Employee or independent contractor?

Businesses are always looking for ways to save money while maintaining productivity, especially in trying economic times. One way of achieving this has been for companies to hire independent contractors in lieu of employees.

Businesses can reap several benefits, both financial and legal, from hiring properly classified independent contractors. On the one hand, they can avoid the financial burden of hiring employees, including employment taxes, worker’s compensation insurance, Social Security and Medicare, and other withholding. Businesses who hire independent contractors also may not be subject to minimum wage, overtime and antidiscrimination laws. On the other hand, businesses that get this analysis wrong may be exposed to hefty fine, penalties, back taxes, and damages in employment lawsuits.

As a general rule, workers are considered employees when someone else controls how and when they do their work. Independent contractors, on the other hand, work for themselves, decide how they perform their jobs and secure their own clients.

The Bureau of Labor Statistics estimated that 10.3 million workers, over seven percent of the workforce, were classified – correctly or not – as independent contractors in the United States in 2005.

Government Crackdown

In recent years, federal and state agencies increasingly have scrutinized companies that try to pass of regular employees as independent contractors: A 1984 IRS study estimated that 15 percent of employers misclassified approximately 3.4 million employees as independent contractors, resulting in a tax revenue loss of $1.6 billion (in 1984 dollars). And a Department of Labor (DOL) study in 2000 that found that 10 to 30 percent of firms audited in 9 states misclassified at least some employees.

Consequently, since February 2010, the IRS has been implementing a program that aims to audit 6,000 businesses regarding employee misclassification over the next three years. Additionally, the DOL’s proposed 2011 budget includes $25 million for a joint initiative with the Treasury Department to combat the misclassification of independent contractors through the hiring of 90 additional investigators and 10 additional lawyers.

Specific Tests

Employers should be aware that specific tests are required to determine independent contractor status. The requisite tests are complex and varied and depend on the state or agency involved. U.S. government agencies that are interested in worker misclassification include the Department of Labor, Social Security Administration, and the IRS. State departments of labor and revenue also are expanding their focus on this issue. Generally, the classification is dependent on the amount of control the business has over the worker.

The IRS has taken the lead in helping employers correctly classify workers by developing so-called “common law rules.” The IRS lists three main criteria that should be taken into account when considering if a worker is an employee or independent contractor:

• Behavioral Control: The more influence the business has in directing and controlling the worker, the more likely it is that the person is an employee. An evaluation system that measures a job’s details is indicative of an employee; an evaluation system that looks at the end result could indicate an employee or independent contractor. Similarly, a training program indicates that the company wants the job done in a particular way and is indicative of an employee.
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• Financial Control: If a business has the right to control the economic aspects of a worker’s job, this would indicate that the person is likely an employee. An independent contractor often has a significant investment in the equipment he or she uses and independent contractors are more likely than employees to have unreimbursed expenses. Independent contractors are generally free to seek out business opportunities and to have the opportunity to make a profit or loss. Employees, on the other hand, are usually guaranteed a regular wage amount for an hourly, weekly or other time period.

• Type of Relationship: The business relationship between the company and worker is another good indication of whether the worker is an independent contractor. Benefits such as insurance, pension and paid vacation or normally not paid to independent contractors. If there is the expectation of a long-term relationship and a worker provides services that are a key aspect of the business, this would indicate an employer-employee relationship. How the parties work together defines the worker’s status – regardless of whether the worker is contractually defined as an “independent contractor.”

In addition to the above, the IRS has also used a “20-factor test” to further determine the extent of control that an employer has over a worker – though this test has recently been simplified and refined (see www.irs.gov/businesses/small/article/0,,id=99921,00.html). No one factor stands alone in ascertaining whether a worker is an employee or an independent contractor: all factors, especially the extent of the right to direct and control, should be weighed in making a determination.

Legislative Developments

The Obama administration is also focusing on strengthening legislation in this area. Four bills have been introduced in the 111th Congress concerning the misclassification of workers: H.R. 3408, S. 2882, H.R. 5107 and S. 3254. And in his 2011 budget, President Barack Obama proposed to “increase certainty with respect to worker classification” by a modification of the Section 530 of the Revenue Act of 1978.

While misclassification can save a company money in the short term, there are clearly significant long-term risks, including the possibility of getting audited by one of the agencies mentioned above.

In determining whether to classify a worker as an employee or independent contractor, look at the entire relationship: if workers look, act and are treated like employees, the chances are that they should be classified as such. Other helpful hints are whether the independent contractor has a separate legal entity such as a corporation; hires or employs its own workers; receives payment to the entity rather than the individual; and provides similar services for entities other than the putative employer.

Finally, care should be taken to document the factors used in classifying a worker as an independent contractor. This will be helpful if a company ever faces an audit or lawsuit. Remember that state and federal agencies prefer that you lean towards classifying workers as employees rather than independent contractors.
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Todd Fredrickson is managing partner of the Denver office of Fisher & Phillips LLP, representing employers nationally in labor, employment, civil rights, employee benefits and immigration matters. Contact him at [email protected] or 303.218.3660