Employee or Independent Contractor?
By: Gregory L. Cartwright
One of the areas where employers can go easily astray is the mischaracterization of their workers as independent contractors when they really should be treated as employees. Making this common mistake can expose the employer to civil lawsuits as well as costly governmental enforcement actions and penalties. And, it is a common occurrence. Estimates range, but approximately 3.5 million workers in the U.S. are misclassified as independent contractors when they should rightly be classified as employees with the Federal government being underpaid roughly $60 billion a year in payroll taxes.
The Benefits Of An Independent Contract vs. An Employee
In an attempt to reduce employment costs, limit the legal rights employees might otherwise have, and increase flexibility, many employers opt to categorize their workers as independent contractors. In most cases, by doing so employers can avoid the added expense for things like workers’ compensation and health insurance. Employers are not required to pay employer contributions for such things as Social Security Insurance or the other components of FICA for independent contractors as they are for employees. This is reflected in the fact that independent contractors have their income reported for tax purposes on a 1099 form instead of a W-2 form as you would with an employee. And depending on the jurisdiction and the circumstances, many of the laws designed to protect employees may not apply to independent contractors.
So, you might be saying to yourself: “That sounds perfect! This worker will cost me less, I have less paperwork to worry about, and maybe they’ll have less ability to sue me under my state’s labor laws since they’re not an employee.” You might also be asking the next question: “Why would anyone ever have an employee if they could just call their workers independent contractors?” The short answer is because it’s illegal in many cases, and the penalties can cost you hundreds of thousands of dollars if you’re caught.
And the reason it’s illegal is that it’s an improper work around of the tax and labor laws. Labor laws were based to protect workers. Tax laws were passed to raise revenue for government. When these facts are viewed against the general legal principal that prizes substance over form, you can quickly see how this workaround will get an employer into trouble. With employees, as with most things, there’s no free lunch.
What Is The Downside To Misclassification?
Penalties. And lots of them. Everything from a $50 penalty for failing to properly file a W-2, to back wages and waiting time penalties owed to the employee, to all back taxes owed in addition to a 25% penalty; if the conduct is found to be intentional even criminal penalties of an additional $1,000 with a possibility of 1 year in jail. Depending on the size of the company, these could spell the end of your business permanently. This of course, does not take in to account the other costs to your business if you’re required to litigate over this: the time lost from growing your company and the legal fees paid to your lawyer to assist you in defending these claims.
When Can You Characterize A Worker As An Independent Contractor?
With those facts in mind, the next question in your mind will likely be “When can you categorize a worker as an independent contractor instead of an employee?” Luckily, there is a very well developed area of law that provides guidance to a business owner in this area. Both the Courts and the taxing authorities will look to what are called the ‘common law factors’ to determine how a worker should be categorized.
The IRS has issued a Revenue Ruling (Rev. Ruling 87-41) on this issue that lists 20 of these common law factors or elements to consider. Courts will also generally look at these factors as well in making the determination. And, while no single factor will control the entire analysis, the key issues center on “whether sufficient control is present to establish an employer-employee relationship” in a particular situation.
The questions asked to get to that answer generally focus on things like:
• Does the worker have the right to work for someone else at the same time?
• Does the worker have their own separate business, business license, and/or business insurance for their work?
• Can the employer control the worker’s schedule, hours worked and the manner in which the job is performed?
• Does the employer provide the materials, tools, and equipment necessary for the worker to do their job such as a computer, space to work at the employer’s location, business cards, a company email or phone number?
• Is the worker integrated into the company’s business?
• Is there an ongoing and continuous working relationship between the two?
Always Have A Written Independent Contractor Agreement In Place!
In addition to observing the common law factors, having a written independent contractor agreement can help clear up a lot of uncertainty. While “having a written agreement” is not one of the 20 factors listed by the IRS, it may very well be a key fact in any dispute an employer will have with an employee. And, while having an agreement between the company and the worker that confirms them as an independent contractor and not an employee cannot magically convert a true employee into a contractor, it may be evidence that can be used to overcome certain presumptions under state law. Moreover, it’s simply in the best interests of each party to have such an agreement.
The employer is always in a stronger position having an agreement in place if there is a dispute about the worker’s status. Moreover, regardless of whether or not such agreements on their own can convince the IRS or a judge or jury on this issue, there are also other very good reasons to have written agreements in place as they will typically address other important issues such as non-disclosure of the company’s trade secrets, non-solicitation of customers or employees, addressing questions of ownership of intellectual property, pay rates, requirements of work quality, deadlines and similar matters.
Having a written agreement in place will also benefit the independent contractor as it will clearly set out what they are to get paid, when, and under what conditions. Having those understandings reduced to a written contract will help them in the event the employer disagrees on compensating them.
So, whether you are an employer who is hiring an independent contractor or you are the worker performing independent contractor services for a company, the best approach to protect both your interests is to adopt a clear, comprehensive and legally sufficient agreement which lays out everyone’s rights. Failure to do that will only increase risks and the potential costs to all involved.
© Copyright 2017 Gregory L. Cartwright. All rights reserved.