By Jessica E. Schwie, Esq., Jardine, Logan & O’Brien, PLLP 

Date: September 2021

The U.S. Department of Labor (DOL) and Internal Revenue Service’s (IRS) joint nationwide investigation into labor agreements with independent contractors examined whether many contracts for labor services should have been classified as employment agreements, and if so, employers should have withheld payroll taxes from payments.

According to the DOL’s Strategic Plan 2011-2016, the DOL and IRS estimate that the misclassifications were many. The IRS created a website addressing the issue and various resources. The Minnesota Department of Revenue also a similar website.

Misclassification of independent contractors is not only a tax issue; it also comes into play in several other areas of the law, such as the Workers’ Compensation Act, Fair Labor Standards Act, Minnesota Payment of Wages Act, and others. Therefore, unintended liabilities and penalties may result from misclassification.

Passing the Test for an Independent Contractor

There are several tests that are used to determine whether an agreement to perform labor is an independent contract or an employment agreement for different contexts.¹ Although the tests are many, all of the them focus on three core factors of the relationship between the employer and employee or contractor: 1) behavioral control; 2) financial control; and 3) the nature of the relationship.

Independent Contractor Agreements in Practice

The more the public entity controls the behavior of the contractor, the more likely it will be determined to be an employment agreement. Evidence of controlling behavior includes the provision of training, expected compliance with workplace rules, provision of tools and equipment, limitations upon who may perform the work, and/or limitations on the method and hours of work.²

With regard to the financial control factor, the primary issue is the ability to make a profit or suffer a loss. A true independent contractor performs labor under a business name, markets services to the general public and has made a substantial investment into overhead. The contractor also tends to offer to perform work at a flat amount based upon profit calculations, not the going rate for comparable hourly work.

For a service provider to be considered an independent contractor, the nature of the relationship factor should reflect independent operations. An oral contract to provide one of the key services provided by the public entity for an indefinite period feels like an employment agreement. A true independent contractor performs work pursuant to a written contract, for a fixed period or project and performs only a discrete task that is incidental to the general operations.³

Many Consequences for Misclassification

For the public employer that misclassifies an independent contractor, there is a potential parade of horribles.  The obligations toward a contractor are less than those owed to an employee, such that there may be mistakes regarding:

• Withholdings for state and federal income taxes, Social Security and Medicare taxes, and unemployment insurance taxes.
• Workers’ compensation.
• Wage and hour requirements (e.g., overtime, rest breaks, lunch breaks, etc.).
• Workplace safety requirements.
• Method of payment.
• Inclusion in benefit plans, including PERA.
• Medical leave, parental leave and other leave laws.

As a result, the public employer may be ordered to pay back taxes, penalties, interest and attorney fees or suffer other liabilities available under certain laws, including possible jail time.⁴

¹ See, e.g., I.R.S. Rev. Rul. 87-41, 1987-1, C.d. 296 (1987) (the “IRS 20 factor test”); Minnesota Statutes, Sections 176.041, 176.205, 181.723, and 268.035, subdivision 25b; Minnesota Rules, Parts 3315.0555 and 5224.0330 (workers’ compensation, unemployment, and wage act tests); Rutherford Food Corp. v. McComb, 331 U.S. 722, 726-28 (1947) (the DOL’s “economic realities test”); Guhlke v. Roberts Truck Lines, 128 N.W.2d 324, 326 (1964) (the common law five factor test).

² Compare, e.g., Air Terminal Cab, Inc. v. United States, 478 F.2d 575 (8^th Cir. 1973)(cab drivers misclassified for purposes of payroll taxes where drivers were required to have regular working hours, had limitations on how to do their job and use the equipment, and there was some control of their profits) and Moeller v. Hauser, 54 N.W.2d 639 (Minn. 1952) (doctor of county hospital was employee for purposes of medical malpractice liability where he performed the routine hospital functions and supervised staff), with Boily v. Comm’r of Econ. Sec., 532 N.W.2d 607 (Minn. App. 1995), aff’d as modified, 544N.W.2d 295 (Minn. 1996) (dentists were independent contractors for purposes of unemployment taxes where they provided their own tools and equipment and could work at other locations).

³ Compare, e.g., Wass v. Bracker Const. Co., 185 Minn. 70, 72, 240 N.W. 464 (Minn. 1932)(window cleaner was misclassified and was an employee where he was supervised in even the provision of services as “menial” as washing windows) with Wangen v. City of Fountain, 255 N.W.2d 813, 815 (Minn. 1977)(plumber was independent contractor where city only pointed out the location of leaks and left the plumber to figure out the rest on how to meet the city’s needs).

⁴ See e.g., 29 U.S.C. § 260.101; 29 CFR Part 578; and Minn. Stat. §§ 176.194, 177.27, 181.13, 181.171, 181.722, 181.944 (various violation provisions of state and federal employment laws).

The information contained in this document is intended for general information purposes only and does not constitute legal or coverage advice on any specific matter.