Independent Contractors: New Department of Labor Guidance Spotlights the Pitfalls of Misclassification

November 15, 2022

Employers often find themselves with a sudden need for additional temporary coverage for one or more areas of their business. Maybe a mission-critical but discrete project awaits completion: you need the labor but only through project completion. Perhaps you would like access to the institutional knowledge and professional expertise of a soon-to-retire employee once they have ceased working full-time. Your first thought might be to engage these services on an independent contractor basis.

At first blush, it seems like a winning proposition: your organization can reap the benefits of the needed labor at a cost that does not include payroll taxes, unemployment insurance premiums, overtime, office space, the tools required for the job, or other incidental expenses occasioned by a permanent employee. Independent contractors would be individually responsible for all those expenses.

Additionally, independent contractors do not have all of the legal rights of employees. Independent contractors cannot claim unpaid wages or unpaid overtime under the Fair Labor Standards Act or similar state wage payment statutes. Nor can they bring discrimination claims under Title VII or its various state and local analogues.

Even better, independent contractors can be hired for a finite duration.

But don’t let the potential cost savings blind you to the hidden liabilities of misclassifying an employee as an independent contractor. Those liabilities can be costly, cumbersome, or both, and may arise in a variety of circumstances. For example, a worker you paid as an independent contractor could apply for unemployment alleging they were misclassified and were actually an employee. Or your state’s department of labor may conduct a spot audit of your workforce that determines that you inadvertently misclassified employees as independent contractors. Current independent contractors could file suit alleging unpaid overtime due to misclassification. These are just a few of the circumstances under which misclassification, unintended or otherwise, could lead to significant liability.

If an independent contractor successfully argues they were actually an employee, misclassification can be a costly error.

Your organization may be liable for the employer’s share of payroll taxes for the duration of the individual’s engagement. You may find yourself owing unpaid unemployment insurance premiums or worker’s compensation premiums. You could be found liable for unpaid overtime, which would entitle the misclassified worker to the overtime itself, liquidated damages in an amount equal to the unpaid overtime, plus fees incurred for the worker’s attorney to litigate the matter. In short, the penalties for misclassification – whether intentional or inadvertent – can far outweigh any cost savings.

To make matters more fraught, recent trends have shown a renewed governmental push to define independent contractor status more narrowly. Historically, courts have applied somewhat ambiguous multi-factor tests to determine the line between an employee and an independent contractor.

In Pennsylvania, for example, courts employ a ten-pronged test to evaluate independent contractor status in most circumstances. Pennsylvania’s Supreme Court has adopted a somewhat-simplified six-part “economic reality” test specific to unpaid wage and unpaid overtime claims. The economic reality test evaluates certain factors – such as the degree of control exercised over the contractor’s work, whether the contractor supplies their own tools for the job, the degree of permanence of the working relationship, and the extent to which the work is an integral part of the employer’s business – to determine whether a worker is truly independent, or if they rely on the employer for their livelihood. These convoluted tests create unpredictable results, sometimes reaching contrary conclusions with only a slight change in the underlying facts.

In the face of this unpredictability, all levels of government have begun to reassess how workers are classified. As taxing authorities, governments are motivated to ensure a steady stream of tax revenue with as little effort as possible. Holding employers responsible for payroll taxes and government insurance premiums, such as unemployment or worker’s compensation premiums, significantly reduces the amount of effort taxing authorities need to expend to collect taxes. Think of it this way: it’s much easier to collect taxes from a single business with one hundred employees than to collect taxes from that business and one hundred individual workers classified as independent contractors.

Unsurprisingly, governments have moved toward simpler – and much narrower – definitions of independent contractors. At the federal level, the Department of Labor (DOL) recently issued a proposed rule that would make it more difficult for employers to show that workers are independent contractors. The proposed rule would repeal a Trump Administration rule employing a five-factor “economic reality” test that focused primarily on two factors: the level of control a worker has over the work performed, and the worker’s opportunity for profit or loss. In place of the “economic reality” test, the DOL’s updated rule would require a fact-intensive evaluation of six broad criteria with no emphasis on any particular factor. The upshot: it will potentially be more difficult to defend classification of a worker as an independent contractor.

The new proposed DOL rule, which would apply to federal wage and hour law, still needs to wind through the administrative process, during which it will likely evolve. The proposed rule will not become final until mid-2023 at the earliest.

Meanwhile, at the state level, lawmakers have advocated for – and in some instances enacted – the much more stringent “ABC” test. To properly classify a worker as an independent contractor under the “ABC” test, the worker:

  1. must be free from control or direction of their work;
  2. must perform work outside the usual course of business of the employer; and
  3. must be engaged in what is customarily considered an independently established trade, occupation, profession, or business.

The employer must satisfy all three prongs to pass the test.

As a practical matter, the second, or “B,” prong creates the most difficulty for employers looking to engage independent contractors. This prong requires the work performed by an independent contractor to be unrelated to the business of the employer. For example, a restaurant would be permitted to engage a CPA for tax preparation purposes as an independent contractor. But that restaurant would be unable to engage a chef as an independent contractor, even for a one-off event.

At least thirteen states have adopted some form of the “ABC” test, including New Jersey, California, Massachusetts, and West Virginia. Additional states, including Pennsylvania, appear poised to adopt the ABC test in the immediate future.

Given the shifting legal landscape and the potential for significant liability if an employee is misclassified as an independent contractor, employers should consult with counsel before attempting to classify any worker as an independent contractor.

The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.