The Unemployment Insurance Division (UI) of Hawai‘i’s Department of Labor and Industrial Relations (DLIR) has stepped up its efforts to investigate use of independent contractors for purposes of Hawai‘i’s UI law. Over the past few years, the DLIR has hired and trained new investigators who are now reviewing independent contractor relationships. Because a determination by the DLIR’s UI Division of an employment relationship could trigger similar determinations by other agencies, employers who misclassify employees as contractors can be exposed to back wages, unpaid overtime, additional benefits and tax assessments.
In many situations use of contractors makes good business sense. The cost to operate a business in Hawai‘i is high, and managers know employee wages and benefits are among their largest expenses. For many small employers, employment costs and HR administration expenses have been overwhelming. Many have turned to using contractors or outsourcing their employee management functions to staffing agencies or Professional Employment Organizations. Those options can offer reduced employment costs. However, because Hawai‘i’s DLIR is carefully reviewing contractor relationships, employers must understand the requirements to correctly utilize contractors. The DLIR’s focus on contractors has surprised many Hawai‘i employers who have received a request to answer detailed lists of questions sometimes including 50 to 70 questions.
Employers have questioned why the DLIR is expending such efforts to create and ask those detailed questions because the unemployment tax assessment for a single employee is generally far less than the time it takes to pay a manager to answer the questions. The DLIR believes its efforts are necessary to prevent employers from classifying employees as contractors to avoid paying employment taxes and providing expensive employee benefits. Investigators have been preparing those questions to answer the 20 factors listed in Hawai‘i Administrative Rules § 12-5-2. That rule lists 20 factors, similar to the 20-factor test codified by the Internal Revenue Service in 1987 to determine contractor relationships. (https://www.irs.gov/pub/irs-utl/x-26-07.pdf)
The DLIR’s use of the 20-factor test has caused confusion because Hawai‘i human resource professionals applied Hawai‘i’s Unemployment Insurance statute, which requires employers to satisfy the “ABC” test before independent contractors can be excluded from UI taxes. Hawai‘i Revised Statutes section 383-6 requires the following:
Master and servant relationship not required when services performed by an individual for wages or under any contract of hire shall be deemed to be employment subject to this chapter irrespective of whether the common law relationship of master and servant exists unless and until it is shown to the satisfaction of the department of labor and industrial relations that:
(1) The individual has been and will continue to be free from control or direction over the performance of such service, both under the individual’s contract of hire and in fact;
(2) The service is either outside the usual course of the business for which the service is performed or that the service is performed outside of all the places of business of the enterprise for which the service is performed; and
(3) The individual is customarily engaged in an independently established trade, occupation, profession, or business of the same nature as that involved in the contract of service.
The DLIR has explained that employers must satisfy the ABC test, but its investigators use the 20-factor test in HAR §12-5-2 to determine if the employer satisfies each part of the ABC test.
Employers are required to satisfy each part of the test before the DLIR will consider their contractor to be a true independent contractor. However, special attention must be place on part 3, which focuses on the contractor. Part 3 requires the employer to prove its contractor is an independent business. Toward that end, DLIR’s investigators ask for the following: the contract between the employer and contractor; an explanation of how the rates were set; copies of the contractor’s business registration and license, insurance certificates, advertisements, business card(s), and invoices; and asks if checks are issued to a business or individual. If the employer is unable to prove the contractor is a business, the DLIR finds the employer cannot satisfy part 3 and classifies the contractor an employee.
Bottom Line for Employers
If independent contractors are used to perform tasks company employees had performed or continue to perform, employers should be sure it can satisfy all three parts of the ABC test and review the administrative rules to understand the level of proof required. Also understand it is important to have an independent contractor agreement, require invoices for services, issue checks to a company, and be prepared to prove the contractor is a bona fide contractor.
Paul M. Saito is a partner in Cades Schutte’s Litigation Department. He is currently the editor of Hawai‘i Employment Law Letter, where this article first appeared. In that role, he is also a member of Employers Counsel Network.