Why does classification matter?

One of the fundamental and most important legal issues any employer must address is whether a worker is an employee or independent contractor. While two parties may agree in principle on the arrangement at the outset, taking appropriate measures to ensure the designation is clear and legally sound is critical for avoiding costly litigation down the road. In addition to facing potential liability in a civil suit brought by an individual that a company employed or contracted with, companies can be liable under federal and state law for misrepresenting or misclassifying the nature of employment relationships.

The primary concern at the federal level for businesses is payment of taxes. The IRS will impose significant penalties for failing to properly deduct and withhold employment taxes as a result of misclassifying employees as independent contractors. See 26 U.S.C. § 3509. This misclassification may also create liability for failing to comply with the Fair Labor Standards Act (FLSA), which sets minimum standards for wages and hours of non-exempt employees. See 29 U.S.C. § 206 and § 207. In Minnesota, Minn. Stat. § 181.722 broadly prohibits misrepresenting the nature of an employment relationship. Violations of the Minnesota statute could lead to further administrative proceedings and further liability for the employer. If a court finds that a violation of 181.722 has occurred, it is required to report its findings of fact and conclusions of law to the commissioner of labor and industry, who then must report to the relevant state and federal agencies (for example: the IRS and Department of Revenue for the imposition of employment taxes, Minnesota Unemployment Insurance Program for unemployment benefits, etc.).

Suffice it to say there is no shortage of opportunities for state and federal authorities to penalize businesses for not accurately classifying their workers as employees.

What factors will be considered in determining whether someone is actually an employee or an independent contractor?
Unfortunately, the definitions of an employee set forth in statutes can be maddeningly circular. Minn. Stat. § 268.035, for example, defines “Employee” as “every individual who is performing or has performed services for an employer in employment.” The Employee Retirement Income Security Act (ERISA) is more concise without being any more helpful: “The term ‘employee’ means any individual employed by an employer.”
Needless to say this lack of clarity in the wording of the statutes, combined with the potential liability, presents significant challenges for businesses. Fortunately, through case law, courts have developed a straightforward, broadly applicable 5-factor test to determine whether a worker is an employee in non-FLSA actions. Minnesota courts have adopted this test, which allows an employer or employee to make some judgments concerning the appropriate characterization.

  1. the right to control the means and manner of performance;
  2. the mode of payment;
  3. the furnishing of materials or tools;
  4. the right to control the premises where the work is done;
  5. and the right of the employer to discharge.

Guhlke v. Roberts Truck Lines, 128 N.W.2d 324; see also Minnesota Department of Labor and Industry website, http://www.dli.mn.gov/WC/IndpCont.asp.

It is important to consider each one of the factors when trying to determine whether an employer-employee relationship exists. However, the degree of control one party exerts over another has emerged as the most important factor. Hunter v. Crawford Door Sales, 501 N.W.2d 623. The fundamental question is whether the business has the right to control, not just whether they exercise that control. Id. at 624. Thus, it is important to clearly state in contracts that independent contractors have significant autonomy over how they perform work for which they are hired.
There are a number of questions to facilitate an analysis of the control factor, including:

  • Is the worker required to comply with instructions about time, place, and method of work to be done? If so, then the control factor is likely present.
  • Has the worker been given specific training? If yes, the employer has indicated a specific preference for how the work is to be done, indicating control over the method and, thus, giving rise to an employment relationship.
  • Does the worker have a continuing relationship with the employer? If the arrangement is ongoing and involves continuous work—not sporadic or infrequent engagements—this may indicate evidence of control.
  • Does the worker set his or her time? If the employer sets the days and hours of work, this may indicate control.

In addition to the behavioral control factors of when, where, and how to perform work, the amount of financial control is another important element to consider.

  • Is the worker reimbursed for expenses by the employer?
  • Does the worker perform work for other companies?
  • Who provides the tools/supplies, etc.?

The “control” test has even gained traction at the federal level, where agencies like the Equal Employment Opportunity Commission (EEOC) and the IRS have developed their own variations of the common law test. In the context of wage and hour issues, the Fair Labor Standards Act uses the “Economic Realities Test,” which involves a similar analysis, but remains different from the control test.
For a more complete list of questions to consider, see the Minnesota Department of Labor and Industry’s website.

Remember: Intentions Do Not Determine Compliance
The critical point here is the right to control the means and method of work, not just the end result. The Minnesota Department of Employment and Economic Development provides further guidance on how to assess the degree of control a business exercises over an individual.
With a better understanding of the legal considerations for determining whether a worker is an employee or independent contractor, businesses can take informed steps at the beginning of a relationship and avoid costly disputes down the road.