Mr. Schmidt

Hospitality Law

The Employment Classification Trilogy - Part II of III: Employee/Independent Contractor Dilemma

By Michael C. Schmidt, Partner, Cozen O'Connor

Despite recent news that the economy may be on an upswing, hotels (like many other large and small businesses) continue to look for ways to reduce costs. One method has been to increasingly engage independent contractors in lieu of employees, and to re-classify current employees as independent contractors.

However, this strategy can land hotels in hot water, as individuals or classes of individuals may not be properly classified as independent contractors, leading to abuses both to the federal and state government and to the individuals themselves. In our prior Part I of this three-part classification trilogy, we discussed the pitfalls attendant to the misclassification of hotel employees as "exempt" for purposes of wage and hour laws. In this article, we turn to the second of three classification issues: the employee/independent contractor dilemma.

According to recent IRS data, more than 3 million workers have been misclassified by employers as independent contractors when in fact they should be classified and treated as employees. From the government's perspective, misclassification results in unpaid federal, state and local tax withholding, as well as unpaid Social Security and Medicare contributions. By misclassifying an individual, companies also avoid paying unemployment insurance and state workers' compensation premiums. For workers, misclassification means they will be excluded from coverage from virtually all anti-discrimination and wage and hour laws, resulting in the potential loss of monetary relief and benefits.

The problem is no longer being swept under the rug, as all three branches of government have significantly stepped-up efforts to audit companies and recoup (with penalties and fines) the monetary losses sustained due to misclassification. This year, on April 22, 2010, Senator Sherrod Brown (D-Ohio) introduced The Employee Misclassification Prevention Act to amend the federal Fair Labor Standards Act, which would impose specific record keeping requirements on companies with regard to individuals who work as independent contractors, and provide special penalties for the misclassification of those workers. Similar legislation was introduced in the House of Representatives.

On the federal executive branch side, the IRS has recently determined to perform its most expansive and widespread audit initiative in recent history. Specifically, the IRS will audit the federal tax returns of 6,000 companies to assess compliance with tax and labor regulations, beginning with the IRS studying the returns of 2,000 companies in each of 2010, 2011 and 2012. This determination was likely prompted, at least in part, by the United States Government Accountability Office advising that the IRS and the United States Department of Labor should step up efforts to reduce company misclassification of independent contractors, and to curb abuses in the areas of payroll taxes, fringe benefits and executive compensation. While there has been little disclosure concerning the method and precise focus of these audits, it is clear that the IRS intends to target a wide spectrum of industries to assemble statistical data for future auditing purposes and develop "red flags" for future audits. State legislatures have also increased their focus on this issue.

More than a dozen states, including New York, New Jersey, Maryland, Delaware and Pennsylvania, have either enacted or proposed legislation setting rules for classifying independent contractors and providing steep financial penalties in the event of non-compliance. Hotels operating in multiple states must consider the laws and rules in their particular jurisdictions. And, on the judicial front, at least one court recently refused to grant a hotel's motion for summary dismissal of a lawsuit seeking unpaid overtime and minimum wage compensation, determining that the plaintiff was entitled to have a jury determine if he truly was an independent contractor rather than an employee of the hotel.

So, what should your business do?

While a hotel can never completely eliminate the possibility of a lawsuit or agency audit, there are ways you can minimize the potential for future liability by taking certain proactive measures if you are engaging, or reclassifying workers as, independent contractors:

  • First, hotels should become familiar with the basic standards for independent contractor classification, and conduct their own internal review to determine whether their current workers are properly classified based on the application of those standards to the actual day-to-day activities of the workers. The IRS has largely moved away from its prior 20-factor test for determining proper classification, and instead favors a more simplified test that focuses on the degree of behavioral and financial control the company can exercise over the individual, and the parties' own views and perceptions of their work relationship.

    Put succinctly, an employer/employee relationship will generally be found if the hotel has a right to control and direct the results of the work performed and the means by which those results are achieved. In conducting an internal audit, it is imperative to look not only at a particular job title, written job description, or even supposed "industry standard", but also at the actual day-to-day functions being carried out by the individual for the particular hotel.

  • Second, hotels should create and maintain sufficient documentation setting forth the reasons for a particular classification, or tax reporting practice, so that they can justify those decisions in the event of any audit. Such documents may include a copy of the independent contractor's certificate of incorporation (or similar document), if any, a certificate of insurance, employer identification number, and other indicia that the independent contractor operates his or her own separate business; copies of business listings from the yellow pages, Internet or other directories, showing the contact information for the independent contractor; copies of invoices, business cards, and/or letterhead with the business name of the independent contractor; and copies of any Forms 1099s, if issued from prior years. In light of the IRS' apparent focus on the parties' own views of their relationship, hotels should also make sure that the proper written agreements are in place detailing the terms of the relationship, and acknowledging the independent contractor status.

  • Finally, hotels may want to consider opting for a responsible third-party leasing organization to provide workers. In such cases, the workers will be deemed employees of the leasing organization, which in turn would withhold taxes, make the appropriate unemployment and workers' compensation payments, and also perhaps provide various other employee-like benefits. The worker can continue to provide services to your hotel, while minimizing the hotel's potential exposure in a lawsuit or audit.

Michael C. Schmidt is a member of Cozen O'Connor in the Labor & Employment Practice Group. A portion of his practice is devoted to advising large and small businesses how to avoid litigation and minimize exposure to claims. He has represented clients in the hospitality and restaurant industry in matters involving wage and hour, discrimination and employment contract disputes. Mr. Schmidt is an Adjunct Professor of Law at Touro Law School in Central Islip, N.Y., he teaches employment law. He lectures and conducts seminars for human resources professionals, corporate executives, and lawyers. Mr. Schmidt can be contacted at 212-453-3937 or Extended Bio... retains the copyright to the articles published in the Hotel Business Review. Articles cannot be republished without prior written consent by

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