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Employee Misclassification: An Expensive Mistake, Is Your Company Getting It Right?

By Jessica Kastin, Esq
Posted: 15th May 2012 09:41

Many companies operating in the United States supplement their workforces with contractors, interns and other non-employee service providers.  Typically “non-employees” are not eligible for employee benefits and are not generally protected by various wage and hour and other statutory employee protections.   Non-employee service providers typically fall outside the scope of workers’ compensation insurance, unemployment insurance and employer-paid federal and state payroll taxes.   Employer savings attributed to the use of non-employees are directly correlated to reduced government revenue. 
For these reasons, and in light of the recent economic downturn and high unemployment rates, widespread misclassification has been a focus of President Obama, and a priority for the taxing authorities and the federal and state departments of labor during his term.  The U.S. Department of Labor’s budget for fiscal year 2013 includes $46 million allocated specifically to combat misclassification. The $46 million includes $25 million for state grants aimed at identifying misclassification and recovering unpaid taxes and $15 million for increased Department of Labor personnel to investigate potential misclassifications.  Similarly, millions of dollars were allocated to combat misclassification as part of the President’s “Misclassification Initiative” in the fiscal budgets for the past few years.
What This Means For Employers
The focus on misclassification has lead to greater enforcement efforts and coordination and information sharing among federal and state agencies.  These efforts have lead to increased employer liability.  The U.S. Department of Labor’s Wage and Hour Division’s website currently lists examples of employer violations from 2010 and 2011 resulting in a total of more than $11 million in liability for back wages, overtime and penalties allocated among approximately 30 employers throughout the country.  Damage assessments per employer within this sample range from $30,000 to $2.9 million.
Employers can become a target for investigation and potential liability assessments through various avenues.   Often an independent contractor will file for unemployment benefits which will trigger an investigation into whether the individual was properly classified.   If the investigation leads to a conclusion that the individual was not properly classified, the relevant state department of labor will typically order that all “similarly situated” individuals be reclassified as employees as well.  This could lead to payment of back wages, overtime, taxes and insurance premiums on behalf of a large group of individuals.  Often these amounts are difficult to calculate because employers have not kept careful track of contractors’ hours worked and other information needed to assess the amounts owed.
Disgruntled individuals may also file claims with the federal or state department of labor or the taxing authorities alleging that they have been misclassified and seeking back pay and benefits.  Situations where individuals performing similar jobs are not similarly classified often create a perception of inequity and a greater likelihood that an individual will file a complaint.
Once an employer is targeted, it is subject to time consuming audits involving review of voluminous payroll records and related documents that may not be easily accessible.  These audits may be conducted by various state and federal agencies that share information about potential violators.   Employers may be subject to consecutive audits by, for example, a state unemployment insurance division, a workers’ compensation division and a federal or state taxing authority.  Employers are also vulnerable to both individual and class action law suits seeking back pay and penalties for  any period in which individuals were allegedly misclassified.
Employee vs. Independent Contractor
While different agencies rely on different tests to assess whether an individual is an employee or a contractor there are common factors reviewed in the assessments.  Most tests center upon the amount of direction and control an employer exercises over the individual’s day-to-day responsibilities.  Some common relevant factors include: whether the individual determines his or her own work schedule and hours, the level of supervision and instruction exercised by the employer, and whether the individual provides his or her own work supplies, carries his or her own liability insurance, and is available to provide services to other employers. 
Employers should review the classification of its service providers with these factors in mind.
Common Mistakes And Misperceptions
Often companies believe that because an individual prefers to be classified as an independent contractor and signs a written agreement to that effect that the individual is properly classified as a contractor.  This belief is wrong.  The terms of a written agreement and the individual’s preference with respect to classification play a very small role, if any, as to whether an individual is properly classified.
Another common misperception is that temporary employees may be classified as contractors.   If an individual is performing employee functions and is subject to the direction and control of the company, the individual is likely an employee, even if he or she is hired for a short, finite duration.  Similarly, employees that have been laid off or retire are often subsequently retained as “consultants” or “contractors.”  These arrangements often involve the individual providing the same services they provided as full time employees only on a reduced schedule.  Under such an arrangement, these individuals are most likely still employees and should be classified as such.
In addition to contractors, many companies also utilize unpaid interns.  Often these interns provide services for the benefit of the employer and should be classified as paid employees.  Two recent class actions have been filed by groups of interns seeking back pay alleging that they were misclassified.  Employers should ensure that unpaid interns are not performing services that are also performed by employees, that the services performed are for the benefit of the intern not the employer, and that the intern is receiving academic credit for his or her work.   If these factors are not met, the intern is most likely an employee that should be paid at least minimum wage and be eligible for over time.

How To Get It Right
It is wise for employers to conduct internal audits and take steps to remedy any potential misclassification issues going forward.  The federal Internal Revenue Service and certain state agencies, such as the New York State Department of Taxation, have recently implemented amnesty or voluntary compliance programs allowing employers to voluntarily report misclassification with the opportunity for reduced penalties and liability.

Jessica Kastin is a partner in the New York office of the law firm Jones Day.  She specializes in the areas of labor and employment law.  Ms. Kastin represents employers is a wide variety of industries focusing on compliance with federal and New York State labor and employment laws.  Ms. Kastin’s practice also focuses on traditional labor law in the context of collective bargaining negotiations, the reorganization of unionized companies through bankruptcy, labor issues arising in the context of corporate mergers and acquisitions, grievance and arbitration proceedings, and proceedings before the National Labor Relations Board.  If you have any questions about the proper classification of your workforce, or compliance with any other labor and employment laws, Ms. Kastin can be reached at +1 212 326 3923 or by email at

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