It was approximately two decades ago that an institute concluded that in the United States perhaps forty percent of the actual cost of an employee was caused by the various indirect benefits the employee receives, such as paid time off for illness and vacation, medical and dental benefits, unemployment insurance, and the employer’s contribution to payroll taxes, workers’ compensation, etc. The costs of these often governmentally imposed benefits has steadily increased year to year, with some states, such as California, often imposing even more costs.

Additionally, an entire series of laws ranging from requirements for family leave in emergencies to providing wheel chair accessible work stations are imposed upon companies which have over a certain number of employees, creating significant additional costs to the employer.

With the above facts, it is not surprising that many companies seek to limit the number of employees and, instead, utilize non-employees to perform many of the functions previously performed by employees. These persons, often termed “independent contractors,” are treated as separate businesses contractually engaged in business with the “employer” and the employer is not required to withhold payroll taxes, provide various fringe benefits, nor count the persons as constituting a part of the employed work force. The employer normally executes a formal written agreement with the independent contractor specifying an hourly rate for time expended or a flat amount for a task completed.

As can be expected, a tug of war quickly ensued between the government, unions and employers as to whether persons described as independent contractors were actually pseudo hidden employees, with the employer merely seeking to avoid the cost of a traditional employee. This struggle has been ongoing for decades and the cost to the employer of losing such a struggle can be severe, as discussed below.

This article shall briefly describe the criteria utilized by the Federal government in determining the status of the worker, the benefits normally at issue, and the costs imposed upon the employer who mischaracterizes the worker. It must be kept in mind that each State has its own law on the same topics, though the States normally follow the Federal lead in classification of workers.


Defining the “Employee” and “Employer”

In both California and under Federal law, there is no single dispositive test for government agencies to determine whether workers are independent contractors to a company, or employees. Moreover, different criteria and legal tests are used for determining worker status, because each government agency is concerned with worker classification for a different reason. Accordingly, agencies may use their own independent worker classification criteria, without regard to what other agencies have done. By analogy, this is similar in application to that of a person who might be considered “disabled” for purposes of workers’ compensation, but not for social security benefits. Also possible (but not common) is the result that a worker may be deemed an independent contractor in one state, but an employee in another.

Title VII [42 USC § 2000(e)] defines an “employer” as a person or entity who employs 15 or more employees in 20 or more calendar weeks in the current or preceding calendar year. The term “employee” is only loosely defined as “an individual employed by an employer.” Importantly, Title VII prohibits discrimination by an employer against any individual “with respect to terms, conditions, and privileges of employment.” Once a company or person reaches the status of “employer” under the statute, there may be liability exposure for claims that independent contractors were essentially functioning as employees and therefore entitled to the same privileges and conditions as employees.

Why is the distinction important if Title VII protects any individual, whether an employee or independent contractor? What is meant by the statutory provision is that an employer cannot choose to speciously label one worker as an employee and another as an independent contractor for the purpose of paying one less than the other or providing less benefit coverage for one than the other, or otherwise illegally discriminate between them. If two workers are substantially performing the same work, for purposes of Title VII claims of discrimination, both will be deemed employees and the employer will be required to treat them equally in “terms, conditions, and privileges of employment.”

In adjudicating such claims and controversies, courts often refer to what is known as the “economic realities” of the employment relationship to make a determination of status as applied to the facts presented. In applying an “economic reality test” to the situation before it, a court will review the employment relationship of the parties to see if the worker in question is actually functioning as an employee, because the worker performs most of his work for the employer and derives most of his income from the employer. Conversely, if the worker held himself or herself and his or her services out to several companies, and derived his or her overall income from several of them, he or she might be more appropriately deemed an independent contractor.

Still, other courts find the economic realities test too superficial, and instead look to the common law for guidance. Under the common law standard, the primary emphasis is on a review of the degree of control and autonomy the worker has over his hours, methods used to complete the work, and materials used for the work. If the employer only looks to the end result, the worker is more likely an independent contractor. A milestone court decision on this matter was the case of Viscaino v. Microsoft Corp, (9th Circuit, 1997). Microsoft had routinely brought in outside “independent contractors” to work on various software programs. Microsoft needed their expertise, but made them sign contract agreements, in which they understood that they were not employees of Microsoft. Many of them worked several years in this capacity for Microsoft, and ultimately, a group of them filed suit under ERISA, hoping to recover lost pension and other benefits. Microsoft defended that these individuals were “independent contractors” and had accepted the work with that knowledge and understanding. The Court disagreed. It found that the workers had assigned desks, assigned phone numbers, and were otherwise treated essentially as Microsoft employees. In fact, the only difference was that they did not receive company-paid benefits. Microsoft lost the case.

But the economic reality test was used for claims brought under the Equal Pay Act [29 USC § 206(d)], which amends the Fair Labor Standards Act (FLSA). Generally, for wage/hour claims, the “economic realities test” is used in determining the true status of the worker. An example of this type of claim might involve an independent contractor who is to be paid a contract amount when the work is completed, but in reality, that amount is less than the minimum wage or does not account for applicable overtime pay. If the worker is deemed to be actually functioning as an employee, the employer may be liable for monetary damages.

The Civil Rights law, passed during the post-Civil War era [42 USC § 1981] prohibits discrimination upon the basis of race in making and enforcing contracts. This has provided a cognizable cause of action for independent contractors involving their contractual relations with employers. (See Danco v. Wal-Mart Stores, 1st Circuit, 1999.)

Definitions found in the ADEA [29 USC § 621] are similar to those in Title VII, except that an “employer,” for purposes of the ADEA, (Age Discrimination in Employment Act) must employ 20 or more employees for each working day in 20 or more calendar weeks in the current or preceding calendar year. Likewise, protection against age discrimination by employers covers both employees and independent contractors.

Under the FMLA (Family and Medical Leave Act), an employer is defined as any person or entity that employs 50 or more employees for each working day in 20 or more calendar weeks in the current or preceding year. Eligibility for family leave is premised upon the completion of 1250 hours of service and a work status for at least 12 months. Because the FMLA incorporates FLSA definitions, the same rules would apply in determining worker status (the economic realities test).

Thus, different criteria apply in different situations and different venues and courts disagree on the criteria that will be used. However, in general, the following factors are important in determining whether a worker is more correctly classified as an employee:

  • The worker can be terminated at will;
  • A manager (or designated person) assigns, reviews, and supervises the worker’s work product.
  • The worker performs services that are a part of the regular operation of the business.
  • The worker has other customers of his or her services;
  • The worker provides his own tools or locale for work;
  • The worker was formerly an employee of the company;
  • All of the worker’s time is allocated to the company’s business;
  • Whether the parties have executed an appropriate written agreement providing for delivery of services.


It matters.

The cost to an employer in failing to correctly classify an employee can be a violation of various Federal and State statutes that apply to companies of a certain size, as well as a failure to withhold sufficient taxes and other benefit payments. Interest and penalties can be imposed and they can be substantial. The employee may also face tax liability.

Employers are not required to withhold taxes from independent contractor earnings. Instead, they file information returns to the Internal Revenue Service and state authorities, indicating the amount paid in wages to the independent contractor. This information is also provided to the contractor on IRS Form 1099-MISC.
The Internal Revenue Code and various state laws impose substantial penalties on employers for improper classification of employees as independent contractors.

Likewise, the Code imposes penalties and fines upon independent contractors who either fail to report income or who do not file self-employment quarterly returns. Additionally, the independent contractor will have to back-pay all taxes and social security deductions accrued during the misclassified period, in addition to those currently due.

Penalties to employers for failure to withhold income taxes are generally equal to 1.5 percent of the wages, plus 20 percent of the social security and Medicare taxes that should have been paid by the employee. There is also a liability for the unpaid portion of the employer’s portion of the social security and Medicare taxes.

Assuming the employer failed to conform to Federal statutes (employee family leave and the like) additional fines and penalties may apply and these could be retroactive to the time the number of employees was found to exceed the minimum limit.

It should be noted that the liability may apply even if the independent contractor is obtained through a service company. Companies also may be liable to temporary workers who are employed through third parties (such as personnel agencies). Case law holds that the personnel agency is generally deemed to be a nominal employer and the end-user company is the true employer. In the alternative, some jurisdictions have found that both are joint employers of the worker. In either case, the company faces liability.

Certain states, such as California, are noted for the aggressiveness of their enforcement procedures and have been known to classify temporary student interns as employees requiring withholding and the other fringe benefits. Companies routinely impose a time period before certain benefits accrue, such as health and pension, but other aspects, such as withholding, must be performed immediately.



This is often not a question of worker versus employer so much as the government versus both since it is the government, seeking taxes, that is usually the party insisting upon payment. Unions and labor groups bemoan the fact that independent contractors are actually forced to comply with the company insistence that they are not employees and such undoubtedly does happen. Just as often, in our experience, both the worker and the employer are outraged by the efforts of the government to seek payroll taxes, etc. and to reclassify the relationship to the extra expense of the parties.

But in this time of tax shortfalls, it can be expected that scrutiny will be increased by the various governmental agencies and the wise company or contractor will take the time to ensure that they actually meet the criteria for the appropriate classification of their relationship.