NJ Supreme Court Reminds Employers: Substance Prevails Over Form When Determining Whether a Worker is an Independent Contractor or Employee

On August 2, 2022, the New Jersey Supreme Court issued its decision in East Bay Drywall, LLC v. Department of Labor and Workforce Development, holding that an employer, East Bay Drywall, LLC, misclassified sixteen workers as independent contractors instead of employees, even though several of them operated through separate limited liability companies. The case provides important guidance to businesses who utilize independent contractors regarding the evidence necessary to show their contractors are properly classified.
New Jersey’s ABC Test for Independent Contractors
New Jersey uses the three-prong ABC Test to determine whether workers are independent contractors or employees. For a worker to be properly classified as an independent contractor, all three prongs listed below must be satisfied:
A. The individual has been and will continue to be free from control or direction over the performance of work performed, both under contract of service and in fact; and
B. The work is either outside the usual course of the business for which such service Is performed, or the work is performed outside of all the places of business of the enterprise for which such service is performed; and
C. The individual is customarily engaged in an independently established trade, occupation, profession or business.
Background of the East Bay Case
East Bay is a drywall installation business that hires workers as needed on a per-job basis. When a builder accepts East Bay’s bid to work on a project, East Bay reaches out to workers (whom it claims are subcontractors) to determine their availability. These workers have no obligation to work on the project. According to East Bay, some of the workers work for businesses other than East Bay. The workers use their own tools, while East Bay provides the raw materials to complete the drywall installation. East Bay is ultimately responsible for the final product, but it does not direct how the workers install the drywall and allows the workers to hire additional laborers to complete the project.
In June 2013, despite continued operations, East Bay stopped reporting wages to the New Jersey Department of Labor and Workforce Development. This served as a de facto announcement by East Bay that it no longer had any employees. After several years of not reporting wages, an auditor for the Department conducted a review of East Bay’s workers hired between 2013 and 2016 to determine if they were misclassified as independent contractors instead of employees—the consequence being that if they were misclassified, East Bay would owe back contributions to the temporary disability and unemployment compensation funds. As part of the audit, the auditor met with East Bay’s accountant and principal, and requested documentation to determine whether the workers were truly independent entities, including insurance information, tax forms, and business cards.
Ultimately, the auditor concluded that twelve business entities and four individuals working for East Bay during the reviewed period were misclassified as independent contractors instead of employees.  This was about half of East Bay’s workers during that period. As a result, the Department told East Bay that it owed $42,120.79 in unpaid temporary disability and unemployment contributions.
East Bay contested the results and demanded a hearing in the Office of Administrative Law (“OAL”). After a hearing, the OAL found that only three of the workers were employees, while thirteen were appropriately classified as independent contractors.  In the final agency determination, the Commissioner of the Department disagreed with the OAL, finding that all sixteen of the workers were employees and that each failed all three prongs of the ABC Test. East Bay appealed the Commissioner’s determination to the Superior Court of New Jersey, Appellate Division, which affirmed the Commissioner as to five workers, but reversed as to all others.
The Department then sought review by the New Jersey Supreme Court.
The NJ Supreme Court’s Decision
On review, the New Jersey Supreme Court reinstituted the Commissioner’s finding that all sixteen East Bay workers were misclassified as independent contractors. According to the Court, the Commissioner’s finding that the workers failed to satisfy prong “C” of the ABC Test—relating to independence—was supported by substantial, credible evidence in the record.
Analyzing the record under prong “C”, which “broadly asks whether a worker can maintain a business independent of and apart from the employer[,]” the Court noted:
  • East Bay’s principal’s testimony “that he believed the subcontractors worked for other contractors, that sometimes a subcontractor would leave the job before it was completed, and that the subcontractors were free to accept or decline work[,]” without more, was insufficient to establish independence of the workers.
  • Evidence that the business entities operated by East Bay workers had their own insurance did not prove they were not wholly dependent on East Bay for work.
  • The lack of documentary evidence concerning whether the business entities “maintained independent business locations, advertised, or had employees” cut against East Bay’s position that the workers’ entities were truly independent.
In conclusion, the Court explained that “[a] business practice that requires workers to assume the appearance of an independent business entity — a company in name only — could give rise to an inference that such a practice was intended to obscure the employer’s responsibility to remit its fund contributions as mandated by the State’s employee protections statutes.”
The Court chose not to analyze whether the workers met the first two prongs of the ABC Test. While the Department had asked the Court to find that each East Bay jobsite constitutes East Bay’s place of business under prong “B,” arguing performance of the core functions of East Bay’s business occurred at the jobsites, the Court left the answer to that question open for another day—this question was particularly interesting given the prevalence of remote work. Instead, in a footnote, the Court suggested that the “Department exercise its statutory authority and expertise, particularly in light of the prevalence of remote work today, to promulgate regulations clarifying where an enterprise ‘conducts an integral part of its business’ and what constitutes the ‘usual course of the business’” under prong “B” of the ABC Test.
Takeaways for New Jersey Employers
East Bay provides several lessons for New Jersey employers regarding worker classification, including:
  • Substance beats form. Even if a worker operates through an LLC or other business entity, he or she can still be deemed an employee if the ABC Test is not satisfied. There must be sufficient evidence that the entity operates independently of the employer.
  • Maintain records on independent contractors. Testimony from employer representatives may not be sufficient to show workers classified as independent contractors satisfy the ABC Test.  Employers should require from their independent contractors business records, such as business cards, evidence of insurance, evidence that the contractors perform work for other companies, and records showing an independent business address.
  • Contact your employment attorney if faced with a government audit. If an employer receives communication from a government agency regarding an audit of its workers, the employer should contact a seasoned employment attorney to effectively communicate with the agency and ensure the proper documents are produced.
Properly classifying workers is important not only for purposes of contributions to state unemployment and disability funds, but also to ensure that the employer complies with wage and hour laws, such as overtime requirements. Misclassification can lead to government fines and employee lawsuits. As with everything in business, an ounce of prevention is worth a pound of cure.
For Further Information:
If you have questions about this Alert or actions your business should take concerning independent contractors and worker classification, please contact Benjamin Teris, or any other member of our Labor & Employment Group.