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October 14, 2009

Independent Contractor or Employee? How Do You Know and What Does It Matter?

Filed under: General HR Buzz — Tags: , , — Jane @ 1:53 pm

Independent Contractor Classification Issues Coming Under Greater Scrutiny

The independent contractor “issue” has become more visible in the last year, Congressional hearings have been held in which legislators have been urged to take action to address the issue of misclassification of employees as independent contractors.  Several states have also taken action to apply pressure to companies to revisit classifications.  It’s a subject that will likely see even more attention in the future.   Legislators have apparently heard enough complaints that some companies unfairly avoid their obligations by using contractors or that there simply is no justifiable reason to treat contractors so differently.

Independent Contractors:  A Money Saver and a Great Employer Solution?

The use of independent contractors has increased significantly in the last few years as employers seek to reduce costs and keep their workforces flexible. Whether a worker is an employee or a self-employed independent contractor imposes very different obligations on an employer.  Independent contractors are not on the payroll and do not enjoy many of the legal protections and benefits given employees. They also typically don’t count toward minimum thresholds required to determine whether employers are covered by certain federal employment laws. Generally, employers are not required to:

  • Provide Employee Insurance, Retirement and Leave Benefits
  • Pay Social Security & Medicare Taxes
  • Pay Federal & State Unemployment Taxes
  • Pay Overtime or Minimum Wages
  • Maintain Pay Records Under the FLSA
  • Pay Worker’ Comp Premiums
  • Provide protections under Title VII, the ADEA, ADA,  and Other Discrimination Acts
  • Provide protections under The National Labor Relations Act (which involves union issues)
  • Provide Leave Under the FMLA

Or, A Business Decision That Can Have Significant Negative and Costly Consequences…

It is often difficult to determine whether an individual should be classified as an employee or an independent contractor. Some organizations incorrectly assume that they can “declare” an individual as an independent contractor and that such a declaration will make it so.  But as with all things HR related, nothing is simple. Failure to make a legally correct contractor vs. employee determination, can lead to serious and expensive consequences.  The issue typically arises because of a government audit or an employee complaint.  In fact an employee (or an employer) can submit a Form SS-8 to the IRS (http://www.irs.gov/pub/irs-pdf/fss8.pdf) for a finding of whether an individual is an employee or a contractor.  Over 85% of these forms are submitted by employees and in more than 90% of the cases the IRS finds an employee, not contractor situation.  We’ve included a copy of the Form for your review so you can see what the IRS considers in its determinations.

Too many organizations have ignored this issue (admittedly there are more interesting things to think about!).  Others have simply tried to save money by not following the law. Unfortunately, some of them have paid a high price for doing so.

Or, A Business Decision That Can Have Significant Negative and Costly Consequences… (Continued From Page 3)

In any event, it may be a good time to re-familiarize yourself with the law and various tests swirling around the independent contractor issue. Then examine your own contractors, audit your company’s practices, and take steps to assure future compliance.

How Do You Know if You Have an Independent Contractor?

Legal tests and factual situations, not labels determine whether someone is a contractor or an employee. Simply calling someone an independent contractor and having him sign a contract to that effect is not controlling. A number of details about the work relationship must be analyzed.

And…To Make Things More Confusing, There Is More Than One Test

Several different tests (Common Law, IRS Factor Control, Relative Nature of Work, ABC, and Economic Reality) are used to determine independent contractor status under federal and state law.  Which test is used depends upon the particular statutes or government agencies involved.  The result may be that a worker is an “employee” under one statute and can be considered an independent contractor under another.  As you might expect, the tests are not clear-cut and are open to interpretation.  However, the tests do have some significant similarities, with the main issue being:

Does the company control how the work will be performed (in which case you’ve likely got an employee) or does the company simply oversee the result(which would be more favorable to a finding of an independent contractor relationship).

Various Tests Used to Determine Employment Status Include:

Area/Statute

Test Commonly Used

IRS Withholding

IRS Factor Control Test

Fair Labor Standards Act (FLSA)-

overtime & minimum wage

Economic Reality Test

Workers’ Comp

Relative Nature of Work

Unemployment Benefits

ABC Test

Discrimination (Title VII, Age Act, ADA) &

Affirmative Action

Common Law (“Right to Control”)

Test plus the Economic Reality Test)

Immigration (I-9’s)

IRS Test

ERISA (employee pension & welfare benefits)

Common Law (“Right to Control“)Test

Worker Adjustment & Retraining Notification Act (WARN)

Common Law (“Right to Control”) Test

National Labor Relations Act &

Labor Management Relations Act

Common Law (“Right to Control”) Test

The IRS Factor Control Test

For many years, the IRS used its “20 Factor Test” to determine if an employer exercises sufficient control to establish an employer-employee relationship. The IRS has attempted to “streamline” this by organizing the Factors into 3 groups: behavioral control, financial control, and the type of relationship. (The “20 Factors” remain important.).  The Factors are only guidelines and are not all applicable in every situation.  No one Factor is decisive, rather the entire situation must be considered.  The IRS Test includes most of the elements of the other tests and was based on the common law test.

Behavioral Control Factors

Indicative Of Employee Status

Indicative of Independent Contractor Status

Training

On-the-job training often required. Provided training regarding processes & methods.

Already highly skilled and receives no training.

Instructions

Must comply with company’s instructions and actions are more controlled. Tools & equipment supplied, dictated, and told where to purchase. Directed regarding what workers to hire or assist with work and what work must be performed by certain individuals. Order, sequence, hours, location of work may be determined.  Regular reporting.

Broader discretion and decision-making authority.  Supply own tools & equipment.  Hires. Pays, and  supervises own assistant. May or may not render services personally.  Sets own schedule.  May determine where work is performed. Regular, frequent reporting may not be required.

Financial Control Factors
Significant Investment in Facilities or Equipment

Little or None.

Considerable investment.

Expenses

Company reimburses.

Pay own.

Profit/Loss

Doesn’t incur any economic loss.

Realizes a profit or loss.

Payment

Paid hourly, weekly.

Often paid by the job or project.

Parties’ Relationship
Written Contract

Not likely in an employee relationship. May be fired or can quit any time.

Possible evidence of independent contractor.  Contractual relationship affects termination.

permanency

Ongoing relationship. Works full-time for company.

Projects begin and end.  Hours not totally given to the company.  Generally shorter term and temporary.

Benefits

Receive insurance, retirement, paid leave, etc.

No benefits.

Integration

Functions are an integral part of the business; similar to regular employees.

Services are separate and distinct from regular employees.

Multiple Employers & service availability

Doesn’t work for multiple employers and services not available to public.

Provides services to multiple organizations & services available to public.

Several factors, beyond the IRS test can also be considered.  High level, specialized skills are often indicative of independent contractor status.  The extent to which an individual establishes his own rate of pay, is paid after submitting an invoice, carries the risk of work accident, has consulted with an accountant regarding his business, or has a reputation as being available in the business community may also be relevant.

Final Things to Worry About

Remember that states have also gotten into the act.

Don’t think that you can relax once you’ve figured out the federal law and related tests. (If you ever do.) Some states have also been active in this area. Be sure you are familiar with your particular requirements. If nothing else you’d likely have workers’ comp and state unemployment issues to consider.

Using independent contractors inappropriately can create significant risks and liabilities. Payment of back taxes, back overtime, and related penalties could be just the beginning.  Consider the consequences of misclassifications if an individual is:

  • Improperly denied benefits. (ERISA provides protection here, forcing payment of back benefits and possibly creating breach of contract claims)
  • Injured on the job. (No workers comp coverage, so a company is vulnerable to a lawsuit)
  • Seriously ill and had not been considered eligible for FMLA.
  • Disabled and was discriminated against. (e.g., not reasonably accommodated)
  • Not counted as an employee.  (So the company appears not to be covered by Title VII, ADA, ADEA, FMLA, WARN Act, Affirmative Action purposes, etc….. when it really is.)
  • Not considered an employee and as a result no I-9 is on file.
  • If you use independent contractors be sure you know who owns the rights to the work. In the case of an employee, absent an agreement to the contrary, the company generally automatically owns the work product. That may not be the case with an independent contractor.
  • If you use independent contractors, use a contract. Make the contract in the name of the individual’s business, not her name. If possible, avoid hourly pay and reimbursement arrangements, and have the individual perform discrete projects, not ongoing work.
  • Remember,  sometimes no matter what you call the relationship, how you attempt to structure it, how you “dress it up” and even if you draft the best contract ever, you’ve still got an employment relationship, not an independent contractor.
  • Audit   your independent contractors’ status, before you’re challenged by an individual or the government.  Form SS-8 (included here) can help with that.
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