Employees misclassified as contractors can cost firms a bundle

FedEx Ground truck
A FedEx Ground truck departs an alley after making a delivery October 1, 2002 in Park Ridge, Ill. In 2005, FedEx Ground drivers sued the company, claiming they were being taken advantage of by being classified as contract workers, which they argue violated federal overtime and state labor laws.
Tim Boyle/Getty Images

In the wake of the Great Recession, many employers are choosing to use independent contractors instead of hiring permanent employees.

Doing so can produce big cost savings for employers because they typically don't have to pay for health benefits, overtime or certain taxes. From workers' perspectives, there are advantages, too. Contract work might allow them to get a foot in the door of a company that otherwise wouldn't hire them and earn more money on an hourly basis than in a salaried job.

But this arrangement, if mishandled, can carry a steep price for companies. The U.S. Department of Labor and the Internal Revenue Service are investigating businesses that misclassify workers as contractors. Some workers have filed lawsuits that allege businesses denied them benefits by wrongly classifying them as contractors.

"In some cases, employers are aggressively fighting these claims because the downside of an adverse decision could be quite significant," said Chuck Knapp, a Minneapolis lawyer who represents companies on worker classification issues. "The amount of fines or liability or settlement you see ranges from thousands to millions."

The cases center on the question of what makes a worker an employee or contractor.

Knapp said the distinction generally has to do with the level of control the employer exerts. A worker who must work set hours and perform the work in a particular way looks a lot like an employee. If the worker decides when and how the work is to be done and is at liberty to subcontract the work to another person, courts would likely consider the person a contractor.

MPR News is Reader Funded

Before you keep reading, take a moment to donate to MPR News. Your financial support ensures that factual and trusted news and context remain accessible to all.

"There is no standard definition," said Matthew Bidwell, a professor of management at the Wharton School of Business at the University of Pennsylvania. "There is no one test. It's never clear who's a contractor and who isn't. It's a very murky question in and of itself."

"There is no standard definition. There is no one test. It's never clear who's a contractor and who isn't. It's a very murky question in and of itself."

These vague distinctions have proven troublesome for a Twin Cities woman hired as a contractor to build a database and perform other tasks for a local company. The woman, whose first name is Rebekah, agreed to speak of her former client, but did not want to be identified by her full name because she fears that could jeopardize her employment prospects.

For Rebekah, the tip-off that something was amiss came at tax time, when her accountant tried to determine what deductions she could claim from her contract work.

When the accountant asked if the company provided Rebekah with clients, determined her work hours, gave her a place to work and told her when to arrive and what to do, she could only answer "yes."

That, the accountant said, made Rebekah an employee.

One of the taxes that employers pay on their employees' behalf funds unemployment insurance. Except in some circumstances where it's provided by an employment agency, unemployment is typically not available to contractors when their work is done.

But given the questions her accountant raised, Rebekah nevertheless filed for jobless benefits. The Minnesota Department of Employment and Economic Development turned her down, effectively agreeing with the company Rebekah worked for that she was just a contractor, not an employee.

Her accountant disagrees and still plans to report the company to the IRS.

Knapp, of the Minneapolis law firm Faegre Baker Daniels, notes that under the Obama administration, the Department of Labor and the IRS are collaborating with Minnesota and several other states to police the misclassification of workers as contractors. Last year, federal officials won a settlement with a landscaping company in Shakopee. The firm had to pay about $500,000 in retroactive overtime pay and penalties.

A lawyer for the landscaping firm declined to comment on the case and said the proprietors wouldn't either.

The Department of Labor would not provide a list of other companies in Minnesota that it has investigated.

Despite the government's focus, Knapp said the real heat is coming from class action lawsuits, which have been on the rise. One of the most famous cases involves the tech giant Microsoft. In the 90's, the company agreed to pay $97 million to settle a suit brought by workers wrongly classified as independent contractors.

FedEx has already paid out millions of dollars in several settlements. One lawsuit involves nearly 30,000 drivers. If it succeeds, the settlement could be massive. However, a judge has ruled that drivers from most of the states covered by the class-action suit were not misclassified as contractors. That ruling is on appeal.

The increased threat of litigation is causing big headaches for employers, said Ann Costello, an executive recruiter with Venteon Finance in Edina, Minn. After the job cuts of the Great Recession, many firms are hesitant to add permanent positions.

"They're afraid to hire someone, because they don't want to end up laying someone off again in six months," Costello said. "And a contractor-- they're there temporarily."

Recruiters and employment lawyers say some firms are trying to work around the legal grey zone of contract work by procuring their contractors through a third party. Others might set "term limits" on contractors, limiting their work to a set period of time, such as 12 months. The longer a worker is employed, the more their conditions of employment might align with those of a payroll employee.

It's unclear if the increased scrutiny around contractors is keeping companies from hiring contractors altogether.

For people like Rebekah, contract work is still abundant, whereas permanent jobs are not.

"You've got to take what comes at ya, and contract work is there," she said.

That said, Rebekah said she would not return to the company that she believes took advantage of her contractor status to save money at her expense.