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05.12.2015 Virginia & North Carolina Launch New Initiatives on Misclassification of Employees as Independent Contractors By: D. Earl Baggett; Edward S. Schenk III & Amanda M. Weaver

Classifying a worker as an independent contractor rather than an employee significantly affects an employer’s obligations towards the worker and can result in liability for misclassification. Employees are entitled by law to certain benefits and protections to which independent contractors are not entitled. Therefore, employers who misclassify their employees as independent contractors face potential liability for various unpaid employee expenses such as payroll taxes, workers’ compensation and unemployment insurance premiums, and even minimum wage and overtime payments, which are not owed to independent contractors.  Employees are also protected by various federal and state anti-discrimination and medical leave protections under which independent contractors are not protected. 

Various tests and factors apply when determining a worker’s classification as employee or independent contractor in different contexts.  How the parties define their relationship is not determinative; instead, the relevant inquiry is how the employment relationship works in practice. Traditionally, courts in Virginia and North Carolina have focused on the level of control exerted by the employer over the means and manner of the work performed.  Other relevant considerations include whether the worker sets his own work hours, and whether the worker uses his own equipment, facilities and materials or those of the employer.  The factors that the United States Supreme Court has considered significant in determining whether an employer/employee relationship exists are (1) the nature and degree of control by the principal; (2) the amount of the worker's investment in facilities and equipment; (3) the degree to which the worker's opportunities for profit and loss are controlled by the employer; (4) the skill and initiative required to perform the job; and (5) the permanency of the relationship. None of these factors is controlling, and proper classification depends on the economic reality of the individual relationship. Variations of this economic realities test are used to determine employee status under federal laws such as the Fair Labor Standards Act and for federal social security tax purposes. The IRS considers twenty different factors when determining employee status.  Under any of these tests, if the factors weigh in favor of employee status, then the worker should be classified as an employee and is entitled to all benefits and protections of an employee.

In response to the frequency of employee misclassification in Virginia, an inter-agency task force on worker misclassification and payroll fraud was established in Virginia in 2014.  The executive order establishing the task force provides that: “[t]he misclassification of employees as ‘independent contractors’ undermines businesses that follow the law, deprives the Commonwealth of millions of dollars in tax revenues, and prevents workers from receiving legal protections and benefits.” Further, a 2012 report of the Joint Legislative Audit and Review Commission (JLARC) found that “one third of audited employees in certain industries misclassify their employees.”  The executive order goes on to note that “by failing to purchase workers’ compensation insurance, pay unemployment insurance and payroll taxes, or comply with minimum wage and overtime laws, employers lower their costs up to 40%, placing other employers at a competitive disadvantage.” It is estimated that worker misclassification lowers Virginia’s state income tax collections as much as $28 million a year. 

The Virginia initiative will mean that, in addition to potential federal liability, such as substantial IRS penalties, Virginia employers will also face increased state enforcement of payroll requirements and potential liability and state-imposed penalties for employees who are misclassified as “independent contractors.”  If an individual has been misclassified as an “independent contractor,” the employer could therefore be obligated to pay penalties as well as significant amounts of unpaid taxes, insurance premiums, wages, overtime payments, benefits, and attorneys’ fees of the misclassified employee. 

In North Carolina, Senate Bill 694 (entitled "The Employee Fair Classification Act") crossed over from the North Carolina Senate to the House on April 29, 2015. The bill had unanimous Senate approval. The proposed law is targeted to remedy and deter what has been perceived as an excessive worker misclassification problem in North Carolina.  Senate Bill 694 would create a special agency in the State budget office to investigate complaints of independent contractor misclassification, issue substantial fines and limit access to government contracts for employers who are caught in violation of the law.  The bill gives the agency the ability to revoke or suspend the licenses of certain tradespeople (including plumbers, HVAC and sprinkler contractors) who violate the law.  The bill also provides for coordination with relevant State agencies and District Attorneys’ offices for criminal prosecution of employers who fail to pay civil money penalties. Importantly, the proposed legislation contains an amnesty provision to encourage employers to voluntarily phase into compliance.  Finally, the bill would codify a list of eight (8) traditional and common law factors that have been applied in various manners over decades of court decisions to determine whether employees are properly classified as independent contractors.  Senate Bill 694 has been referred to the Committee on Rules, Calendar, and Operations of the House.  Its progress can be tracked here.

No matter the result of this new proposed legislation, in Virginia and North Carolina, employers must be increasingly diligent about worker classification to ensure compliance with applicable federal and state laws. You should ensure that your workers are properly classified and thus avoid future liability for misclassification.