Microsoft: The Freelancers Who Were Employees All Along

What happened

The IRS examined Microsoft's records around 1990 and concluded that as a matter of law its freelancers had been employees, so the company should have been withholding tax. Microsoft agreed, issued W-2 forms and paid the employer's share of payroll taxes, correcting the tax position. In 1992 eight of those former freelancers sued on the obvious next point: if they were employees for tax, they were employees under the benefit plans too, including the stock purchase plan. The Ninth Circuit agreed in 1997, and in 2001 Microsoft deposited $96,885,000 into a settlement fund.

The case, start to finish

Microsoft paid the IRS, agreed with it, and corrected the forms. What it had not corrected was the fact the forms described.

An audit the company agreed with

In 1989 and 1990 the IRS examined Microsoft's records and concluded that a group of long-term workers, engaged on signed agreements calling them independent contractors and known internally as freelancers, were employees as a matter of law. Microsoft agreed. In 1990 it issued W-2 forms and paid the employer's share of FICA taxes to the government.

From inside the company, that closed the matter. A tax authority raised a question, the company accepted the answer, corrected the past and paid the bill. The same people carried on doing the same work under the same arrangements. It is worth pausing here, because nothing about this looks like a mistake. It looks like an organization behaving responsibly.

The word that traveled

What Microsoft had actually accepted, though, was a finding about a relationship, and a finding about a relationship does not stay inside the tax file. In 1992 eight former freelancers sued, arguing that if they were employees for tax purposes they were employees under the benefit plans too: an Employee Stock Purchase Plan created under section 423 of the Internal Revenue Code, and a 401(k) called the Savings Plus Plan.

The defense was the paperwork. These people had signed agreements stating they were not eligible for employee benefits. On 24 July 1997 the Ninth Circuit, sitting en banc, held that the workers were employees who had not given up or waived their right to be treated like all other employees under the plans. A waiver signed by somebody who has been told they are a contractor is not a waiver of rights they were never told they had, and the plans keyed eligibility to employment rather than to the label on an engagement letter.

Where the money actually was

The employment-tax correction was the cheap half. W-2s and back FICA are a calculable bill on a known base, payable once. The expensive half was a stock purchase plan at a company whose shares kept climbing, because worker classification decides who participates, and participation compounds.

In 2001 Microsoft agreed to deposit $96,885,000 into a settlement fund. In 2002 the Ninth Circuit affirmed an attorneys' fee award of $27,127,800, 28% of that cash fund, noting that class counsel's contingency representation had run over eleven years. The same facts the company had settled with the IRS in 1990 were still being paid for twelve years later.

And the exposure was never limited to the eight people who filed. A class action reaches everyone similarly situated, which for a staffing pattern means everyone staffed that way. That is the specific reason a classification question scales so badly: the thing being challenged is a policy, and a policy has a population.

The fix that works, and the one that does not

Microsoft eventually reached the answer that holds. It changed its staffing and classification practices, and over 3,000 class members were hired as W-2 employees. That works because it changes the underlying relationship rather than the description of it.

The popular alternative does not work. Moving the same people onto a staffing agency's payroll while managing the work exactly as before changes whose check they receive and nothing else, because common-law employment turns on control and integration, which is precisely what stays constant. You have added a vendor margin and kept the exposure.

If a tax authority ever tells you your contractors were employees, the useful assumption is that the finding now applies to every obligation you owe an employee: benefit plans, overtime and meal-period rules, workers' compensation, unemployment insurance, and any contract whose terms hinge on the word. Price the benefit plans first, because that is where the number lives. Rules on independent contractor classification differ by jurisdiction and change over time, so this is general education rather than legal or tax advice. The point of the case is knowing when to ask a professional, not how to answer without one.

Timeline

• 1989–1990 The IRS examines Microsoft’s records and decides the company should have been withholding and paying over taxes, because as a matter of law the workers were employees rather than independent contractors. Microsoft had engaged them on signed agreements calling them independent contractors; internally they were "freelancers".
• 1990 Microsoft agrees with the IRS and corrects the past: it issues W-2 forms to the workers and pays the employer’s share of FICA taxes to the government. From the company’s point of view, the matter is now closed.
• 1992 Eight former freelancers sue, arguing that if they were employees for tax purposes they were employees under the benefit plans too: the Employee Stock Purchase Plan created under Internal Revenue Code section 423, and the Savings Plus Plan, a 401(k) governed by ERISA.
• 24 July 1997 The Ninth Circuit, sitting en banc, reverses the district court: the workers were employees who did not give up or waive their right to be treated like all other employees under the plans.
• 2001 Microsoft agrees to deposit $96,885,000 into a settlement fund, to be distributed to class members after incentive awards, costs and fees.
• 15 May 2002 The Ninth Circuit affirms an attorneys’ fee award of $27,127,800, or 28% of the cash settlement fund, noting that class counsel’s contingency representation extended over eleven years. By then Microsoft had changed its staffing and classification practices, hiring over 3,000 class members as W-2 employees.

You're in the owner's chair

It is 1990. The IRS has examined your records and concluded that the long-term freelancers writing and testing your software were employees as a matter of law. You agree, issue W-2 forms and pay the back employer FICA. Your benefit plans, including a stock purchase plan at a company whose shares keep climbing, say eligibility is for employees. What do you do next?

• Move everyone onto a staffing agency’s payroll and keep managing the work exactly as before
• Convert the long-tenured to employees; genuinely restructure what stays contracted
• Nothing further — the freelancers signed agreements saying they are not eligible for benefits

Years after the IRS said the freelancers were employees

• 1992 — eight former freelancers sue for plan benefits: 2 years
• 1997 — Ninth Circuit rules en banc that they were employees: 7 years
• 2001 — the $96,885,000 settlement fund is agreed: 11 years
• 2002 — the $27,127,800 fee award is affirmed on appeal: 12 years

Measured from the 1989–1990 IRS examination. The employment-tax correction itself took months; the consequences of the finding underneath it took twelve years to finish arriving.

Business model

Microsoft’s product business is not the subject here; its labor model is. The company staffed real, ongoing software work with people engaged as independent contractors on written agreements stating they were not eligible for employee benefits. On paper, that structure looks like buying a service rather than employing a person.

Revenue model

Not applicable to the question this case decides. What matters is the cost side: the arrangement was chosen because a contractor costs a rate and nothing else, while an employee costs a rate plus payroll taxes plus whatever the benefit plans promise.

Cost structure

The saving was payroll taxes and benefit participation. The bill, when it arrived, was in the second category and not the first. The IRS correction (W-2s and the employer’s share of FICA) was the cheap half. The expensive half was a stock purchase plan whose eligibility turned on one word: employee.

Strategic challenge

Microsoft did the responsible thing after the audit and still lost, because it fixed the tax status without fixing the status. Once the company accepted that the workers were employees as a matter of law, it had accepted the premise of every other claim that turns on the word employee. The benefit plans defined eligibility by employment, not by what the engagement paperwork called somebody. The signed agreements saying the workers were not eligible for benefits did not save it: the Ninth Circuit held they had not given up or waived their rights under the plans.

Key decision

The decision that mattered was made in 1990, immediately after the audit: pay the back employment taxes, keep the same people doing the same work under the same arrangements, and treat the classification question as settled. The alternative was to read the IRS determination as a finding about the relationship rather than a bill. That would have meant rewriting either the plans or the working arrangement, and doing it before anyone thought to ask about the stock plan.

What worked

The eventual fix. Microsoft changed its staffing and worker classification practices, and over 3,000 class members were hired as W-2 employees. That is the version of the answer that holds: it changes the underlying relationship rather than the label on it.

What failed

Treating a classification finding as a tax event. An employment-tax assessment is scoped to employment taxes; the determination underneath it is not scoped to anything. It travels into benefit plans, into overtime and meal-period law, into workers’ compensation, into unemployment insurance, and into every contract whose terms hinge on who counts as an employee. Microsoft paid the IRS and then paid $96,885,000 more, eleven years later, for the same facts.

Risk factors

Multi-year engagements that look identical to employment; benefit plan documents whose eligibility clause says employee without defining it independently of common-law status; waivers signed by workers who were not told what they were waiving; the long tail of a class action, where the class is every similarly situated person and not just the complainant; and the specific trap that the more valuable the equity plan, the larger the liability that a classification finding unlocks.

Lesson summary

Worker classification is a description of a relationship, not a line on a form, and correcting the form does not correct the relationship. If a tax authority tells you your contractors were employees, assume that finding now applies to every obligation you owe employees. Price the benefit plans, not the payroll taxes, because that is where the number lives. Microsoft settled for $96,885,000 twelve years after an audit it had already agreed with and paid.

Key data

• Microsoft’s records, 1989 and 1990 IRS examination
• The workers were employees as a matter of law What the IRS decided
• Issued W-2s; paid the employer’s share of FICA Microsoft’s immediate response
• ESPP under IRC section 423; the Savings Plus Plan 401(k) Plans at issue
• 1992, by eight former freelancers Suit filed
• 24 July 1997 — workers were employees under the plans Ninth Circuit, en banc
• $96,885,000 Settlement fund
• $27,127,800 (28% of the cash fund), affirmed 15 May 2002 Attorneys’ fee award
• over 3,000 Class members hired as W-2 employees
• over eleven years Length of class counsel’s representation

Sources & basis

The company here is real and named, and nothing about it was invented to make the story land. The list below is where each fact came from — public filings, court records, published reporting — so you can open a source and check it against the sentence that used it.

1. Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997) (en banc) — the 1989–1990 IRS examination and its conclusion, Microsoft’s issuance of W-2 forms and payment of the employer’s share of FICA, the ESPP under IRC section 423 and the Savings Plus Plan, and the holding that the workers did not give up or waive their rights under the plans View source ↗
2. Vizcaino v. Microsoft Corp., 290 F.3d 1043 (9th Cir. 2002) — the $96,885,000 settlement fund, the $27,127,800 fee award (28% of the cash fund), the eleven-year contingency representation, the 1992 filing by eight former freelancers, and the hiring of over 3,000 class members as W-2 employees View source ↗