Employee or contractor? Worker misclassification is costing employers

By Tina Irgang

In June, FedEx agreed to pay $240 million to settle a lawsuit brought by some 12,000 drivers. The drivers had argued that they were employees of FedEx, but had erroneously been classified as independent contractors.

The settlement came just two months after ride-hailing giant Uber said it would pay up to $100 million to 385,000 drivers in California and Massachusetts. Those drivers also said they had been misclassified and were therefore owed overtime pay, tips and reimbursements for expenses. In August, a federal judge rejected Uber’s settlement offer, saying it was not “fair, adequate and reasonable.” The plaintiffs had estimated Uber’s total liability to the drivers at more than $850 million, according to Wired, so it’s likely that the company’s eventual liability will be closer to that amount.

Misclassification suits involving big businesses are the ones dominating the headlines, but that doesn’t mean smaller businesses aren’t at risk of penalties. In fact, employment attorneys say businesses of all sizes are committing classification errors because they misunderstand or don’t know the rules.

“I don’t think most employers are doing this for nefarious purposes,” says Michael S. Cohen, partner at Duane Morris, LLP’s Philadelphia office. “It’s just the way things were done for a very long time. Employers who didn’t have a complete understanding of what the nature of a contractor relationship was just assumed they could classify someone as an independent contractor.”

“Everyone thought it was this great cure-all and the answer to their economic woes,” says Nicholas Woodfield, principal attorney and general counsel at The Employment Law Group. “We don’t have to put [contractors] on the 401(k), we don’t have to pay unemployment. … The idea sort of spread, like lice in a classroom of kids.”

However, the government is now paying attention. “The Department of Labor (DOL) issued guidance in July of 2015 on this misclassification issue, expressing very deep concern that
there are a lot of employees who are classified as independent contractors,” Cohen says. “Clearly, they’re taking the position that most people performing work are employees.”

Why is misclassification a government focus?

While the DOL seems a natural fit to focus on worker misclassification, the IRS has also been taking an interest. Why? The government “may receive less tax revenue from independent contractors than employees with equivalent incomes,” says Declan Leonard, a managing partner at Berenzweig Leonard, LLP. For example, contractors are not subject to tax withholding, but instead pay “estimated taxes” throughout the year, he notes.

The DOL, on the other hand, is primarily concerned with enforcing key laws designed to ensure workers receive benefits due to them, says Jack Garson, an attorney at Garson Law LLC. Those are the Fair Labor Standards Act, which governs minimum wage and overtime payments, and the Family Medical Leave Act (FMLA), which requires businesses to provide their employees with job-protected leave for family and medical reasons.

“A misclassified worker may be wrongfully denied important benefits such as health insurance, family and medical leave, unemployment insurance, and employer-provided workers’ compensation,” notes Leonard.

So how does the government learn of a suspected violation? While both the IRS and the DOL will periodically conduct proactive audits of businesses, the majority of misclassification cases are the result of complaints, says Garson. “A worker will go to an attorney and complain about an issue that’s really bothering them” — say they didn’t receive a payment that they felt was due to them, he says. In the course of the conversation, the attorney takes a look at the worker’s contract with the company. “That’s when I say, wait a minute, this isn’t a contractor agreement — it’s an employment agreement,” says Garson.

What are the penalties?

In fiscal year 2014 alone, DOL misclassification investigations resulted in about $80 million in back wages being awarded to more than 100,000 workers, says Cohen.

The penalties of misclassification are “not at all insignificant,” notes Garson. “For example, if you treated someone as an independent contractor, you failed to do withholding of their employment taxes, and that’s not only their but your matching taxes,” he says.

A business that’s found to have misclassified its employees as independent contractors could also be liable for Social Security and Medicare contributions, notes Leonard. In addition, the misclassified worker may be due unpaid workers’ comp premiums, back wages, work-related expenses, and sick and vacation pay. There could also be civil penalties associated with failure to provide FMLA leave or health benefits required under the Affordable Care Act, he adds.

Garson recalls one case where a company was forced to pay some $100,000 for the surgery of an employee who had been misclassified and therefore wasn’t covered by the company’s health insurance.

Then there’s the possibility that the government could interpret your violation as intentional — meaning you knew the worker was an employee — which would trigger criminal penalties, Garson adds.

Who is a contractor? Common misunderstandings

However, for those employers who are committing unintentional violations, misconceptions about the relevant laws are often the culprit. Here is a list of common assumptions that may lead you to misclassify employees:

  • Our contract agreement clearly states that the worker is an independent contractor.
    “A rose is a rose by any other name, including that of independent contractor,” says Garson. “Just because you call someone an independent contractor doesn’t make them one.”
  • I pay these workers by commission only, so they must be contractors. “The method of payment is not in and of itself a determining factor for independent contractor status,” says Leonard.
  • If the worker opts out of being an employee, I’m OK. “With so many things in the business world, if you have a contract, you can change you rights,” notes Garson. “But in the employment world, it’s not at all like that.” Employees cannot waive their rights as an employee even by signing a contract. That’s because the government feels that if employees’ rights could be waived, “every employer would make them waive those rights as a condition of employment,” says Garson.
  • Any workers that I hired through a staffing agency must be independent contractors. “A joint employment relationship may exist between the on-site employer and the staffing firm, whereby both are jointly and severally liable for violations of employment and tax laws,” says Leonard.

Even if you think you know the law, however, it’s in your company’s best interest to take a good look at all contractor agreements — and not just because of a fear of penalties.

“I actually think it’s good for companies to take those extra steps and have workers as actual employees,” says Leonard. “You want to know workers are loyal and have some vested interest in your company. With independent contractors, you don’t get that same level of commitment.”


A bewildering number of criteria governs whether workers are considered employees or contractors. The IRS has a set of 20 questions it uses to determine employment status. Then there are state laws to consider, and you need to be aware that courts will use whatever legal standard is most favorable to the worker, notes Michael Cohen, a partner in Duane Morris, LLP’s Philadelphia office.

That’s why your best bet in rooting out misclassification at your company is to consult an attorney. However, as your introduction, here is the six-part “Economic Realities Test” used by the Department of Labor to determine whether a worker is an employee:

1. Is the work an integral part of your business? If so, it’s more likely that the worker performing it is an employee. For example, it’s unlikely you would be able to argue that the person managing projects for your construction company — and yours alone — is a contractor, says Declan Leonard, a managing partner at Berenzweig Leonard, LLP.

2. Do the worker’s manager skills affect his or her opportunities for profit and loss? If workers circulate advertising, decide whether to hire helpers to assist in a job, or recruit new clients, they are probably independent contractors, says Leonard.

3. How does the worker’s investment compare to the employer’s investment? If you supply the tools workers need to perform their job, it’s more likely you’re dealing with an employee, says Leonard. Even issuing a laptop to the worker could count in favor of an employment relationship.

4. Does the work performed require special skills or initiative? This doesn’t necessarily mean technical skills. “For example, specialized skills possessed by carpenters, construction workers and electricians are not themselves indicative of independent contractor status; rather, it is whether these workers take initiative to operate as independent businesses, as opposed to being economically dependent, that suggests independent contractor status,” according to DOL guidance.

5. How permanent is the relationship between the worker and employer? An independent contractor is more likely to work on a single project for a business, rather than performing repeated or continuous work. However, be careful with this aspect of the test. “An employer will assume that because the employee is only there for a short period, you can classify them as a contractor, but that’s not the case,” says Cohen.

6. What is the nature and degree of the employer’s control? “The whole idea of an independent contractor relationship is just that — independence. The more control, the more likely it is the DOL will deem that individual as a contractor,” says Cohen. Control could revolve around issues such as requiring workers to wear certain outfits, or to work during certain hours. Let’s say you own a country club and hire someone to mow the lawn. If you tell that worker to wear khaki pants and a white shirt, come in five days a week and take an hour for lunch, you have an employment relationship, says Nicholas Woodfield, principal attorney and general counsel at The Employment Law Group. “But if you decided you were going to have cable TV at the club and you called up Comcast and said, I want you to wear khakis, and I want you to arrive at nine and leave at five — the Comcast guy would laugh at you for two days.”