By Nigel P. Avilez and Michael J. Killeen
In 2009, Washington state’s Employment Security Department (ESD) paid out nearly $4 billion in unemployment benefits, setting a state record for unemployment claims. This compares to $1.2 billion in 2008 and $725 million in 2007.1 With the increased demands for benefits, Washington, like other cash-strapped states and the federal government,2 is trying to increase payroll tax collections by aggressively challenging independent contractor classifications, tax rates and reporting.
ESD in particular has made no secret of its effort to address the issue, announcing earlier this year: “Cheaters, beware! Employment Security Department is on your tail!”3 In stepping up enforcement efforts, auditors and investigators assigned to ESD’s “Underground Economy Team” have targeted a broad swath of employers, with a focus on employers whom they accuse of misclassifying workers as independent contractors rather than employees. Indeed, the department has characterized employee misclassification as “one of the most common mistakes businesses make when filing their unemployment insurance tax reports.”4
This advisory describes ESD’s independent contractor exemption statute and how the agency has chosen to apply it, often with devastating consequences to businesses including back taxes, penalties, interest and contractor reclassification.
Are your workers exempt independent contractors?
The “independent contractor exemption” under the Employment Security Act provides that an individual is not required to be part of the unemployment insurance system if:
- The individual is free from the employer’s control or direction over the performance of services under the contract; and
- The services are performed either outside the employer’s usual course of business or
outside the employer’s place of business; and
- The individual is customarily engaged in an independently established trade, occupation, profession or business.5
The three-part test is conjunctive. That is, all three parts must be satisfied before a business can properly claim contractors are exempt. The requirements are more strict than the traditional common law independent contractor test and may exclude some individuals who are otherwise independent contractors for Internal Revenue Service (IRS) or other purposes. It often surprises employers to find out how easy it is to fail ESD’s test—a predicament now made worse by the department’s aggressiveness in finding that employers flunk the test.
Part one: Free from direction or control
The extent to which a contractor is free from direction or control is critical.
Evidence that workers are free from direction or control include:
- Employer gives minimal day-to-day directions to contractor, is not on the “jobsite” checking up on contractor, and has minimal contact with contractor. The ideal circumstance is where the employer engages the contractor and walks away;
- Contractors perform services away from employer’s place of business;
- Contractors are experienced in their field and perform work independently;
- Employer does not provide training;
- Contractors are free to accept or reject contracts without jeopardy;
- Employer does not terminate or take disciplinary action against contractors.
ESD often takes an expansive view of this element, arguing that even general instructions in contracts, or merely including a termination provision in contracts, is evidence that the employer controls the methods and details of performance. Employers should expect ESD to be aggressive in claiming direction or control in nearly every interaction between a business and its workers, which places the burden and expense on the employer to seek reversal by means of an administrative or judicial appeal.
Part two: Services outside employer’s usual course of business or away from employer’s place of business
The second element of the test requires that the services either be performed outside all places of business or outside the usual course of business. Satisfying either prong is sufficient. This is the most objective part of the inquiry. As a simple example, if you’re in the widget delivery business and you enter into an agreement with an individual contractor to deliver widgets, then you almost certainly cannot satisfy the “outside employer’s usual course of business” prong. And, if you provide work space to the contractor at your place(s) of business, then the contractor is not performing services away from your place of business.
Unfortunately, some ESD auditors ignore the disjunctive nature of the test and use failure of one prong to conclude that the employer fails this part of the test in its entirety. During audits, employers should ensure that auditors engage in a full analysis of the alternative branches of this element.
Part three: Engaged in an independently established trade, occupation, profession or business
An independently established business exists where an individual’s business exists “separate and apart from the relationship with the employer.” Penick v. ESD, 82 Wn. App. 30, 44 (1996). A frequently cited factor is whether an individual has the ability to continue in business even after the termination of the relationship. Other factors courts consider include whether:
- Contractor has separate office or place of business outside of the home;
- Contractor has investment in the business;
- Contractor provides equipment and supplies needed for the job;
- The alleged employer fails to provide protection from risk of injury or nonpayment;
- Contractor works for others and has individual business cards; and
- Contractor is registered as independent business with state, i.e., has a UBI.
In practice, ESD’s analysis frequently focuses on two things:
First, is whether the contractor provides services in the manner of a traditional business, i.e., does the contractor conduct business under a company name with office space as his or her place of business; does he or she employ others, etc. Accordingly, the department tends to fail employers who engage entrepreneurs operating informal small-scale sole proprietorships. Nor does ESD seem to accept that independently established professionals, who operate simple, small capital businesses, could satisfy this element.
Second, is whether the contractors are registered as independent businesses. ESD will often use the presence or absence of a UBI as determinative of whether a contractor can pass this test. That is, no UBI means no possibility of obtaining contractor status. Because, as a matter of law, having a UBI is only one factor of this test, and not even the crucial factor, this is error for ESD to do. Nevertheless, to avoid a costly fight with ESD over this point of law, employers should ensure that contractors they engage possess UBIs.
Keeping ESD off your tail
The cost of misclassifying contractors can be substantial, not only due to back taxes, penalties and interest, but also because reclassifying contractors as employees may be an untenable business model for certain employers. To avoid or mitigate risk of tangling with ESD (and other state agencies or the IRS who engage in similar inquiries) and having contractors reclassified, there are several steps employers should take:
- Consult with experienced counsel about applicable law, and how ESD, as a practical matter, applies the law.
- Review independent contractor relationships to ensure that the classification complies with applicable statute, and reclassify contractors as employees if necessary and feasible.
- Do not primarily rely on contract language or industry custom; look for how much control is exercised, either in the contract or in practice, over how the contractor does his or her job.
- Take proactive steps with counsel to (1) revise and simplify contracts with independent contractors to closely track the independent contractor statute and other applicable law; (2) structure relationships with independent contractors to ensure that relationship, in fact, complies with applicable law; and (3) maintain and update records of contractor UBIs.
1 “2009: A Record-setting Year for Unemployment Claims, Job-seekers,” ESD News Release, Dec. 29, 2009, available at http://www.esd.wa.gov/newsandinformation/releases/2009-a-record-setting-year-for-unemployment-claims.php.
2 See Stephen Greenhouse, “U.S. Cracks Down on ‘Contractors’ as a Tax Dodge,” New York Times, Feb. 17, 2010, available at http://www.nytimes.com/2010/02/18/business/18workers.html.
3 “Investigators, Auditors Shine Light on Cheaters,” ESD News Release, Feb. 8, 2010, available at http://www.esd.wa.gov/newsandinformation/releases/investigators-auditors-shine-light-on-cheaters.php.
4 Independent Contractor Information, available at http://www.esd.wa.gov/uitax/taxreportsandrates/whoandwhattoreport/independent-contractors.php.
5 RCW 50.04.140(2) states an alternative six-part test, containing three additional elements. Employers should be aware that some improperly trained and/or overzealous auditors may attempt to use an employer’s failure to satisfy additional elements in this six-part test as basis to disqualify contractors.