When is an Independent Contractor Really an Employee?

Robin Foret
April 22, 2008 — 2,074 views  
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The story is all too familiar.  A company engages the services of an individual as an independent contractor.  In reliance on this type of relationship, the company does not deduct payroll taxes from compensation amounts paid, does not pay the individual overtime, does not provide company benefits, and takes other positions consistent with the existence of an independent contractor arrangement.  Several months or even years later, taxing authorities and/or other governmental agencies notify the company that the individual has been misclassified, and that the company must pay substantial amounts in taxes, overtime or other charges associated with the error. To be sure, at some point, it is inevitable that the true nature of the relationship will be scrutinized, and it may be discovered that the independent contractor is not really an independent contractor at all, but instead, an employee entitled to all company benefits and all employee rights under applicable federal and state laws.  This problem is referred to as misclassification, and has far reaching implications.  In fact, some businesses are unable to absorb the financial ramifications of having a large number of individuals misclassified as independent contractors.  This article outlines some of the important aspects of the independent contractor relationship, as well as the consequences of misclassification.        I. Independent Contractor Status: A. General Requirements - the test for independent contractor status varies somewhat among different jurisdictions, but in many respects, it is similar.  Most states use the "right of control" test, the "economic realities" test or a combination of those two methods.  Regardless of the method chosen, the inquiry is whether the company has engaged someone who runs their own business, or instead, is using the independent contractor label to avoid paying taxes and to avoid other employment-related obligations.   1. Right of Control Test - evaluates the level of control exercised over the person engaged to perform the work.  Many states use the "right of control" test, which analyzes the company's right to control (as opposed to actual control exercised) the individual's day-to-day activities.  Typically, a true independent contractor must have the training, knowledge and skill to perform the task for which he or she has been engaged, without the need for more than minimal interference.  Such individuals pay their own tax obligations, obtain their own benefits, and often have some sort of agreement under which they perform the work for which they are engaged.  The ability to terminate the individual at will without notice or cause is a factor that favors an employee designation.  Moreover, an agreement that contains a non-competition clause is likely to result in a finding of an employment relationship.  Other important factors include: whether the individual furnishes his own tools and supplies; pays his own business overhead expenses; and, to a large degree controls the progress of the work.  If the company exercises too much control over day-to-day activities, other than to approve final results, this may militate in favor of the existence of an employer-employee relationship.  Requiring individuals to follow applicable laws and/or safety standards, however, will not generally destroy independent contractor status.  2. Economic Reality Test - analyzes whether the individual is truly in business for themselves, or instead, is dependent on the company for financial wellbeing.  Factors include: whether the company pays a salary (more like an employee) or pays per job performed and/or time spent; whether taxes are withheld and benefits paid by the employer; the permanency of the relationship (long-term indicates employee status); and, the skill and initiative required to perform the work.  Taking certain deductions from compensation, such as those to defray company costs may be acceptable, however, an independent contractor should be provided with a 1099 for tax purposes.     B. Internal Revenue Service (IRS) - the IRS has set forth a 20 factor test that incorporates the "right of control" test and the "economic reality" test to determine whether taxes are being paid properly, or whether the company has failed to pay the employee portion of the tax liability.  The test includes the following factors:  1. Contractors can assign part of work to their chosen employees; 2. Contractors hired by job or project rather than on salary; 3. Contractors can set their own hours and schedule; 4. Contractors work from their own office and use their own telephone, desk, etc.; 5. Contractors have more than one customer and can take more than one project on at a time; 6. Contractors generally cannot be fired unless they fail to meet specifications or to comply with requirements for satisfactory completion of work; 7. Contractors generally hold business licenses and are available for hire by the public; 8. Contractors generally take care of their own expenses and account to themselves for expenses; 9. Contractors can realize a profit or suffer a loss as a result of their services and decisions;  10. Contractors furnish their own tools and pay their own overhead expenses; 11. Contractors generally hired to perform particular job - no ongoing relationship; and 12. An employee can quit a job at any time - an independent contractor must complete job. Because it uses features of both the "right of control" and the "economic reality" test, the IRS test has many similar features and is analyzed in a similar fashion to the guidelines used by most jurisdictions.  Also important, is that all of these various tests will be applied to the specific facts at issue, which makes it somewhat difficult to predict the proper designation of certain individuals who may have some but not all of the necessary elements of independent contractor status.  When in doubt, check with a professional such as a CPA or tax lawyer for IRS liability, or an attorney for guidance in connection with other federal and state laws affected by independent contractor status.    II. Consequences of Misclassification:   In addition to decreased tax obligations, there are other benefits to a company using independent contract labor.  There are many federal and state laws that do not apply to independent contractors.  For example, Title VII discrimination laws and the Fair Labor Standards Act ("FLSA") governing wages do not apply to independent contractors. In many instances, unemployment and workers' compensation laws only protect employees.   Accordingly, the consequences of labeling an employee an independent contractor can be far reaching indeed.  In addition to tax consequences, the company-employer may be liable for overtime pay, unpaid benefits, reimbursement of unpaid expenses and unemployment benefits, as well as incurring other liability under various federal and state laws.  How can a company avoid these problems?  First, make sure all individuals performing work for the company are classified correctly.  Taking chances with classifications to save money can be a dangerous game, especially if you cannot afford the consequences of a mistake.  Second, use well drafted independent contractor agreements to document the understanding between the company and the individual engaged to perform work.  Although this is not sufficient in and of itself to confer independent contractor status, it provides some evidence of the intent of the parties.       III. Do's and Don'ts: The following chart should provide assistance when determining what restrictions and limitations to impose on independent contractors.  Employing certain rules and regulations can be fatal to the determination that an independent contractor relationship exists, even if the other requirements have been met.   Below are some helpful general hints. Do's: 1. Issue 1099 tax statement to worker 2. Hold harmless/indemnity provisions are O.K. 3. List clear statement of all deductions for failure to perform job to specifications 4. Include specifications of job 5. Include confidentiality information provision 6. Include safety provisions to be followed by contractor 7. Can include no interference with contract or business relations provision Don'ts: 1. No non-compete clause in contract- person should be free to accept other customers/clients 2. No unilateral fire for any reason clause in contract 3. No open-ended deductions from payment to contractor for simply any reason 4. No restrictions on hours unless job site related 5. No restriction on who contractor hires 6. Do not exert general control over project 7. Do not reimburse for general overhead expenses or tools of trade The information contained in this article is not designed to address specific situations, and does not include rules and regulations that apply to all states. If you have questions concerning this topic, you should consult with legal counsel of your choice to obtain advice on various fact specific matters.

Robin Foret

The Foret Law Firm

Robin Foret practices in the areas of employment law, commercial litigation and specialty insurance defense claims. She handles a variety of employment matters such as theft of trade secrets, breach of employment agreements, non-competition agreements, wage and hour issues under the Fair Labor Standards Act (FLSA), discrimination and harassment issues under Title VII of the Civil Rights Act of 1964 (Title VII) and the Texas Commission on Human Rights Act (TCHRA), the Americans with Disabilities Act (ADA), Family Medical Leave Act (FMLA) issues, and the Sarbanes-Oxley Act (SOX). Robin has handled a wide variety of employment law matters for employers, as well as for executive-level employees, before agencies, and state and federal courts.