States Cracking Down on Employer Misclassification of Independent Contractors

Michael Ossip and James J. Kelley II
August 18, 2007 — 1,411 views  
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For the past several years, a number of federal agencies, notably the Internal Revenue Service, the National Labor Relations Board and the Equal Employment Opportunity Commission have targeted employers that misclassify workers as independent contractors and thereby avoid the tax or employment law consequences of a traditional employment relationship. The decision of employers to classify certain workers as “independent contractors” has come under close scrutiny recently in a number of states. The states’ motivation for this attention is principally economic, but the new regulatory initiatives will create new layers of compliance challenges for companies that engage independent contractors as part of their business strategy. Earlier this month, New York Governor Eliot Spitzer announced plans to launch an enforcement campaign directed at companies that misclassify workers as independent contractors instead of employees. The State now appears poised to take action, as the Governor has proposed an aggressive campaign to seek out misclassification and recoup lost tax revenue.

The stakes are high. A February 2007 report produced by the Cornell University School of Industrial and Labor Relations estimates that misclassification of employees as independent contractors in just five industries—construction, finance, insurance, wholesale and retail trade, and professional and technical services—results in New York State’s loss each year of approximately $175 million in annual unemployment insurance tax revenue. The report based its estimate on a finding that approximately 39,587 employers in New York misclassify as many as 704,785 workers as independent contractors each year—approximately 10 percent of the workforce in these combined industries. Lost taxes are not the only consequence of misclassification. Misclassified workers are not protected by most employment-related federal and state statutes and are ineligible for workers’ compensation and unemployment benefits. The Cornell study concluded that the practice of “tactical” misclassification also puts responsible employers who properly classify their workers at a competitive disadvantage by shifting a higher tax burden onto their cost of operations.

New York is not alone in its efforts to take on the misclassification issue. In 2004, Massachusetts undertook a legislative review of misclassification and its impact on the commonwealth. Earlier this year, the New Jersey legislature approved a bill that would subject employers who contract with the state to criminal penalties and possible debarment from receiving public works projects if they misclassify employees as independent contractors in an effort to avoid prevailing wage or other state law requirements. Similarly, in Connecticut, Governor M. Jodi Rell recently approved legislation that authorizes the Connecticut Department of Labor to issue Stop Work Orders to employers that misclassify workers as independent contractors in order to reduce their employment-related insurance premiums.

These initiatives signal that worker misclassification is a growing state concern. All employers should carefully review their roster of independent contractors to ensure that they are properly classified. They should be alert to the probability of a federal or state regulatory inquiry into their classification practices and the consequences of failing to ensure that all contractors they engage are truly independent and will not be deemed a “camouflaged” category of employees. The consequences of misclassification are costly—and rising. The standards to be applied in determining which workers are employees and which are independent contractors may vary from state to state and may differ from the IRS’s established “control” test. Thus, employers must focus on this issue on a state-by-state basis to ensure compliance with all applicable regulatory requirements.

Morgan Lewis’s Labor and Employment Practice regularly advises employers about the proper classification of independent contractors and in litigating employment-related claims by such individuals. If you would like to discuss these issues, please do not hesitate to contact the following attorneys:


Michael J. Ossip   215.963.5761   [email protected]

James J. Kelley II   202.739.5095   [email protected]

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Michael Ossip and James J. Kelley II

Morgan, Lewis & Bockius LLP