By Adin C. Goldberg

When we think of "the Microsoft case," the current Justice Department antitrust suit quickly comes to mind. But for those in the labor and employment law field and for employers throughout the United States, Microsoft brings to mind the continuing litigation involving that company's classification of workers as independent contractors, and the expensive consequences of that decision.

The classification issue has broad ramifications for corporate America. The dangers of worker misclassification are significant. Potential tax liability may result, since companies do not withhold income taxes or pay Social Security taxes on behalf of independent contractors. Liability for benefits (such as retirement, health, stock purchase plans and other types of employee fringe benefits) is possible, both to workers improperly classified as independent contractors and to those employed by staffing firms. And, companies may be subject to claims under employment discrimination, labor law, unemployment compensation, and other statutes.

Following a decade of restructuring, reorganizations and downsizing, millions of American workers departed the traditional workforce and became self-employed, or went on the payroll of temporary, leasing, payrolling or staffing companies.

The structure of these arrangements varies. Many companies continue to use independent contractors, often entering into contracts with individual workers to define and delimit the nature of their relationship. Others contract with temporary employment agencies, employee leasing firms, payrolling services, or outside contractors to provide services. A whole new industry has emerged, known as professional employer organizations ("PEOs"), supplying companies with workforces to provide all types of services.

Whatever the arrangement, companies are looking outside the traditional employment box in an effort to achieve flexibility in staffing, reduce or control labor costs, obtain help for specific, targeted projects or for ancillary services in a way that does not expand the payroll, and avoid the burdens and legal risks of managing employees. Often, company management believes too simplistically that by retaining another company to employ workers, or entering into an independent contractor relationship, exposure to liability can disappear or be shifted to others. Recent cases demonstrate, however, that shifting liability is easier said than done, and that the risks of entering into these relationships can be great. The Microsoft case is a prime example.

'Microsoft' Case

Prior to 1990, Microsoft entered into written agreements with hundreds of so-called temporary workers who worked as proofreaders, software testers, production editors, and formatters. Many were labeled "temporary" despite years of working at Microsoft. The agreements included the workers' signed acknowledgements that they were "independent contractors" and not employees, and were responsible for their own insurance, benefits, and taxes, including Social Security taxes. The agreements specifically provided that the workers were not entitled to the various employee benefit programs available to Microsoft employees. The workers submitted invoices for their time which were paid through the company's accounts payable system rather than being paid through the payroll process. Yet, they worked side-by-side with Microsoft employees, performing the same functions under the same supervision, with the same access to the company's offices.

In 1989 and 1990, the Internal Revenue Service conducted an employment tax audit and found that Microsoft either exercised, or retained the right to exercise, control and direction over the services performed by these individuals. Accordingly, the IRS concluded that these workers should have been considered employees, at least for tax purposes.

Microsoft accepted the IRS determination and began to restructure its relationship with the workers. Some of the former contractors were hired directly onto the Microsoft payroll. Others were retained by placing them on the payroll of an employment agency which then contracted with Microsoft to provide the services of the workers. Microsoft's assumption, of course, was that because these workers technically were employed by the agency, and not on the payroll of the company, it had no liability to them.

A few years later, the workers commenced a class action, claiming that prior to the 1990 audit, they were really employees and thus should have had the right to participate in all of Microsoft's employee benefit plans, including the valuable stock purchase and 401(k) savings programs offered to Microsoft's employee workforce. A federal district court rejected the plaintiffs' argument, finding that regardless of their employment status they had contractually waived their rights to Microsoft benefits.

The plaintiffs appealed the dismissal of their claims relating to participation in Microsoft's 401(k) plan and stock purchase plan. Siding with the workers, the United States Court of Appeals for the Ninth Circuit reversed the district court's dismissal.1 In an en banc decision, the court determined that as to the 401(k) plan, the terms of the plan should, in the first instance, be reviewed by the plan administrator to determine whether, under the plan, the workers were covered. As to the stock purchase plan, the court held that the workers were both common law employees and employees under the terms of the plan and as such entitled to participate in the plan. The court remanded the case to the district court to determine an appropriate remedy.

On remand, the plaintiffs raised the issue of the status of those workers who, following the IRS audit, continued to perform work for Microsoft while on the payroll of a temporary agency. Additionally, they sought relief for those who were hired by the temporary agency to work at Microsoft after the 1990 audit. This issue once again made its way to the Ninth Circuit which earlier this year ruled that all of those performing work for Microsoft while on the payroll of the agency were covered by the class action.2 The court reasoned that "even if for some purposes a worker is considered an employee of the agency, that would not preclude his status as common law employee of Microsoft. The two are not mutually exclusive." Thus, according to the Ninth Circuit, a worker is not automatically excluded from participation in one company's benefit plans merely because he is on the payroll of another company.

Cases Proliferate

If you think Microsoft was an aberration, think again. There are a growing number of cases in which similar claims are being made. Last year, the U.S. Department of Labor brought suit against Time-Warner in its capacity as administrator of the company's employee benefit plans.3 According to the Labor Department, the entertainment and publishing giant mistakenly classified workers as independent contractors or temporaries, thereby depriving them of the health and retirement benefits provided to "regular" employees. The Labor Department is alleging that Time-Warner and its administrative committee have violated the Employee Retirement Income Security Act, the federal employee benefits law, and that the committee has breached its fiduciary obligations by failing to enforce the participation rules of the plans to include temporary workers. Time-Warner disputes the allegations.

A recent court of appeals decision reinstated a suit against California's Pacific Gas & Electric Company by a group of workers who worked at a PG&E office but were on the payroll of an employee leasing agency.4 The workers claimed that PG&E violated ERISA by failing to include them in the company's benefit plans, including a retirement benefit plan. The retirement plan covered all PG&E employees but excluded "leased employees, as defined by §414(n) of the Internal Revenue Code." The plan administrator determined that because the employees were employed by a leasing company, they were not entitled to coverage under the plan. A district court dismissed the action, concluding that the workers were not PG&E employees.

The appellate court refused to defer to the plan administrator's determination, concluding that because the plan incorporated a statutory definition of a worker's status, no deference was required. The court remanded the case to the district court for a determination of whether the leased employees were "common law employees" and thus entitled to coverage.

Beyond Benefits

The classification issue goes beyond employee benefits. The Equal Employment Opportunity Commission, which enforces the nation's employment discrimination laws, has gotten into the act. It recently issued extensive guidelines on the subject of who can be held liable for discrimination and harassment claims, particularly in situations where a worker is on the payroll of one company, but actually performs services for another. According to the EEOC, liability in these cases can be the joint responsibility of both companies (often referred to as the "joint employer" theory). But the EEOC also would absolve the payrolling employer in many cases where the discriminatory conduct was solely the responsibility of the company at which the work was performed.

The EEOC's view has support among the federal courts. Under the theory of "joint employer," both the "technical" employer and the company for whom the work actually is performed have been held liable for discrimination under Title VII of the Civil Rights Act of 1964, the Age Discrimination in Employment Act of 1967, and the Americans with Disabilities Act of 1990.5 In other cases, courts have ruled that the company at which an individual works, rather than the firm which issues the paycheck, is liable for discrimination or harassment, particularly where the payrolling firm has no knowledge of or involvement in the decisions or behavior being challenged.6 The Labor Department also has adopted this view in its interpretation of the requirements of the Family and Medical Leave Act.

Recent Fair Labor Standards Act decisions also reinforce the need for proper classification of workers. In those cases, individuals treated as independent contractors sued for overtime pay violations, contending that they should have been considered employees. Labor Department regulations recognize that an individual can be a statutory employee of more than one employer at the same time for FLSA purposes.7 Under this theory, the company for whom the work is performed may be liable for a staffing company's noncompliance with minimum wage, overtime pay, child labor, and equal pay violations.

Similarly, under the National Labor Relations Act, "joint employer" status has been found in a number of cases where both the payrolling company and the firm for whom the work is performed exercise control over the worker. The National Labor Relations Board has included a staffing company's workers in the bargaining unit of the company at which the work is performed if there is a sufficient nexus between the staffing firm's employees and the company.8

The test for determining whether an individual is an employee varies according to the statute at issue. For purposes of the employment tax laws, for example, the Internal Revenue Code defines "employee" to mean "any individual who, under the usual common law rules applicable in determining the employer-employee relationship, has the status of an employee." IRS regulations state:

Generally such relationship exists when the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done. In this connection, it is not necessary that the employer actually direct and control the manner in which the services are performed; it is sufficient if he has the right to do so.9

20 Questions

The IRS's "20 questions" test often is used as a guide to determine whether sufficient control exists to establish an employer-employee relationship.10 The test, which has been criticized in recent years as too cumbersome and leading to uncertain results, nonetheless serves as a useful guide to the factors looked at to determine employment status. According to agency regulations, the relevant factors are as follows:

1. Instruction: the company provides the worker with specific instructions on how the services are to be performed.

2. Training: the company provides the worker with training relating to the services to be performed.

3. Integration: the nature of the services are an integral part of the company's operations, rather than merely a support, staff or ancillary function.

4. Personal services: the individual personally performs the services for the company, rather than hiring his own workforce to do so.

5. Hiring and paying: the company hires and pays the worker.

6. Length of relationship: there is a continuing relationship between the worker and the company, similar to the continuing relationship between an employer and its employees.

7. Hours of work: the company establishes the hours during which the work is to be performed.

8. Amount of time: the worker devotes all or substantially all of his time working for the company, restricting his ability to sell his services to others.

9. Location of work: the work is performed on the company's premises, particularly where the work could be performed elsewhere.

10. Order of work: the company determines the sequence or order of the work performed, or sets the priority of work.

11. Reports: the company requires the worker to submit reports.

12. Payment: rather than payment by the job, the company compensates the worker by the hour, day, week or month.

13. Expenses: the company reimburses the worker for expenses relating to the work, rather than those expenses being figured into the overall price by the worker.

14. Tools and equipment: the company supplies the tools and equipment necessary to perform the work.

15. Capital investment: the worker has made a significant investment in the business.

16. Profit or loss: the worker can realize a profit (or loss) by the investment of his time and effort.

17. Multiple companies: the worker can perform work during the same time frame for more than one company or individual, indicating that the worker is in business for himself and is not dependent for his income on one company.

18. Making services available: the worker engages in efforts to market his services to others, not merely to the company for whom he is performing work.

19. Discharge: the company retains the right to discharge the worker in the same manner as it does its employees.

20. Terminate: the worker can terminate his relationship with the company without incurring liability.

Review Required

Intensified Internal Revenue Service scrutiny, combined with the rise in lawsuits and agency enforcement, mandate that companies review the status of all workers who are being treated differently than "regular employees" under company benefit programs. The IRS and the courts look at a variety of factors to determine whether an individual truly is an employee of a company, including the degree of supervision and control which the company exercises over that individual, the regularity of the work, the freedom of the individual to sell his services to others, where the work is performed, who provides the tools and materials, and how payment is made.

A word to the wise: prevention remains the best cure. A self-audit of the company, focusing on those not classified as company employees in the context of factors relied upon by the IRS, the Labor Department, other government agencies and the courts, will go a long way toward limiting company exposure to the growing threat of government and worker litigation.

ENDNOTES

1 Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997)(en banc), cert. denied, 118 S.Ct. 899 (1998).

2 Vizcaino v. Microsoft Corp., 173 F.3d 713 (9th Cir. 1999).

3 Herman v. Time Warner, Inc., No. 98 Civ. 7589 (S.D.N.Y., filed October 26, 1998).

4 Burrey v. Pacific Gas & Electric Co., 159 F.3d 388 (9th Cir. 1998).

5 See, e.g., Rivas v. Federacion de Associaciones Pecurias de Puerto Rico, 929 F.2d 814 (1st Cir. 1991); Poff v. Prudential Insurance Co. of America, 882 F. Supp. 1534 (E.D. Pa. 1995); Guerra v. Tishman East Realty, 52 Fair Empl. Prac. Cas. (BNA) 286 (S.D.N.Y. 1989).

6 See, e.g., Caldwell v. ServiceMaster, 966 F. Supp. 33 (D.D.C. 1997).

7 29 C.F.R. §791.2.

8 NLRB v. Western Temporary Services, 821 F.2d 1258 (7th Cir. 1987); Continental Winding Co. and Kelly Services, 305 N.L.R.B. 122 (1991).

9 Treas. Reg. §31.3121(d).

10 Rev. Rul. 87-41.

Adin C. Goldberg is a partner in the Labor and Employment Department of Whitman Breed Abbott & Morgan LLP. If you have questions or concerns, please call Adin at 212-351-3453 or e-mail him at agoldberg@wbam.com.

Reprinted with permission from the Outside Counsel column in the November 8, 1999 edition of New York Law Journal. @1999 NLP IP Company.