Mitigating the Risks of Misclassifying Employees as Independent Contractors

Dental practices, medical practices, real estate agencies, and several other industries routinely utilize independent contractors to staff their operations. Whether inadvertently or not, businesses commonly misclassify employees as independent contractors. The independent contractor relationship provides several key benefits to businesses, with potential cost savings and liability protections.

For example, from a cost perspective, classifying workers as independent contractors rather than employees allows a business to avoid various employee-related expenses, including worker’s compensation insurance, unemployment compensation insurance, state and federal employment taxes, and various employee benefits. From a liability perspective, independent contractors pose less of a threat of asserting first-party claims—i.e., those by workers against the business—because independent contractors are afforded significantly less protection under federal and state employment laws than traditional employees. Independent contractors also pose less liability risk on third-party claims because a business generally is not liable for the tortious acts or omissions of its independent contractors, whereas an employer generally can be held vicariously liable for its employees.

While these benefits often lead businesses to classify their workers as independent contractors, the unfortunate reality is that many "independent contractors" are not truly independent contractors in the eyes of the law. The Department of Labor, in its recent "misclassification initiative," has begun to crack down on employee misclassification. The consequences of the Department of Labor, a court, or another governmental entity finding that an employer has misclassified its workers as independent contractors may be grave for the employer, with such rulings often resulting in a "one-two punch" to the employer in the form of substantial penalties (such as Department of Labor or IRS fines) followed by employee lawsuits over health benefits, overtime pay, and retirement contributions.

Properly classifying workers can be tricky, especially in industries where roles are not always clear. For example, while real estate agents generally tend to be independent contractors when actually selling real estate, an agent who also wears another hat for a brokerage (e.g., as an office manager) may need to be classified as an employee in that other role. Misclassification is also common among associate dentists of dental practices and associate physicians of medical practices, where an associate’s professional qualifications may suggest an independent contractor relationship but the level of control or other factors may require classification as employees.

Unfortunately, there is simply no "bright line" legal test to determine whether a worker is an employee or an independent contractor. The IRS, the Department of Labor, and common law courts each use their own tests and consider different factors in reaching conclusions as to a party’s true employment status. Nevertheless, several important factors are present in nearly every independent contractor analysis regardless of the governing authority.

For example, key factors include (1) the scope and extent of control the employer may exercise over the worker, (2) the extent to which the worker is economically dependent on the employer, (3) the relative investment of the worker in the business, (4) the manner in which the worker is compensated, (5) the location and instrumentalities of the worker, and (6) the duration of the worker’s relationship. No single factor is determinative of the employee relationship. Rather, evaluating whether a worker has been misclassified as an independent contractor involves weighing of these and other factors in light of the facts of a given case.

The upside to the situation is that, despite the Department of Labor’s recent initiative and similar enforcement activities by the IRS and other agencies, businesses may avoid the pitfalls of misclassification with careful planning. For example, dental practices may still be able to employ associates as independent contractors with minimal fear of judicial or governmental reclassification by utilizing creative structuring of an associate’s employment. Careful consideration of the various employee status factors, with guidance from counsel where the analysis may be less clear, can help significantly minimize a practice’s risk of exposure to the severe penalties associated with employee misclassification.

In addition, further risk mitigation is available in the form of the IRS’s Voluntary Classification Settlement Program (VCSP). As the name suggests, the VCSP permits an employer to voluntarily reclassify its workers as employees and, as a result, exempts such employers from IRS employment tax audits for prior years with respect to the reclassified workers. Additionally, the program allows employers to make significantly reduced settlement payments to the IRS in lieu of paying all of the back taxes it would otherwise owe.

In light of the potentially severe consequences of worker misclassification and the Department of Labor’s crack down on the issue, it is more critical than ever for businesses to carefully plan and reconsider their employment structures and take necessary steps to mitigate the risk of unnecessary exposure to liability for employee misclassification.

Authors – Michael S. Byrd and Michael R. Steinmark

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