It is estimated that more than 30% of business misclassify employees as independent contractors. Are you one of them? Misclassification often results from simply not understanding or not properly applying the tests for independent contractors. There are also businesses who believe that simply calling someone an “independent contractor” and having them sign an agreement stating they are an independent contractor is sufficient. Of course there are also businesses who know the worker should be classified as an employee, but call them “independent contractors” or “1099s” to avoid withholding payroll taxes, providing workers compensation insurance, providing benefits, paying minimum wage or overtime and other legally required employment benefits. Whatever the reason, misclassifying workers can be risky business.
Misclassifying employees as independent contractors costs state and federal governments billions of dollars in unpaid taxes every year. Needless to say, the government wants that money. The federal government has also made it clear that it sees the misclassification of workers as exploitation. Thus, the Department of Labor (DOL) has launched the “Misclassification Initiative” to crack down on business that, in the words of the DOL”den[y] access to critical benefits and protections” to workers. Through the Misclassification Initiative, numerous state and federal agencies, including the IRS and the DOL are sharing information and resources to reduce the tax gap and improve compliance with federal labor laws. This has resulted in increased scrutiny of worker classification.
In addition, your business could be one unemployment or worker’s compensation claim away from an audit. Even though independent contractors are not entitled to unemployment benefits or worker’s compensation benefits, many apply for those benefits after being hurt on the job or having their contract terminated. Once that claim is filed, it will trigger an investigation into whether the worker was properly classified as an independent contractor.
So why should you care about worker classification? If an employee is misclassified as an independent contractor, the business, its officers and decision makers face significant penalties, including unpaid payroll taxes, unemployment taxes, workers compensation penalties (both civil and criminal), interest and penalties. For example, the IRS will be looking for back taxes of as much as 41.5% of the worker’s wages per year, for up to the prior three years, as well as penalties for not filing W-2’s and for failing to withhold payroll taxes and interest. In addition, the DOL and state counterparts will be looking for back wages, overtime, and the value of benefits the worker should have received. In addition, failing to provide worker’s compensation insurance can be a criminal offense, subjecting owners to possible fines and jail time. Moreover, should a misclassified worker be injured on the job, the employer will be responsible for those injuries and may not have the benefit of the damage caps usually available under the state’s worker’s compensation law. As if that is not scary enough, the penalties are not limited to the business–officers and employee’s with authority over financial affairs can be held personally liable! With the stakes so high, it is important to make sure that workers are properly classified and that the business has agreements and records to support the classification.
DETERMINING WHETHER A WORKER IS AN EMPLOYEE OR INDEPENDENT CONTRACTOR
There is no bright-line test for whether a worker is an employee or independent contractor and simply calling someone an independent contractor does not make it so. Instead, the classification is determined on a case-by-case basis, considering all relevant facts. In the end, whether someone is an independent contractor or an employee often comes down to one word:
The more control a company asserts over the worker, the more likely that worker will be considered an employee. Conversely, the more control the contractor has over the work and more opportunity the contractor has to realize a profit or loss based on their work, the more likely the worker will be considered an independent contractor.
Control can be highly subjective. Your view of the facts may be very different from the IRS’s analysis. In the end, it is the IRS’s analysis that matters. Therefore, it is essential to obtain an objective assessment of the relationship between the company and the worker. A tax professional or employment attorney can help make that determination. If the independent contractor classification is appropriate, an employment attorney can also draft an Independent Contractor Agreement to help protect the classification by including terms consistent with the factors used to make the determination.
There are numerous tests for determine whether someone is an independent contractor or an employee. For purposes of this post, we will focus on the IRS test. The IRS has 20 factors it uses to determine the proper classification. No single factor is determinative. Instead all factors must be considered. As described here and here, the IRS factors fall into three main categories of control:
- Behavioral Control–Who directs or controls how the worker does the work?
- Is the worker given extensive instructions or training? The more instructions and training given to worker, the more likely they are an employee.
- Who decides when, where or how the work will be done? If the company tells the worker when, how and where to do the work, they are more likely an employee.
- What tools are used and who supplies the tools? If the company supplies the tools necessary to do the work, the worker is more likely an employee.
- Does the worker have to perform the services personally? If the services must be performed by the worker, and cannot be performed by an agent or substitute of the worker, it is more likely an employment relationship.
- Financial Control–Who controls the business/financial aspects of the relationship, such as the ability to make a profit or experience a loss?
- Does the contractor make a significant investment (i.e. purchasing tools, materials, supplies) to do the work? If the worker has a significant investment in the work, such as buying materials, supplies or have their own office space, the more likely they are an independent contractor.
- Does the company reimburse the worker for expenses or does the worker pay the expenses himself? If the company reimburses the worker for expenses associated with the work, they are more likely to be an employee.
- Opportunity for profit or loss–Is the worker just being paid for his time or for results? If the worker can realize a profit or suffer a loss, it suggests that they are in business for themselves and favors an independent contractor designation. If instead, the worker simply gets paid for his time, it points to an employment relationship.
- Relationship of the Parties–How do the business and the worker perceive the relationship?
- What does the contract between the parties say about the relationship? While simply putting a sentence in the agreement identifying the worker as an independent contractor will not turn an employee into a contractor, including language about the factors (such as a requirement that the contractor provide his own tools), shows that the parties view it has an independent contractor relationship. Of course, “actions speak louder than words” and the parties must act in a way that is consistent with the contract language.
- Is the work being performed integral to business? When the success or continuation of a business depends on the performance of certain services, the workers performing those services are more likely to be employees.
- Is the worker permitted to work for other businesses or must he work full time for the company? Allowing a worker to work with other companies and market his services to the general public favors an independent contractor designation.
- Does the company provide benefits, such as insurance, paid leave, etc that are usually associated with an employer-employee relationship?
THE BOTTOM LINE
Whether a worker is going to be considered an independent contractor or an employee will depend on the level of control the company seeks to have over that worker. If the company seeks to control how, when and where the work is done, pays the worker for their time (as opposed to paying for results) and requires the worker to devote his full time and effort to work for the company, that person will likely be an employee. However, if the worker has independence in deciding how, when and where the work is done, makes significant investment of their own money to perform the work and has the ability to profit by his efficiency or to incur a loss if he is inefficient, that person is more likely to be an independent contractor.
The best way to protect yourself and your company is to have a tax professional or employment attorney to objectively assess each of the relevant factors and determine the appropriate classification. If the worker can properly be classified as an independent contractor, it is essential to have a written Independent Contractor Agreement. The agreement should be drafted by an employment attorney who can include provisions addressing the applicable factors and help protect the independent contractor classification.
Given the significant risks businesses face for misclassifying workers, businesses are encouraged to carefully review their relationship with their workers, including any written agreements, policies and procedures used to govern the relationship. Moreover, before businesses enter into an independent contractor relationship, they are encouraged to seek the advise of a tax professional and/or employment attorney. Businesses should also detailed notes of how the determination was made and all facts that apply to each factor.
If you have more questions about worker classification, consider attending a free presentation of Employment Law Essentials for Small Business and Entrepreneurs being presented by Julie Kinkopf, Esquire in Radnor on August 4, 2014 at 9:00 (more information and sign up here).
“Control” image courtesy of Stuart Miles / Freedigitalphotos.net
Julie Kinkopf, Esquire is principal of Kinkopf Law LLC and is an accomplished attorney who has represented employers for over 15 years. Ms. Kinkopf helps businesses develop sound employment practices and provides training to supervisors and employees designed to avoid litigation and government audits. She also represents employers before various governmental agencies as well as in state and federal courts in post-employment litigation, including discrimination, retaliation, pay disputes and non-compete/trade secret matters. More information may be found at www.kinkopflawfirm.com or www.linkedin.com/in/juliekinkopf/
Disclaimer: The contents of this post are for informational purposes only, are not legal advise and do not create and attorney-client relationship.