Labor costs are one of the biggest expenses for any business.[i] One of the most important factors in determining the cost of labor is whether your workforce will be composed of employees or independent contractors. When appropriate, a contractor-based workforce is significantly cheaper to utilize. There are, however, significant risks in using contractors for everyday business needs.
In this blog article, I will briefly discuss the difference between an employee and an independent contractor. Then, I will explain why using contractors is risky based on the Fair Labor Standards Act. This discussion is meant to be educational only; as with most legal issues, the analysis will vary greatly based on your business and its surrounding circumstances. Further, it is limited to only the FLSA. Other federal statutes, such as the Internal Revenue Code, also impose penalties and potential criminal charges in connection to misclassification of employees.
Contractor vs. Employee
Someone starting their own business with no legal counsel or experience might ask: what’s the difference between an employee and contractor? Both are selling their labor. Both are hired to perform specific tasks on behalf of someone else. Why are employees guaranteed certain legal protections, such as minimum wage, overtime, unemployment benefits if laid off, and so forth?
The answer lies more in history than reality. Most Americans sell their labor in exchange for a wage to survive. Employers dictate who does what work, how it’s done, when the worker shows up for work, and dictates their payrate. In order to protect American workers against potential abuse imposed by employers, Congress passed several statutes providing employees with protections. Other non-protective statutes impose duties on those who employ employees, such as a duty to withhold federal income tax.
Independent contractors, in contrast, are viewed as businesspeople in their own right who can adequately protect their rights and negotiate on their own behalf. A plumber is the quintessential example. He or she invests in their own equipment, advertises their services to the broader public, takes on several clients at a time, and largely determines the nature of their work.
Unfortunately, there is no clear-cut bright line between who is an employee and who is a contractor. For example, the Fair Labor Standards Act — the federal minimum wage and overtime statute — defines the term “employee” as “”any individual employed by an employer…”[ii] Helpful, right?
Potentially the most important point in this article is this: the hiring entity and the hired worker CANNOT agree that he or she is a contractor or employee! Whether someone is an employee or contractor is a legal question because most employee protections cannot be voluntarily waived. This makes some intuitive sense because the entire point of protections for employees is the power imbalance between hiring entity and worker; what company wouldn’t require a waiver of minimum wage and overtime as a condition of being hired?
Courts, scholars, and executive agencies tasked with enforcing laws protecting employees generally agree that the focus is: how much control does the hiring entity impose on the hired person? Currently, the U.S. Department of Labor uses a multi-factor test know as the “economic realities test.”[iii] The factors are non-exhaustive, and none weigh heavier than others. The factors are:
- The extent to which the services rendered are an integral part of the hiring entity’s business.
- The permanency of the relationship.
- The amount of the alleged contractor’s investment in facilities and equipment.
- The nature and degree of control by the hiring entity.
- The alleged contractor’s opportunities for profit and loss.
- The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
- The degree of independent business organization and operation.
Several federal agencies and other state minimum wage & overtime laws use their own test. Some are more lenient while others are more stringent. In addition, the federal economic realities test has changed over time and may be different when the reader first reviews this blog article. Caution should be warranted, and an attorney should be consulted.
Misclassification & the Resulting Consequences
As mentioned previously, whether a worker is properly classified as an independent contractor or employee is a legal determination. Because there are no bright line rules, any use of contractors in your workforce risks a judge or government agency deciding you misclassified them because they were actually employees. Whether that inherent risk is worth the cost savings depends heavily on the business industry, work performed by the contractors, and innumerable other factors which are beyond the scope of this article.
Assuming a worker is misclassified, here are some of the bad things that can happen.
FLSA: Unpaid Minimum Wage, Overtime, Liquidated Damages, & Attorneys’ Fees
Most businesses contemplate using contractors in lieu of employees to avoid paying minimum wage or overtime compensation. The cost savings can be enormous on overtime alone. It’s far easier to manage three employees working eighty hours a week than six employees working forty hours per week.
The Fair Labor Standards Act, however, gives workers a right to sue if they are not paid correctly.[iv] The statute of limitations is generally three years. As you can imagine, three years of unpaid overtime and minimum wage per worker can be an immense burden to bear all-at-once but it gets worse. Generally, misclassified employees are also entitled to liquidated damages which, in the context of the FLSA, are a doubling of however much they were not paid. For example, an employee owed $10,000 in overtime would also get $10,000 in liquidated damages as well.
Potentially the most dangerous consequence of misclassification are the potential attorneys’ fees awards. The FLSA requires employers to pay the legal fees of any employee who had to sue for their unpaid wages. Attorney fee awards can far exceed the unpaid wages. For example, one lawsuit in Florida for $21,000 in unpaid wages resulted in almost $500,000 in attorneys’ fees.[v]
Are you an entrepreneur looking to start your business off the right way? Are you an employer who needs some guidance moving forward? Please feel free to reach out via phone at 903-221-9180, email at firstname.lastname@example.org, or submit a Contact Us form via our website.
Note: This article was not written with any particular state law in mind. It is generalized information intended to be used exclusively for educational purposes. This is not legal advice, and no attorney-client relationship has been formed between the reader and the Law Office of Matthew C. Lewis.
[i] See, e.g., Paycor, The Biggest Cost of Doing Business: A Closer Look at Labor Costs (Feb. 23, 2022) (quoting labor expenses as being as high as 70% of overall cost of doing business).
[ii] 29 U.S.C. § 203(e)(1).
[iii] U.S. Dept. of Labor, Fact Sheet 13: Employment Relationship Under the Fair Labor Standards Act (FLSA), https://www.dol.gov/agencies/whd/fact-sheets/13-flsa-employment-relationship (last accessed July 25, 2022).
[iv] 29 U.S.C. § 216.
[v] Wales v. Jack M. Berry, Inc., 192 F. Supp. 2d 1313 (M.D. Fla. 2001).