The subject of who is an “independent contractor” and who is an “employee” has become an important topic over the past few years. With the explosive increase in the use of independent contractors by private employers, state and federal governments, with a concern on evaporating tax revenues, are placing increased pressure on employers to classify their workers correctly. Recently, California State updated their labor codes to place severe monetary and non-monetary penalties on employers that willfully misclassify their workers as independent contractors. In addition, The U.S. Department of Labor has also recently announced that it has joined up with 12 U.S. states to coordinate efforts to combat the intentional misclassification of workers by employers seeking to reduce their costs.
The question whether a worker is an independent contractor or an employee is one that is determined through a review of the facts of any particular case along with the application of law and regulations for worker classification issues known as “common law.”
Common law flows primarily from court decisions. Under common law, the treatment of a worker as an independent contractor or an employee originates from the legal definitions developed in the law and depends on the employer’s right to direct and control the worker in the performance of his/her duties. Section 3121(d) (2) of the Internal Revenue Code provides that the term “employee” means any individual defined as an employee by using the usual common law rules.
Following this standard, an employment relationship or “employee” exists if the principal has the right to direct and control the worker who performs the services. Control exists where the employer influences not only the results to be accomplished, but also
the means and details by which the results are to be accomplished. That is, where the worker is subject to the will and control of the principal not only as to what is to be done, but how it shall be done.
On the other hand, an independent contractor is a worker or business entity that provides a good and/or service to another individual or business entity under the terms of a specified contract. The independent contractor is not subject to the employer’s control or guidance except for what is designated in a mutually binding agreement. The contract for a specific job usually entails the outcome of the good and/or service rather than the process or methods to fulfill the job. Under Department of Treasury Regulation 31.3401(c)-1, “physicians, lawyers, dentists, veterinarians, contractors, subcontractors, public stenographers, auctioneers, and others who follow an independent trade, business or profession in which they offer their services to the public” are usually considered independent contractors. If a service requires special skill, any specialist called in to perform the task is usually an independent contractor.
For many years the Internal Revenue Service (IRS) used a 20 Factor Test to determine as whether an individual was an employee or independent contractor. However, more recently the IRS, took the 20 Factor test and combined the factors into three broad categories that contain 11 factors. With IRS Publication 1779, Independent Contractor or Employee . . . the IRS details the three categories that include: (a) behavioral control; (b) financial control; and (c) Relationship of the Parties.
The common law test and its IRS factor and control tests may be the most well-known tests for determining worker status. However, in enforcing the Fair Labor Standards Act (“FLSA”), which contains federal minimum wage and overtime requirements, the U.S. Department of Labor (“DOL”) looks instead to the “economic reality” of the relationship and considers the following factors to be significant: (1) the extent to which the services rendered are an integral part of the employer’s business; (2) the permanency of the relationship; (3) the amount of the worker’s investment in facilities and equipment; (4) the nature and degree of control by the employer; (5) the worker’s opportunities for profit and loss; (6) the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor; and (7) the degree of
independent business organization and operation.
Then, there’s the U.S. Courts. They use approximately 10 factors to determine if a worker is an employee or independent contractor. Many of the factors used by the courts are also used by the IRS. The common law test puts emphasis on who controls or directs the means or methods of work, like the IRS test.
The different tests and many factors considered in determining worker status create uncertainty for businesses. However, this
uncertainty is reduced to some degree by the many published federal court decisions and IRS and DOL opinion letters and rulings over the years. Many companies take some comfort in knowing that federal courts and agencies have examined and accepted similar independent contractor relationships. For federal law purposes at least, businesses are often able to model their independent contractor relationships based upon what upon courts, the IRS and/or DOL have said is correct. Moreover, businesses can go further and request formal determinations from the IRS concerning worker status by submitting an IRS Form
SS-8 (Determination of Employee Work Status for Purposes of Federal Employment Tax Obligations).
The last consideration with defining who is an independent contractor versus an employee is that of the individual U.S. states. Unfortunately, the situation gets more complicated and problematic for businesses when different states in which they operate establish their own tests for determining worker status. There are increasingly more states with statutes, legal standards as well as major initiatives established to define what constitutes an independent contractor. Although many of the statutes and
standards set up by individual states have similarities with the major rules already established under common law, you should check with your individual state to check for any additional factors or contradictions.
Finally, we come to what can an employer do. The following are a few recommendations to consider:
- To determine if a worker you want to employ as an independent contractor qualifies, you should first review the IRS 11-Factor Test. You can easily do an internet browser search by typing “IRS 11-factor test for independent contractors” and get several examples of the test. Reviewing this test should give you fairly good idea of what you’re dealing with. In addition, you should check your individual state’s laws to see if they define independent contractors. In most cases, an individual state that has its own definition will have some variation of what is done at the IRS, Department of Labor or within the courts.
- If you have a worker that qualifies as an independent contractor, you should formally define the relationship in an independent contractor agreement. Also, you should use the appropriate tax forms including the W-9 and 1099.
- It’s probably not a good idea to hire former employees as independent contractors. This is especially relevant if you hire them to perform the same work. Unless they can meet most of the independent contractor requirements, your risk chances are high if you get caught.
- Use independent contractors only for work that isn’t part of your core business. The reason for this gets threaded back to the IRS 11-factor test. One of the factors asks the question, are the services performed by the contractor a key aspect of the regular business of the company? If so, there’s a strong indication of an employer/employee relationship.
- For any contractor that you use, they should have their own business in place such as a formal business name, business cards, an office, advertisement to the general public, and other customers. This is a strong indication that they are truly an independent contractor.
- Independent contractors are not generally paid for their time but rather by the job to be done. Also, you shouldn’t pay a contractor benefits or reimburse specific expenses like you pay a regular employee. It’s up to the contractor to come up with a contract for their fees that include the compensation they need for their own business expenses.
- An independent contractor has control of their time. If you require the contractor to report to your office for a set schedule, you have little chance that you will be successful to win a misclassification challenge.
- An independent contractor has control and judgment over their work. In general, a contractor decides when, where and how to accomplish the task which they have been contracted for.