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In this difficult economy, many companies are grappling with declining profit margins and pressure to offer their goods and services at reduced prices. To meet these challenges, businesses are reducing their labor costs by eliminating employee overtime, laying off employees or hiring independent contractors. By hiring independent contractors, companies avoid payment of employment taxes, unemployment and workers' compensation premiums, vacation and sick pay, health insurance premiums, and responsibility for most worker negligence, while rendering various discrimination, union, immigration and employee benefits laws inapplicable. Businesses avoid having to comply with minimum wage and overtime laws, meal and rest period mandates and, if applicable, benefit plan requirements for eligible workers.

The practice of classifying workers as independent contractors rather than employees has come under growing scrutiny in recent years. In situations where a company exercises control over the independent contractor, the Internal Revenue Service, state agencies and courts have increasingly found that the workers are actually employees who are entitled to the protections and benefits of federal and state labor and employment laws. Recently, a California federal court ordered a cleaning service to pay more than $4.5 million in back pay and liquidated damages for failing to pay minimum wages and overtime to 400 house cleaners who had been misclassified as independent contractors. This litigation followed a U.S. Department of Labor suit alleging that the workers had been misclassified as independent contractors in violation of the Fair Labor Standards Act.

With a more liberal administration in Washington and mounting union pressure, we will undoubtedly see more aggressive enforcement of laws governing the classification of workers as independent contractors. Evidence of this aggressive enforcement is California Senate Bill 1490, which would require a company to provide an independent contractor with written notice advising him of labor and employment law protections, tax consequences of the independent contractor classification and a right to an Employment Development Department assessment to determine if he was properly classified.

The trend continues on a different playing field. Plaintiffs' attorneys are bringing class actions on behalf of workers misclassified as independent contractors. They are targeting companies that retain construction workers, accounting personnel, janitorial staff, messengers, drivers, technology workers and salespeople as independent contractors in the hope of collecting unpaid minimum wages, overtime, missed meal and rest period compensation, benefits, penalties, interest and attorney fees. As workers struggle with reduced compensation in a tough economy, misclassified workers may be more inclined to participate in class actions - or bring claims of their own - when they realize that they have performed employee-type work, but were not afforded the benefits that their employee counterparts received.

What does it take to properly classify a worker as an independent contractor?

It is no longer as easy has having both parties agree to an independent contractor classification. Instead, courts and government agencies look to the specific facts of the relationship. As part of that analysis, various tests are used in deciding whether a bona fide independent contractor relationship exists. California does not have one catchall test. The California Employment Development Department, the California Workers' Compensation Appeals Board and the California Labor Commissioner's office have varying tests. At the federal level, the IRS has a 20-factor test, while the U.S. Department of Labor uses its own criteria. Each of these agencies gives more weight to some factors and not others. All look to the degree of control the company exercises over the workers. Some of the factors include: whether the parties entered into a written agreement to establish an independent contractor relationship; whether the working relationship can be terminated at any time on an "at-will" basis; whether there is a continuing relationship between the company and the worker; whether the worker is paid by the job rather than by the time spent on the job; whether the company controls the manner and means by which the service is performed; whether the worker performs work that requires a special skill without training from the employer; whether the worker provides the tools, materials or equipment and pays his own expenses; whether the worker is free to hire assistants to perform some or all of the contracted work; whether the worker is performing work that is part of the employer's regular business; whether the company provides the worker with employee benefits, such as vacation, insurance or sick leave; whether the worker has an independently established business with an opportunity to realize a profit or loss as a result of his business and whether the worker is free to work for other entities or on several projects for other businesses.

No one factor is determinative and the degree of importance of each depends on the particular business, the worker involved and the context in which services are performed. Some of these factors are subjective in nature; however, the primary focus is the amount of control the company exercises over the worker's activities. As that control increases, the probability that the worker is an employee increases and the liability for misclassification penalties mounts. Misclassification can result in the costs that companies sought to avoid when they hired the workers as independent contractors. These costs can include unpaid minimum wages, overtime, compensation for missed meal and rest periods and benefits. The liability for these misclassification violations is retroactive and can stretch back three years, four years if a claim under California Business and Professions Code Section 17200 is asserted. Additionally, a company that has misclassified a worker as an independent contractor will be required to pay back employer contributions for unemployment taxes and state disability insurance premiums, state and federal income tax withholding and Social Security contributions, plus interest and penalties.

In light of these penalties, even employers with clearly established contractor relationships must monitor their independent contractors' activities - without crossing the "control" line - to ensure that they are, indeed, working as independent contractors. The more a company does to monitor its contractors and the employees of those contractors, the greater the likelihood that its contractor classification will be questioned. This puts the company at risk of becoming a "joint employer" and incurring liability for the wages, overtime, benefits, and work injuries of its contractors' employees.

Other than classifying every worker as an employee, there is virtually no fail-safe way to avoid misclassification problems. There are, however, some measures businesses can take to substantially minimize the risk of misclassifying independent contractors.

Use independent contractors who have established businesses and perform services for several unrelated entities. Maintain copies of contractors' licenses, staffing resources, advertising materials, references, proof of insurance, office leases, etc.

Draft contracts that emphasize the business-to-business relationship of the parties. The contracts should not include language suggestive of an employer-employee relationship.

Avoid hiring former employees and designating them independent contractors. Such a practice is problematic since workers return as contractors and oftentimes, perform tasks they performed as employees.

Make the decision to engage or classify a worker as an independent contractor on a case-by-case basis. Do not rely on any one factor, but rather, examine the totality of the circumstances.

Comply with state and federal mandates once a worker is classified as an independent contractor. Many California businesses overlook their obligation to report the independent contractor retention to the Employment Development Department. While the purpose for this requirement is to locate parents working as independent contractors who are delinquent in child support obligations, companies should note that the department routinely conducts audits to determine whether businesses are properly classifying workers.

If, after evaluating an independent contractor relationship, it appears that a worker has been misclassified, it is advisable to consult labor counsel. The company may, for example, modify the worker's tasks and responsibilities to strengthen the contractor classification, reclassify the worker as an employee in a manner that willnot raise an IRS red flag or lease a worker from a temporary staffing agency.