Winter 2008

Archived Articles

I. Introduction: Use of Independent Contractors

For startup companies inevitably constrained by limited funding and resources, independent contractors have historically provided a cost-efficient supplement or even substitute for their workforce. Without shouldering the costs of training or, in many cases specialized equipment, startup companies can retain the services of skilled professionals to help develop and establish their companies’ core business. Independent contractors also allow startup companies to bring on experts on an as-needed basis to provide companies with one-time services such as information technology setup or website design. Further, independent contractors can provide companies with substantial savings in taxes, benefits and administrative costs and convert fixed cost to variable cost.

As a state that has served as a launching ground for so many startup companies, Massachusetts’s involvement in regulating independent contractors has varied over the years and has recently evolved again. Prior to 2004, the Massachusetts legislature identified independent contractors using the same age-old twenty-factor process adopted by the Internal Revenue Service. However, in 2004, under pressure from construction industry unions and with little regard for how it would impact other industries, Massachusetts enacted Massachusetts General Law chapter 149 §148B, also known as the Massachusetts Independent Contractor Law (the “MICL”). In December of that year, the Massachusetts Attorney General (the “Attorney General”) issued an advisory (the “2004 Advisory”) stating that the MICL would qualify far fewer workers as independent contractors generally and make it nearly impossible for individuals providing services within the company’s usual course of business to be considered independent contractors. The 2004 Advisory also listed a variety of civil and criminal penalties companies could face for noncompliance with MICL.

In May 2008, the Attorney General issued Advisory 2008/1 on the MICL (the “2008 Advisory”) which superseded the 2004 Advisory discussed above in an attempt to further clarify the three elements of the MICL.

This article presents an overview of the MICL and the 2008 Advisory and its potential application in the context of hiring and outsourcing practices of startup companies.

II. Interpreting the Language of the MICL

The MICL presumes that “an individual performing any service” is an employee unless she fulfills all three of the requirements listed by the statute. These elements are:

(a) Freedom from control;

(b) Service outside of the usual course of business; and

(c) Independent trade, occupation or business.

(a) Freedom from control

To fulfill this element, an employer must show that a would-be independent contractor is:

. . . free from its control and direction in performing the service, both under contract and in fact.

The Attorney General has stated that in order for an employer to fulfill this element, any employment contract or job description with an independent contractor must indicate that a worker is free from supervisory direction or control, although a contract stating this by itself is not sufficient to classify a worker as an independent contractor. The worker must actually be free from control, examples of which include working without instructions and dictating her own working hours. The only additional guidance the Attorney General offers in its 2008 Advisory is a 2007 case interpreting analogous provisions in the insurance statute[2] generally confirming this principle although further stating that this element did not require that the worker be entirely free from direction and control.

(b) Service outside of the usual course of business

The second element represents perhaps MICL’s most stringent requirement and the greatest departure from the law it replaced in 2004. This element states that to show an individual is an independent contractor the employer must show

that the service provided by the worker is outside the employer’s usual course of business.

The Attorney General notes in its 2008 Advisory that prior to the 2004 amendments “the employer could alternatively demonstrate that the work was performed ‘outside of the all places of the business of the enterprise.’” With the change in the law, this is of course no longer relevant. Recognizing the lack of judicial precedent directly interpreting this second prong and its inherent complexity, the Attorney General  has indicated that in its enforcement actions, the question it will ask is whether or not the service the worker is providing is “necessary” to the business of the employer or merely “incidental.”

Taken at face value, this restriction can be particularly troubling for startup companies since it seems to require companies to hire all personnel related to the companies’ key services or procedures as employees even if it may be more cost-efficient to bring in a temporary workforce of contractors. In the application of the necessary versus incidental analysis, the Attorney General has offered up three examples of how it will view potential violations of this element:

• A drywall company classifies an individual who is installing drywall as an independent contractor. This would be a violation of prong two because the individual installing the drywall is performing an essential part of the employer’s business.
• A company in the business of providing motor vehicle appraisals classifies an individual appraiser as an independent contractor. This would be a violation of prong two because the appraiser is performing an essential part of the appraisal company’s business.
• An accounting firm hires an individual to move office furniture. Prong two is not applicable (although prongs one and three may be) because the moving of furniture is incidental and not necessary to the accounting firm’s business.

These examples call into question various common startup practices, such as bringing on functions initially via independent contractors until the startup is better funded and establishing virtual companies where most if not substantially all functions are outsourced.  In addition, many technology startup companies are not involved in trades or other easily identifiable industries. What is the business of a college social networking website that derives its revenues principally from advertising? Which functions are an essential part of its business? Website development, sales, business development, finance?  Arguably all of those functions are necessary or essential.

 (c) Independent Trade, Occupation or Business              

Finally, the MICL requires employers to show

that the worker is customarily engaged in an independent trade, occupation, profession or business of the same type.           

This language suggests that to be considered an independent contractor a worker must provide to others or hold himself out as providing similar services as those provided to the to the employer. The Attorney General’s 2008 Advisory again cites a case interpreting the insurance statute where the court indicates it will consider “whether a worker is capable of performing the services to anyone wishing to avail themselves of the services [or whether] the nature of the business compels the worker to depend on a single employer . . . In this regard, we determine whether the worker is wearing the hat of the employee of the employing company, or is wearing the hat of his own independent enterprise.”

III. Liabilities for Noncompliance

The range of potential legal actions that may be taken against employers who violate the MICL is wide. The Attorney General may issue a civil citation or institute criminal prosecution for both intentional and unintentional violations of the MICL. Misclassified employees themselves may also bring actions. Potential liabilities include:

• Employers may be debarred from public works project for up to two years.

• Civil violations can carry penalties of up to fifty-thousand dollars ($50,000) while criminal violations could result in prison time and/or fines.

• Generally, liabilities and punishments are greater for employers who willfully violate the MICL. Willful violations are defined as when an employer either knew or showed reckless disregard for whether its conduct is prohibited.

• Additionally, employees misclassified as independent contractors may institute private actions for themselves or others similarly situated. Such actions could include treble damages, attorneys’ fees and costs.

IV. Enforcement

The Attorney General’s 2008 Advisory outlines a number of factors that the office considers “strong indications” of misclassification. These factors include:

• Individuals providing services that are not reflected on the employer’s business records.

• Individuals paid in cash, “under the table” or otherwise provided no documentation as to payment.

• The employer has insufficient or nonexistent workers’ compensation coverage.

• Individual workers are not provided a 1099 or W-2.

• Whether the alleged independent contractors are performing identical services as some employees of the employer.

• Whether the employer provides the equipment, tools and supplies to the worker or requires the worker to purchase such materials from the employer.

• Whether the alleged independent contractor is paying income taxes or paying into the Unemployment Compensation Fund.

IV. Conclusion

If a company using the services of an individual independent contractor is successfully challenged under the MICL, the adverse consequences of this could be numerous, including violations of wage and hour laws, an obligation to pay unemployment following termination and perhaps even damages arising out claims of unlawful termination, in addition to the penalties described above. Fortunately, the IRS and the Massachusetts Department of Revenue have both stated that they will not be guided by the strictures of MICL when determining whether or not withholding and related income taxes are due.  Any company retaining the services of independent contractors should at least consider including clauses in written consulting or independent contractor agreements reciting, acknowledging and/or representing that the independent contractor is free from the company’s control, provides his or her services outside of the company’s usual course of business and to other third parties in the ordinary course. Such clauses may, however, be adverse to the company’s own interest (e.g., in maintaining control over the service person’s activities) and ultimately will not prevent an independent inquiry by the Attorney General as to whether the recited, acknowledged or represented facts are in truth correct and accurate for any particular worker. Accordingly, any company that is using independent contractors should proceed with independent contractor relationships with great caution and strict attention to the MICL.