the relationships are really employment relationships because businesses have retained the right to direct and control the workers with respect to when, where and how work is performed. A determination that a company misclassified employees as independent contractors can have serious consequences.
States also have an interest in seeing that employees are not misclassified as independent contractors, as it affects state tax revenues, workers’ compensation, and unemployment compensation. Many businesses are surprised to learn that states often apply different tests than the IRS for determining worker status (at least for purposes of determining worker unemployment benefits).
Massachusetts is one of those states and has gone even further by enacting an independent contractor law that creates a “presumption” of employee status for purposes of the Commonwealth’s wage laws and requires businesses to meet a strict three-part test to overcome this presumption.
Recent amendments to the Massachusetts law make the test essentially impossible to meet for a company with workers providing services that are within the company’s usual course of business. The amendments also broaden the law’s applicability, increase its penalties for noncompliance, and make it a more attractive vehicle for private lawsuits, including class actions.
The Risk of Misclassification
Using independent contractors creates the risk that the IRS or other government authority will determine that a business should have treated particular independent contractors (or an entire class of contract workers) as employees. Misclassifying employees as independent contractors may subject a business to (1) income tax liability for monies that should have been withheld from the “wages” of the “employees;” (2) employer FICA and FUTA contributions; (3) potential overtime pay and other wage claim liability; (4) state unemployment insurance payments; (5) workers’ compensation insurance premiums (and potential liability for workplace injuries); and (6) other civil and criminal liability. Additionally, workers may be entitled to coverage (and benefits) under existing employee benefit plans.
Determining Worker Status
The IRS is responsible for determining whether a worker is an employee or independent contractor for purposes of federal employment taxes. While the term “employee” is defined slightly differently for FICA, FUTA and federal income tax withholding purposes, the principal test applied by the IRS is called the “common law test,” which examines the extent to which the business retains the right to direct and control the worker with respect to when, where and how work is performed.
The IRS has a list of 20 factors in applying the common law test. No one factor is decisive and the degree of importance of each depends on the occupation and factual context in which services are being performed.
The common law test and its 20 factors may be the most well-known test for determining worker status. However, in enforcing the Fair Labor Standards Act (FLSA), which contains federal minimum wage and overtime requirements, the U.S. Department of Labor looks instead to the “economic reality” of the relationship and considers the following factors to be significant: (1) the extent to which the services rendered are an integral part of the employer’s business; (2) the permanency of the relationship; (3) the amount of the worker’s investment in facilities and equipment; (4) the nature and degree of control by the employer; (5) the worker’s opportunities for profit and loss; (6) the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor; and (7) the degree of independent business organization and operation.
The different tests and many factors considered in determining worker status create uncertainty for businesses. Unfortunately, the situation gets more complicated and problematic for businesses when different states in which they operate establish their own, such as has occurred in Massachusetts.
Massachusetts is among 19 states that have a three-part test (the “ABC” test) for determining worker status for unemployment compensation purposes. The strict three-part test makes establishing an independent contractor relationship for unemployment compensation more difficult than the IRS common law test or the FLSA “economic reality” test.
While the test in Massachusetts creates problems for some businesses, at least it is consistent with the law of 18 other states as well as the law’s broad social purpose, which is “to lighten the burden which now falls on the unemployed worker and his family.” M.G.L. c. 151A, Sect. 74.
Massachusetts, however, set itself apart from other states in 1990 when it enacted the Independent Contractor Law, M.G.L. c. 149, Sect. 148B (MICL). In doing so, the Commonwealth took the ABC test, which is generally only contained in unemployment compensation laws, and made it part of to the wage law requirements of MICL. Though significant, for almost 15 years MICL remained somewhat unnoticed. Many businesses using independent contractors continued to view the federal law tests, and especially the 20 factors used by the IRS, as the standard for determining worker status.
MICL was amended on July 19, 2004, and is now getting plenty of attention. The amendments expanded the application of MICL to M.G.L. c. 151 (which contains minimum wage and overtime requirements), increased the penalties for misclassification, and changed the second part of the ABC test to make it impossible for some businesses to meet.
As before the 2004 amendments, MICL creates a presumption that “an individual performing any service” is an employee. To overcome this presumption, the party receiving services must now establish: (1) that the worker is free from its control and direction in performing the service, both under a contract and in fact; (2) that the service provided by the worker is outside the employer’s usual course of business; and (3) that the worker is customarily engaged in an independent trade, occupation, profession or business of the same type.
Prior to the 2004 amendments, the second part of this three-part test stated that a business must establish that “such service is performed either outside the usual course of the business for which the service is performed or is performed outside of all places of business of the enterprise.”
The deletion of the phrase “or is performed outside of all places of business of the enterprise” is very significant and impacts a broad range of businesses that use independent contractors to perform certain work at home, at the contractor’s own place of business, or at client locations.
The 2004 amendments were initiated by Massachusetts construction industry trade unions who view the use of independent contractors by construction companies as a major problem. Companies can save significant costs, including workers’ compensation costs, by classifying workers as independent contractors.
The deletion of the “or is performed outside of all places of business of the enterprise” was viewed, essentially, as closing a loophole in MICL. The amendments were part of a public construction-related bill (Chapter 193 of the Acts of 2004), and passed at the end of the legislative session, in the middle of summer, with little, if any, opposition or debate.
It appears most legislators did not recognize the impact the amendments would have on non-construction industry businesses. And business groups outside the construction industry were unaware of the legislation before it passed and never weighed in on it.
Business groups believe that the broad impact of the deletion of the “or is performed outside of all places of business of the enterprise” language was not intended.
Regardless, as a result of the amendments to MICL, many types of businesses can no longer properly classify workers as independent contractors. Affected businesses include accounting firms, law firms, engineering firms, various consulting firms, and home health care businesses, among many others.
In December 2004, the Massachusetts Attorney General issued an “advisory” which declared that MICL, as amended, “excludes far more workers from independent contractor status than are disqualified under the IRS common law test.”
The Attorney General noted that, while the 20 factors considered by the IRS are considered flexible and can be adjusted to the circumstances of the work arrangement, Massachusetts law establishes a rigid, three-part test that must be met to overcome the law’s presumption of an employment relationship.
MICL has other significant provisions.
A written contract or job description indicating that a worker is free from supervisory direction or control is required to establish independent contractor status (at least according to the Attorney General). An employer’s failure to withhold taxes, contribute to unemployment compensation, or provide worker’s compensation may not be considered when determining worker status, thus suggesting that an employer’s subjective belief that a worker is an independent contractor has little relevance under the law.
The law also creates broad liability for both business entities and individuals, including corporate officers and those with management responsibility over affected workers.
The Attorney General can issue civil citations and institute criminal prosecution for both intentional and unintentional violations of MICL. Willful violations can result in fines up to $25,000 or imprisonment for up to one year for a first offense, and fines up to $50,000 or imprisonment for up to two years for subsequent violations.
Non-willful violations can result in fines up to $10,000 or imprisonment for up to six months for a first offense, and fines up to $25,000 or imprisonment for up to one year for subsequent violations.
Employees also may file civil actions for themselves and others similarly situated seeking treble damages, attorneys’ fees and costs. This is a fertile area for claims, and money damages can be substantial.
For example, if a group of workers treated as independent contractors worked over 40 hours per week without receiving one and one-half times their regular rate of pay, damages may include three times the owed overtime pay for a period going back as far as three years.
What Should Businesses Do?
What should businesses do? All companies using independent contractors need to evaluate these relationships carefully to determine whether the classification is proper under the MICL. (Of course, in the process some businesses will learn that their independent contractors are misclassified even under federal law and/or the pre-amended MICL.)
All written independent contractor agreements should be reviewed carefully and modified where appropriate. According to the Attorney General, MICL requires that all independent contractor relationships be reflected in written agreements or job descriptions.
After evaluating independent contractor relationships it may become clear that certain workers are misclassified under the MICL test and should be treated as employees. One option is to do nothing and hope that no worker complains, the Attorney General’s Office does not come knocking, and maybe the Legislature will recognize the problems created by the amended MICL and do something about it.
Indeed, there is some hope among business groups that corrective legislation will be enacted to eliminate the “unintended impact” of the amendments.
Doing nothing, of course, has its risks. MICL gives the Attorney General and private litigants potent ammunition in the form of stiff penalties, treble damages, and the right to recover attorneys’ fees and costs.
The Attorney General’s approach to enforcing the amended MICL is not yet clear. Will it be more aggressive as a result of the amendments, perhaps targeting particular industries for non-compliance? Only time will tell.
Regardless, private civil actions may pose the greater danger for businesses. As word of MICL spreads, more and more workers and attorneys will recognize it as a relatively easy way to recover money from non-compliant businesses, particularly those businesses that use many independent contractors.
As a result, many businesses will decide to stop using certain (or all) independent contractors, or to change the status of these workers to employees. Where workers are reclassified, businesses will have to consider whether the reclassifications will be retroactive or just prospective.
What are the legal ramifications? What effect will the reclassifications have on employee benefits? Businesses will need to examine employee handbooks, policies and benefit plan documents to ensure that no unintended extension of employer obligations or employee benefits results from reclassification. Employer plans and policies may need to be amended.
Another alternative is to maintain the independent contractor relationships but take steps to limit potential exposure.
Robert M. Shea, a shareholder of Morse, Barnes-Brown & Pendleton, P.C. (www.mbbp.com) counsels businesses and individuals in all areas of employment and labor law. He represents clients in employment litigation before federal and state courts and agencies, and also serves as a neutral in mediation and arbitration proceedings. He can be reached at (781) 622-5930 or [email protected]. Morse, Barnes-Brown & Pendleton provides sophisticated legal services and practical advice to businesses, from technology start ups to Fortune 500 companies.
