Employee Privatization Concerns Exist in Light of Recent Court Decisions and Legislation

With tight budgets, school districts are likely to consider privatization of noninstructional support services and contracts with third parties for administrators. The decision to use contracted service arrangements raises numerous legal issues, not the least of which involves employee misclassification, which may result in serious consequences. In the past, this firm has cautioned its retainer clients that contracted services agreements with third-party vendors are not a panacea and should be approached with caution. See, e.g., School Law Notes, October 28, 2010. This is especially true in light of recent court decisions and legislation such as the Patient Protection and Affordable Care Act (“PPACA”).

The Michigan Court of Appeals has recognized that a school district may contract with a third party to provide individuals to perform noninstructional services. See, e.g., Mantei v Michigan Pub Sch Employees Retirement Sys, 256 Mich App 64 (2003). In Mantei, the Michigan Public School Employees Retirement System (“MPSERS”), using the 20-factor test most commonly applied by the IRS, determined that a contracted individual was an employee of the district, rather than an independent contractor. The Court of Appeals reversed the determination made by MPSERS and, instead, applied a more limited, and district-friendly, “economic reality test.” The “economic reality test” analyzes four factors: (1) control of the worker’s duties; (2) payment of wages; (3) the right to hire, fire, and discipline; and (4) performance of duties toward the accomplishment of a common goal. Narrowly interpreting the unique facts in Mantei, the Court of Appeals determined that the contractor controlled the individual’s duties, paid his wages and had the right to hire, fire, and discipline. Thus, the contractor, rather than the school district, was found to be the service provider’s employer.

While Mantei continues to provide guidance regarding whether a true independent contractor relationship exists, such arrangements are being scrutinized with increasing vigor by the State of Michigan and federal government. Consequently, it must be emphasized that the Mantei decision is not an unlimited right to secure individuals as “contractors” who otherwise typically would be employees. The Mantei case likely would have had a different outcome if the facts had been altered even slightly. When reviewing a contractor relationship, school officials should consider criteria including:

  1. Does the school have the right to control the manner and method of the individual’s performance, including a duty to train the individual? An individual who is required to comply with another’s instructions as to where, when, or how work is to be accomplished is generally considered an “employee.” Schools must avoid contractual language, or actual practice, in which its administrators directly control the performance of contracted service providers. Further, contracts with a third party that require the school district or academy to direct or train the third party’s employees must be avoided.
  2. Will the individual incur substantial cost to perform the services? Employees typically do not invest in supplies, materials, and other items necessary to run a business. This lack of investment indicates dependence upon the “employer.” Districts should avoid providing the tools necessary to perform the duties. Similarly, certain “independent contractors” who provide third-party noninstructional services have indicated that they intend to assess directly to their school district customers the cost of the PPACA penalty for not providing health insurance to full-time employees. We caution that the PPACA penalty is one that is assessed against the “employer” and could be used as evidence of an employer-employee relationship between the contracted individual and the school district or academy.
  3. Will the individual have an opportunity for profit depending upon management skill? This factor assesses whether a contractor’s profit may be enhanced by managing the operation in a manner that reduces costs to the contractor, thus leaving more profit between the cost of operation and the agreed upon price for the service. Some contracts do not contain a set price for the services, but, rather, require the district to pay the wages for the employee plus a set administrative fee. In such circumstances, the contractor may have little or no interest in reducing the hours necessary to accomplish their task. Care must be taken to avoid assuming contractual responsibility for costs that typically fall to the employer, such as increases in employment taxes or workers’ compensation costs.
  4. Will the school district have the right to hire? If the contract (directly or indirectly) mandates that the third party send a particular individual to perform services, or mandates that a third-party hire the district’s former employees, it is more likely that a court will find that those individuals remain employees of the district.

The above criteria are not exhaustive. More recent guidelines have focused on whether there is a presence or absence of instructions (the giving of instructions by the service recipient is an indicator of “employer” status). Regardless of how an entity or court arrives at a determination of an “employer-employee” relationship, an adverse determination can be devastating to a school district’s finances.

Consequences of Misclassification

Accurate classification of an individual as an employee or independent contractor is essential for several reasons.

PPACA Misclassification. As noted above, some thirdparty contractors have determined to avoid providing health insurance to employees performing as alleged “independent” contractors, opting instead to pass the cost of the PPACA penalty to the school where the individual provides services. Not only does this suggest an employer-employee relationship, but it could have a significant financial impact. If the “contracted” individuals are found to be school employees, they would be counted when determining whether the school provides health insurance to its full-time employees. By way of example, if a school with 200 full-time employees contracts for 15 full-time custodians who are later found to be “employees” of the school, the school would no longer fall within the safe-harbor created by providing 95% of fulltime employees with health insurance. This could subject the district to a potential $430,000 PPACA penalty.

MPSERS Contribution. Public school districts are not required to make MPSERS contributions for individuals who are independent contractors. If, however, MPSERS determines that an individual has been erroneously classified as an independent contractor instead of an employee, retroactive contributions may be required, including the payment of a $25 per day, per individual, penalty. Individuals violating the Michigan Public School Employees Retirement Act with intent to deceive, are guilty of a criminal misdemeanor, which is punishable by imprisonment for not more than 90 days or a fine of not more than $500, or both. MCL 38.1405.

Unemployment. The issue of “employee versus independent contractor” may arise in the context of a separated individual’s claim for unemployment compensation benefits. An employer-employee relationship also involves potential for unemployment compensation liability, while an independent contractor arrangement does not.

IRS Code Implications. Erroneous categorization of an employee as an independent contractor also may affect employee annuities through salary reduction plans. To qualify under Section 403(b) of the Internal Revenue Code, a salary reduction plan must (with limited exceptions) be offered to all employees. IRC §§ 403(b) (12) (A); see Notice A9-23, 1989-1. Similar provisions apply to Section 125 plans. Failing to properly categorize employees could prevent a school district from gaining the advantages of pretax sections of the IRS Code and subject it to various taxes and penalties.

Payroll Taxes. Liability may be incurred for failure to pay and withhold FICA taxes for an employee. The potential exposure is a penalty based upon the amount of tax that was not withheld due to the original misclassification. If the IRS determines that there was no intentional misclassification, the employer’s penalty is 20% of the amount that should have been withheld from the employee’s wages for FICA. The penalty for failure to withhold is 1.5% of the amount required to be withheld if a Form 1099 is filed. If a Form 1099 is not filed, the amount of liability increases to 3% of the amount required to be withheld. IRC § 3059. If the IRS determines that the employer’s failure to treat the individual as an employee was due to intentional disregard or if the institution withheld income taxes but not FICA, the employer is liable for the full amount of taxes required to be withheld. The institution’s liability is not reduced even if the employee paid the full amount of taxes owed. Some relief for misclassification, however, may be available under IRC § 530 for employment taxes.

Other Statutes. Other “misclassification” consequences can occur under the Fair Labor Standards Act, which regulates minimum wages and overtime, various civil rights legislation such as Title VII and the Age Discrimination in Employment Act, and the Family and Medical Leave Act (“FMLA”). These statutes all extend rights and protections to “employees,” which an institution is likely to disregard or overlook if it has erroneously considered an individual an independent contractor or an employee of an independent contractor. FMLA regulations require a finding of joint employment where a temporary or leasing agency supplies an employee to a second employer. 29 CFR § 25.106(a). Other federal regulatory agencies use a similar approach.

Immunity. School employees generally enjoy governmental immunity from tort claims, while independent contractors do not. Rambus v Wayne Co General Hosp, 193 Mich App 268, 273 (1992). Thus, any transition to independent contractor status creates greater potential exposure to litigation and liability for any alleged negligence connected with the independent contractor’s performance. Likewise, if an individual is found to be dually employed by a public and a private entity, governmental immunity will not apply. Similarly, the immunity afforded to an administrator as an employee of that district would not apply to a “contracted” individual. Nalepa v Plymouth-Canton, 207 Mich App 580, 589 (1994). A similar warning is required for “contracted” coaches. In Sherry v East Suburban Football League, 292 Mich App 23 (2011), the Michigan Court of Appeals affirmed the lack of governmental immunity for coaches employed by a private entity.

The use of contracted services likely will continue as schools seek ways to conserve resources. Accordingly, we remind our clients that an initial review of the proposed arrangement may help reduce the potential pitfalls of a poorly drafted agreement. School officials are encouraged to contact their legal counsel when considering such arrangements.