Don't Treat Contractors Like Employees

Independent Contractors vs. Microsoft

When hiring freelancers and consultants, don’t let what happened to Microsoft happen to you.

“Microsoft.” The word conjures up one of the richest and most powerful corporations in the world: the electronic era’s counterpart to Standard Oil or the British East India Company. Who would think that lowly temporary workers would be able to beat one of the world’s mightiest economic juggernauts? But they did just that in a pair of legal decisions that have shocked and frightened not only the software industry, but all businesses that hire independent contractors.

To see how the Microsoft case may affect both temporary workers and the companies that hire them, a little background is in order.

Like many software companies, Microsoft added to its regular core of employees a pool of workers whom it classified as independent “freelancers,” paying them cash compensation (sometimes more than its employees) but none of the fringe benefits available to employees. At least in theory, these workers were hired to work on specific projects, performing functions such as production editing, proofreading, formatting, indexing and software testing.

Microsoft had the workers sign agreements stating that they were independent contractors, or “ICs” (nonemployees), and were not entitled to participate in Microsoft’s employee benefit plans. Microsoft did not withhold or pay any Social Security or other payroll taxes for them.

Microsoft’s problem was that it failed to treat them like ICs -- that is, like people running their own independent businesses. Instead, Microsoft integrated the workers into its workforce: They often worked on teams along with regular employees, sharing the same supervisors, performing identical functions and working the same core hours. Because Microsoft required that they work on site, they received admittance card keys, office equipment and supplies from the company.

Microsoft’s treatment of the workers clearly spelled out “employee,” not independent contractor. A worker qualifies as an IC under the test the IRS and many other government agencies use only if the worker -- not the hiring firm -- has the right to control the manner and means by which he or she does the job. Government auditors examine a number of different factors to determine whether the hiring firm or the worker has this right of control, such as whether the workers must follow company directions, are furnished with tools and materials, are integrated into the company’s regular business and so on.

Microsoft’s failure to treat the workers as ICs first got it into trouble with the IRS. When the IRS audited the company’s payroll tax accounts in 1989 and 1990, it determined that since Microsoft treated the workers as employees -- not independent contractors who control how their services are performed -- they had to be treated as employees for purposes of FICA, FUTA and withholding taxes. Microsoft agreed with the IRS and admitted that the workers should have been classified as employees for tax purposes. The company paid back payroll taxes and overtime for the workers and moved some of them to employee status. Others were offered the “choice” of being let go or continuing to work for Microsoft as employees of a new temporary employment agency. The agency would treat the workers as its own employees, provide payroll, withhold income taxes and pay the employer’s portion of FICA.

However, Microsoft’s legal troubles were far from over. Upon learning of the IRS’s payroll tax determination, eight of the formerly misclassified workers demanded full employee benefits for the time they spent working as independent contractors. These benefits included coverage in the company’s 401(k) plan and a discount stock purchase plan, both of which were generally available to regular employees, but not to ICs. When Microsoft refused, the workers filed suit.

The federal district court dismissed the workers’ suit, but they appealed to the Ninth Circuit Court of Appeals and won. In a much-publicized decision, the appeals court held that the workers could not be excluded from Microsoft’s benefit plans because they were employees, not ICs. The case turned on the fact that Microsoft’s plans contained very ambiguous definitions of just which employees were covered. (Vizcaino v. Microsoft Corp., 97 F.3d 1187 (9th Cir. 1996).)

Later, a 15-judge panel of Ninth Circuit decided to rehear the case. Their decision, which was issued in Spring 1999, largely affirms the prior decision, meaning that Microsoft owes a small fortune to its misclassified workers. (Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997).)

What’s the moral of this story for employers? For starters, it once again shows that merely having a worker sign an agreement that he or she is an IC will not make him or her one in the eyes of the law. Rather, the worker must be treated like an IC on the job. Since the penalties for misclassification can be severe, you must make sure that everyone who deals with ICs in your company understands that they can’t be supervised or otherwise controlled in the same way as employees. ICs are independent businesspeople who must be treated as such.

Misclassifying workers as ICs has always been expensive (if you get caught), but the Vizcaino case can make it even more expensive if your company has generous employment benefit programs such as Microsoft’s. It’s highly advisable for any company that hires ICs to promptly add provisions to all its employee benefit plans specifically excluding coverage for contingent workers. This includes stock option, vacation, sick leave, health insurance and retirement plans. Had Microsoft done this, it might not have had to provide coverage to its misclassified workers.

Copyright 2004 Nolo