Gary Terrio used to work for himself driving lost luggage from the airport in Manchester, N.H., out to the owners’ homes. “Working with my own business I could deliver whatever I wanted,” he says. “If it was something that was ridiculous, I could say no.”
When he and his wife started a family, he started looking for something more lucrative and stable. He heard that FedEx Ground drivers in the shipping giant’s home delivery division bought their delivery routes and worked them as their own business, which sounded pretty good. He could earn more and still be his own boss.
“And is that how it panned out?” Terrio laughs. “It was nothing, nothing, nothing of what they said.”
Rather than making his own schedule, he had to be at the package terminal for pick-up at 6:00am FedEx Ground paid by the delivery, not the hour, and assigned the roster of packages each day. If Terrio delivered the package outside the window of time that FedEx assigned or if a customer complained, his paycheck got docked. He had to buy his own FedEx specified truck and financed and insured it by refinancing the mortgage on his house. After all the expenses and deductions, he says he’d be lucky to bring home $500 a week. “I would have loved to have been just an independent contractor,” he says. Instead, “I felt like an employee.”
You might think it’s easy to know the difference between an employee and an independent contractor. It’s not. The distinction sits in a stubbornly murky corner of the law, and workers, employers and governments have a lot riding on the outcome. Meanwhile the number of people who are working but not considered employees continues to grow .
Employees are eligible for a host of legal benefit and protection programs that governments run and regulate. Employers must pay into those programs on behalf of “employees,” but not “independent contractors.” The murkiness comes in when someone calls a worker’s status into question, often when a worker and employer disagree over what benefits are due. There is not one single, legal definition for “employee” or one central government agency that decides a worker’s status. Different federal agencies regulate different aspects of employment, and often apply distinct tests to make the decision. State agencies may use other measures still.
Supreme Court Justice Hugo Black wrote in a 1968 opinion that “there is no shorthand formula or magic phrase that can be applied to find the answer,” and, for at least as long, lower courts have bemoaned the difficulty of deciding these cases.
The confusion is so entrenched that in the case of the IRS — which calculates the federal tax employers owe based in part on how many employees they have — there is a federal law prohibiting the service from issuing clearer guidelines for distinguishing between employees and independent contractors. Legislation introduced in Congress as recently as March 1 aims to address these issues, but historically, similar bills have not made it very far in the legislative process.
Terrio felt like he was taking all the risks of being a contractor without being able to exert control over the work. Some of his fellow drivers agreed and in 2005 sued , arguing that in reality they were employees and that FedEx’s treatment of them violated federal overtime and state labor laws. The case is still ongoing.
Increasingly, businesses have been shifting to contractor workforces to save money and reduce regulatory exposure. Critics say the model is so alluring that some businesses find ways to intentionally “misclassify” employees as independent contractors. When that happens people lose legal rights, governments lose tax revenue, and businesses gain an unfair advantage over competitors who pay the extra costs to treat their workers as employees. Federal and state governments have started coming down harder on businesses for misclassification, but without a clear definition for employee, how much of the problem can they really solve?
The right to a Ron Paul bumper sticker?
If Terrio had been working as an employee, the Department of Labor would ensure that he earned overtime pay and could collect workers’ compensation if he had gotten hurt on the job. Anti-discrimination protections would have prevented any of his fellow drivers from being terminated just because they were Latino, a woman, or 52-years-old. As an independent contractor, over 10 percent of his pay went to Social Security and Medicare taxes. As an employee, FedEx would have split that bill and contributed to a state unemployment insurance fund that Terrio could draw on if he lost his job. Independent contractors don’t get any of it.
Once, Terrio’s infant son was too sick for daycare. His wife couldn’t get time off so Terrio had to strap him in the front seat of the truck. An employee whose child has a “serious health condition” would generally be entitled to time off under the Family and Medical Leave Act.
Rich Farrell, a New Jersey FedEx Ground driver and medic in the Army National Guard, was deployed overseas for six months. FedEx terminated his contract and refused to let him come back; a move that would have been illegal if he had been classified as an employee.
Tony Marcellino, a FedEx Ground driver in California, died on the job in a traffic accident. His family couldn’t collect death benefits under California's Workers' Compensation Act that families of employees receive.
While foregoing benefits, Terrio wasn’t getting the freedoms he expected as a contractor, either. He got frustrated when he wasn’t allowed to put a Ron Paul sticker on the truck he’d refinanced his house for, or run personal errands in it without masking all the FedEx logos. “What does it matter if I stop at the store and pick up groceries?” he says. “It’s my truck.”
The government doesn’t regularly count independent contractors. The last time they did, in 2005, contractors represented up to 7.4 percent of the workforce, or 10.3 million  people, up from 6.7 percent, or 8.3 million, in 1995. Observers agree that the number has likely grown since.
Denise Drake , a management-side attorney in Kansas City, Mo., says “We absolutely see employers using as many different staffing arrangements as possible to get their jobs done in the best and most cost-effective manner possible,” Drake says. “This means there has been, and likely will continue to be, a big increase in the use of temporary employees … and independent contractor arrangements.”
Catherine Ruckelshaus , legal co-director for the National Employment Law Project, says businesses can save 30 percent substituting independent contractors for employees. She sees the growth of independent contractors in the workforce running hand-in-hand with increased misclassification. “The independent contractor abuses have been rising for a while. Even before the recession it was really kind of a surge,” Ruckelshaus says.
A Labor Department study from 2000 audited companies in nine states and found that up to 30 percent had misclassified employees. Between 2007 and 2010, New York state alone identified over 50,000 cases of misclassification, assessing over $21.5 million in taxes and over $4 million in fines. The Labor Department study estimated that every 1 percent of the workforce misclassified as an independent contractor cost federal unemployment insurance funds $200 million.
A FedEx spokeswoman says the company stands by its independent contractor model because it “gives us a flexibility to be competitive in the market.” It’s a flexibility FedEx has gone to great lengths to keep. A 2010 audit from the Montana Department of Labor Insurance of FedEx Ground’s operations there shows one way the company keeps workers as contractors.
The audit found  that FedEx Ground would advertise on its website for temporary drivers. FedEx conducted an interview and if they decided to hire, the driver would complete paperwork at the FedEx terminal or online for an outside temporary employment agency. The agency, not FedEx, would issue paychecks. “A few of these drivers were already employees of FedEx in other capacities,” the audit said. Montana ruled those drivers ought to have been classified as FedEx employees.
Rather than comply with the audit determinations, FedEx settled  with the state for $2.3 million, admitting no wrongdoing, and adjusted its business operations there. Meanwhile, a spokesperson for the company says that FedEx has continuing relationships with three different temporary agencies nationwide, and uses them “at any point that there is an operational need.”
Montana is not the only state that has looked into FedEx Ground’s employment practices. FedEx’s 2011 annual report says the company is involved in “numerous” lawsuits and audits. Losing those disputes could entitle drivers “to the benefit of wage-and-hour laws,” the report says, and could force FedEx to change their independent contractor status. If that happens, the report warns, “labor organizations could more easily organize these individuals, our operating costs could increase materially and we could incur significant capital outlays.” Drivers at FedEx’s main competitor, UPS, belong to a union.
Terrio’s lawsuit illustrates how complex the wrangling over “employee” status can get.
His suit was not the only one active against FedEx. In fact it was one of 42 separate drivers’ suits coming out of 27 different states. To streamline the litigation they were all rolled together into one federal courtroom in Indiana. In December 2010, the judge announced that drivers in lawsuits covering 23 states were properly classified as independent contractors, but drivers from three other states should have been employees. The case is now on appeal.
So the Indiana court found employment status distinctions among the drivers even though they were doing identical work in different states. To make matters trickier, some drivers were getting different answers from the Indiana court than they had previously gotten in their home state. While Terrio was fighting FedEx in federal court, the state of New Hampshire audited  their operations in 2008 and found hundreds of state labor violations. As in Montana, FedEx settled admitting no wrongdoing. They wrote the state a check, but did not reclassify the drivers as employees. Instead, they now require drivers in New Hampshire to incorporate as businesses before they can buy delivery routes.
The Indiana decision also ruled that drivers in a California suit were independent contractors even though a landmark decision in a California court granted drivers employee benefits from FedEx in 2006.
Stickier still, while the litigation focuses on FedEx’s labor practices, the IRS has already blessed the drivers’ contractor status for tax purposes. After auditing FedEx’s 2002 filings, the service calculated a tentative assessment of $319 million in back tax, penalties and interest for misclassifying the drivers, but withdrew the case in 2009, letting the contractor designation stand.
The criss-crossing categories reflect the haziness in state and federal law over how “employee” gets defined.
“There is nothing definitive,” says Ann Hodges , a labor law professor at the University of Richmond’s law school.
The IRS, for instance, uses a 20-part common-law test that focuses on how much control the employer has over the work. Scoring 11 out of 20 doesn’t guarantee a victory, and no single point clinches. The Department of Labor uses a 7-point test focused on the “economic reality” of the worker’s dependence on the employer. The National Labor Relations Board uses something in between. Many other government employment tests are variations on one of those themes.
At the IRS the confusion is not an accident, it’s the law. The 1935 Social Security Act set up a trust fund for retirees financed by employers contributing an amount equal to a set percentage of each employee’s pay and withholding a sum from each employee’s check. The IRS hadn’t had to distinguish among workers before, but the statute did not define “employee.” The IRS had to glean its 20-point test from court decisions. That worked until the 1970s when the IRS kicked up its misclassification enforcement. When a major tax reform bill came up in the late ’70s, a coalition of lobbyists representing industries built around a contractor workforce — trucking, real estate, construction and direct sales like Mary Kay — saw an opportunity to get the IRS off their backs.
With help from then-Rep. Dick Gephardt and then-Sen. Bob Dole, they condensed the 20-part IRS test into a single law, but couldn’t get it approved. Instead, Congress passed a temporary measure while, theoretically, better language would be crafted. It specifically prohibited the IRS from publishing regulations “clarifying the employment status of individuals for purposes of the employment taxes.” Rather than replacing the temporary law, Congress made it permanent in 1982.
The 1982 law goes further than just banning a clearer definition. It includes a provision that says that if the IRS ever audits a company and doesn’t find any problems with employee misclassification, it can never demand that the same business change its employment practices in a later audit even if it finds misclassification the second time around. FedEx was able to avoid $319 million in back taxes under this provision.
After 1982, the issue mostly hibernated. “There’s been very lax enforcement by federal and state government agencies that has contributed to a comfort zone for employers to increase their use of independent contractors,” says Richard Reibstein , an attorney in New York City who helps businesses write independent contractor policies that will withstand regulatory scrutiny.
In 2006, the Government Accountability Office released a report  on misclassification and renewed government interest. The next year then-Sen. Barack Obama sponsored a bill that would repeal the 1982 ban on the IRS defining employment, but it died. On March 1 this year, both the House  and Senate  introduced another round of bills to free the IRS from the 1982 law, but similar bills have been killed in every Congress since 2006.
More attention or more confusion
The recession has focused the attention of cash-starved governments on the issue. “The governments need money and they look at this as revenue,” says William Weissman, a tax attorney in California. “I also think there’s a push in the current administration to create a safety net for everyone. So if you want people in the system, you’ve got to collect the taxes.”
What Obama could not do legislatively, he’s attempted to do through his agencies. His Department of Labor budget  for fiscal 2013 proposes $10 million for state grants to combat misclassification and $4 million for new federal investigators. The Labor Department is hoping to add 35 more full-time employees to investigate misclassification. The department has also announced information-sharing arrangements with 12 states.
The IRS has begun allowing companies that voluntarily reclassify  independent contractors as employees and pay 10 percent of what would have been owed the previous tax year to avoid other penalties. The IRS refused repeated requests for information on how many businesses had signed up for the program.
States have begun ramping up regulation, too. A new California law , for instance, includes civil penalties up to $15,000 per misclassified employee and up to $25,000 per willful violation.
“There’s a lot of intentional misclassification going on and we would all agree, whatever your party, that that is wrong,” Reibstein says. He worries, though, that this new run of regulation will hurt businesses that make changes out of fear or have to fight off costly enforcement actions and lawsuits.
Weissman says “a simple brightline test would likely be more useful,” than tougher penalties, but that administration-side enforcement is easier than waging a political battle in Congress for a uniform definition.
“Whether that uniformity would wind up tougher or weaker is a political choice,” says Harold Datz, former chief counsel at the NLRB. Interest groups on both sides — from the unions to the U.S. Chamber of Commerce — are wary of a definition that would go against them.
Russ Hollrah , executive director for the Coalition to Preserve Independent Contractor Status, says “I think current law is fine.” The exemption for businesses with a clean prior tax audit “works very effectively.” As for a change that might provide greater clarity, he says, “It depends on the clarity you get.”
Matt Capece, who works for the president’s office of the United Brotherhood of Carpenters and Joiners of America , says “For us in the construction industry, Jesus Christ could write the definition of ‘employment’ and we’d have a problem because the unlawful practices are so ingrained,” he says.
Construction firms that treat their builders as employees, he says, often “face the double indignity of losing jobs to the cheaters,” whose savings on labor allow them to underbid the competition. “Then they see their tax rates going up to cover the people who don’t pay” for unemployment insurance and workman’s compensation, he says.
Capece doesn’t like the term misclassification. “I refer to it as the ‘M’ word,” he says. “What we see is payroll fraud.” He’s heartened by the state escalations and sees the IRS ban on guidance as a “straitjacket,” but for him, enforcement is the game.
The construction industry is a frequent target for state enforcement. In January, Massachusetts’ attorney general extracted $400,000 in unpaid wages and penalties, and more than $141,000 for Massachusetts’ unemployment system from contractors under Pulte Homes, one of the nation’s largest builders.
“Frankly every time we talk about this issue, the other side paints a picture of a husband and wife sitting at a kitchen table with statutes spread all around them, and they can’t figure out how to classify their workers, and they make a mistake, and the government comes in and severely punishes them,” Capece says.
In fact, sitting at Marie Washington’s kitchen table in a rented townhouse in Owings Mill, Md., she is still trying to sort out what she and her husband could have done differently to avoid the employee misclassification lawsuit they’re stuck in. Her husband, Darian, runs Washington Home Installation, which subcontracts out jobs from the company that manages home deliveries for BestBuy.
He pays his installers by the job, but says they pick how many deliveries they want to do, which order in which they want to make them and if they want to come in the next day. In March 2011, a former installer sued the business saying he was denied overtime pay even though he regularly worked 70-hour weeks. In an affidavit, the installer describes having far less control over the work, meaning the lawsuit will involve heavy fact-finding.
Marie maintains that the independent contractor relationship was clear. When they found out about the lawsuit, the Washingtons discovered that because of the uncertainty of employment lawsuits, many lawyers require a hefty down payment — often as much as $10,000 — before they’ll take a case. It was then that Marie says she realized, “We’re really going to have to exhaust all our financial resources.” When they got married, the plan was for Marie, 25, to finish college and build her own career, but that’s been put on hold.
“Even now there’s not clarity,” she says. “I’ve looked at the IRS website, at the state website — there are no answers.”
Meanwhile, the Washingtons worry that if they lose, other former employees will come after them for overtime pay, and they may be vulnerable to other liabilities, too.
“If we’re wrong in all this,” she says, “then what about the government?”
Correction (Apr. 2, 12:35pm): An earlier version of this story identified Pulte Homes as the target of penalties from the Massachusetts attorney general, but it was contractors of the company that were fined.