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Are Your Independent Contractors Really Employees?
By
Louis B. Meyer III
Many businesses of all sizes use independent contractors for certain tasks or services to reduce the costs and administrative burdens associated with regular employees. Usually, the decision to classify a worker as an employee or independent contractor is made on the basis of the type of services to be performed. Sometimes, tax or employee benefit considerations play a role in deciding how to structure an employment arrangement.
Some businesses choose to classify workers as independent contractors when they should be classified as regular employees. In addition, some businesses classify workers as employees when they should be classified as independent contractors. A business that makes the wrong decision when classifying a worker as an employee or independent contractor may suffer serious tax consequences, jeopardize tax treatment of its employee benefit plans, and incur legal fees and other expenses from an IRS or Department of Labor audit or a legal action by workers.
Therefore, it is important for business owners to appreciate the consequences of misclassification, and understand the legal tests used to determine whether a worker is properly classified as an employee or an independent contractor, so that any necessary corrective action may be taken to avoid an audit or legal action.
Consequences of Misclassifying Workers
Tax Consequences
Misclassification of workers as independent contractors presents significant tax risks, and the IRS is currently devoting a great deal of attention to this issue. If a business classifies workers as independent contractors and the IRS determines they should be classified as employees, the business may be liable for income and FICA taxes not withheld from each employee's wages, plus employer's FICA and unemployment taxes not paid. The business also may be subject to penalties and interest. Moreover, individual owners or officials of a business may be personally liable for the taxes not withheld and paid to the IRS is the IRS views the failure to withhold and pay as "willful".
If a business has classified some of its workers as independent contractors and decides to change its relationship with these workers and make them employees, other tax issues are raised. For example, this sort of change could be viewed by the IRS as evidence against the business to indicate the workers should have been classified as employees for prior periods. In addition, the relief allowed under Section 530 of the Revenue Act of 1978, as described below, would not be available for periods after the change is made. More tax issues for both the business and the workers would be presented if the business incorrectly reclassifies the workers as employees.
Section 530 of the Revenue Act of 1978 provides businesses with limited relief from federal employment tax obligations when the IRS attempts to reclassify workers as employees, if certain requirements are met. If Section 530 is available, the business is relieved of liability for federal income tax withholding, FICA, unemployment taxes, and interest and penalties for the open years. A "safe harbor" may be available under Section 530 which prevents the IRS from reclassifying an independent contractor as an employee and asserting additional employment taxes on the business.
This safe harbor applies with respect to a worker if:
All federal tax returns filed from 1979 through the year in question with respect to the worker consistently treat the worker as not an employee,
Since 1977, no worker holding a "substantially similar" position to the worker at issue has been treated as an employee, and
There is a "reasonable basis" for treating the worker as an independent contractor.
Businesses should be aware of two important limitations of Section 530. First, Section 530 extends relief only to the business that hires the worker. The worker remains liable for his share of FICA or other tax consequences of reclassification as an employee (e.g., nondeductibility of contributions for a Keogh retirement plan available only to self- employed persons, or allowance of work-related expenses only as itemized deductions instead of as deductible Schedule C trade-or-business expenses). Second, Section 530 only applies to a business' liability for FICA, unemployment tax and income tax withholding; it provides no relief from any other issues or obligations arising from a worker's misclassification (e.g., employee benefit plan coverage issues).
ERISA and Employee Benefit Consequences
A business that misclassifies workers as independent contractors faces serious risks related to its employee benefit and pension plans. A business' qualified retirement plan may be subject to disqualification for failing to cover misclassified workers. If an IRS or Department of Labor audit or other legal action results in reclassification or workers as employees, a business also may be required to restore the value of any lost benefits to the workers. Benefit plan fiduciaries may even have an obligation under ERISA to seek restoration of lost benefits.
For example, the Ninth Circuit Court of Appeals recently ruled that Microsoft Corporation had misclassified a large number of workers as independent contractors and improperly denied them coverage under the company's 401(k) plan. These workers held jobs as software testers, production editors and proofreaders, and were considered "freelancers" by the company. However, the court found that the workers shared the same supervisors, performed the same functions and worked the same basic hours as Microsoft's regular employees. As a result, the court decided that Microsoft has misclassified these workers as independent contractors and required Microsoft to provide them with coverage under its 401(k) plan. The court also awarded damages to these workers for past coverage denied to them.
Adverse consequences under "welfare" benefit arrangements are frequently overlooked. A business may be held responsible for payment of any health care expenses incurred by workers who should have been classified as employees. Also, former workers misclassified as independent contractors may have COBRA rights, and the business may be required to restore the value of lost COBRA benefits for former workers and their families. The business' failure to cover misclassified workers under group life insurance, cafeteria or self-insured health insurance plans may cause such plans to violate discrimination requirements, which would make highly paid workers liable for income taxes on the benefits they received.
Conversely, if a business misclassifies workers as employees and allows them to participate in welfare benefit plans, the business may have inadvertently converted such plans into "multiple employer welfare arrangements," which are subject to regulation under the insurance laws of every state in which the business has employees.
Other Consequences
A business deciding whether to classify workers as employees or independent contractors, or a business required to reclassify workers as employees, should be aware of some important legal obligations.
In addition to being excluded from coverage under federal and state tax withholding requirements, independent contractors are not covered under workers compensation and unemployment insurance laws, as well as the overtime and minimum wage requirements of the Fair Labor Standards Act and comparable state laws. When workers are classified or reclassified as employees, a business must include them in its workers compensation and unemployment insurance coverage and meet all wage-and-hour requirements for them.
Businesses generally are not liable to independent contractors for employment discrimination under Title VII, the Age Discrimination in Employment Act, the Americans with Disabilities Act, and state fair employment practices laws. In addition, independent contractors are not entitled to take up to 12 weeks of unpaid leave with the right of reinstatement under the Family and Medical Leave Act. Workers who are classified or reclassified as employees will be entitled to protection under these federal and state laws.
In deciding how to structure an employment arrangement, a business should not overlook the disadvantages of independent contractors. For example, instead of being limited to a workers compensation claim, an independent contractor who is injured on the job because of a business' negligence may file a tort action and may be able to seek punitive damages from the business. Also, a business does not own the intellectual property rights for any ideas, inventions or writings generated by an independent contractor unless the independent contractor specifically assigns these rights to the business in the contract.
Tests for Deciding Whether a Worker is An Independent Contractor
It is critical for a business to know and understand the tests used by the IRS, the Department of Labor and the courts for determining whether a worker is properly classified as an employee or an independent contractor. It is also important for a business to evaluate how these tests might apply to workers whose status is questionable, and consider the possible consequences of an IRS or Department of Labor audit or a legal action by the workers.
The basic rule used by the IRS, the Department of Labor and the courts for determining whether a worker is an employee or an independent contractor is the common-law "right- to-control" test. If the business has the right to control the manner in which the worker performs the services, the worker is an employee. In the absence of a right to control the manner of work, the worker is an independent contractor. However, the relationship between a business and a worker usually has several aspects. Some may indicate the business has control and others may indicate the business does not have control.
The IRS, the Department of Labor and the courts also use another standard known as the "economic reality" test, a worker may be classified as an employee if, as a matter of economic reality, the worker is dependent on the business for which he or she is performing services. For this test, the basic question is whether the worker is in business for himself or herself.
Many factors are considered by the IRS, the Department of Labor and the courts in determining whether a business has the right to control the manner in which a worker performs his or her services, and whether a worker is in business for himself or herself. These factors are all highly specific to the facts of each case.
The 20 Factor Test
Although the "right-to-control" test is easy to state, its application has been difficult and confusing, and enforcement by the IRS has been inconsistent. Historically, the IRS has relied on a 20-factor test to determine whether a person is an employee or an independent contractor. These factors are applied on the basis of the specific facts of each case, and each factor is not always relevant in every case. No one factor is dispositive, and the nature of the relationship must be ascertained from an overall view of the facts. The factors are used as analytical tools, but the overall standard is the basic "right-to-control" test.
The twenty factors historically used to determine whether a worker is an employee or an independent contractor are:
1. Instructions
2. Training
3. Integration Into Business Operations
4. Services Rendered Personally
5. Hiring, Supervising and Paying Assistants
6. Continuing Relationships
7. Set Hours of Work
8. Part-Time or Full-Time Work
9. Doing Work on Employer's Premises
10. Order or Sequence of Services Set by Employer
11. Oral or Written Reports to Employer
12. Method of Payment of Worker
13. Payment of Business-Related Expenses
14. Furnishing of Tools, Materials and Equipment
15. Significant Investment in Facilities
16. Opportunity for Profit or Loss
17. Working for More than One Business at a Time
18. Making Services Available to the General Public
19. Right to Fire
20. Right to Quit
Three Basic Areas of Inquiry
Under recent IRS guidelines for deciding whether a worker is an employee or an independent contractor, the IRS is now focusing on three basic areas of inquiry:
1. Behavioral Control
2. Financial Control
3. Relationship of the Parties
There is no indication the IRS is changing or eliminating any of the original 20 factors listed above, but the focus of the IRS's inquiry may be different than in the past. The following factors appear to be relevant under the each of the three basic areas of inquiry. Some of these factors are the same or similar to the 20 factors listed above, while some are not.
1. Behavioral Control
How the worker performs the tasks for which he or she is hired
The factors that are most significant to the IRS in this area of inquiry are "Instructions" and "Training".
Instructions
An independent contractor is responsible only for accomplishing a job and is allowed to make independent use of his or her special skill, knowledge, or training in getting the job done. Instructions can be evidence that a business not only has the right to direct and control how work is performed, but also that is has actually exercised this right. If a worker must comply with the business' instructions about when, where and how to work, the worker might be considered an employee.
Training
Training is a means of explaining the methods and procedures to be used in performing a job. Training a worker is an indication that the business wants the services performed in a particular manner and is controlling the manner in which the work is done, and therefore is strong evidence that the worker is an employee. A worker who uses his or her own methods to perform a job and receives no training from the business that hires him or her might be considered an independent contractor. However, the IRS guidelines note that if the business gives a worker some orientation or information about the business' policies or products, or applicable laws and regulations, this orientation or information will be viewed as education, not training, and will not be considered in determining the worker's status.
2. Financial Control
How the business aspects of the worker's activities are conducted
This area of inquiry is related to the "economic reality" test. The factors most important to the IRS is this area of inquiry are "Significant Investment in Facilities," Payment of Business-Related Expenses," "Making Services Available to the General Public," "Method of Payment of Worker," and "Opportunity for Profit and Loss."
Significant Investment in Facilities
A significant investment in the facilities or equipment a worker uses to perform services for a business is evidence of an independent contractor relationship. If a worker maintains an office, studio, shop or other place of business at which he or she performs services for a business, this is strong evidence that he or she is an independent contractor. Under recent IRS guidelines, however, a significant investment in facilities is not required for independent contractor status because some types of work do not require costly facilities or equipment, or any required equipment may be rented rather than purchased.
Payment of Business-Related Expenses
If a business pays a worker's expenses, this suggests that he or she is an employee, rather that an independent contractor. Though an independent contractor sometimes is reimbursed for expenses, in many cases a contractor's expenses are included in the cost of his or her services. Because both employees and independent contractors may receive reimbursement of expenses, the IRS guidelines instruct auditors to focus on unreimbursed expenses as a factor indicating independent contractor status.
Making Services Available to General Public
A worker who does not hold himself or herself out to the public for work in his or her field looks like an employee. Even is a worker does not solicit work from the general public, independent contractor status is indicated if he or she is available to work for others.
Method of Payment of Worker
Employees generally are paid by the hour, week, or month. Independent contractors usually do one or more pieces of work for a fixed price or fee based on the quantity of the work, and normally are paid by the job or on a straight commission.
Opportunity for Profit and Loss
If a worker does not realize a profit or loss, but receives a set wage, he or she might be considered an employee. The presence of a chance for profit or a risk of loss suggests that the worker is an independent contractor. If the only risk of loss is the risk of nonpayment of compensation, and there is no risk of loss of investment, then the worker looks like an employee.
3. Relationship of the Parties
How the parties perceive their relationship
The factors most significant to the IRS in this area of inquiry are "Written Contractual Designation of Worker's Status," "Incorporation by Worker," "Employee Benefits," "Right to Fire," "Right to Quit," " Continuing Relationship," and "Integration into Business Operations."
Written Contractual Designation of Worker's Status
In determining a worker's relationship to a business, courts examine the parties' intent for the worker's status and will look at written agreements as evidence of the parties' intent. However, a contractual designation, by itself, is not sufficient evidence for determining a worker's status. For example, in the recent case involving Microsoft Corporation, the fact that there were written agreements between the company and the misclassified workers in which the workers acknowledged that they were independent contractors did not prevent the court from determining that they were employees based on other evidence.
Nevertheless, if evidence outside the contract is evenly balanced, a contractual designation might be viewed by the IRS as an effective way to resolve the issue.
Incorporation by Worker
In some instances, an independent contractor provides services for a business through a separate corporation owned by the contractor. Under recent IRS guidelines, a worker who has created a corporation through which he or she provides services for another party is considered an independent contractor if the corporate formalities are followed and at least one non-tax purpose exists for the corporation. However, the fact that a worker receives payment for services from a third party through the worker's corporation does not automatically require a finding that he or she is an independent contractor for purposes of those services.
Employee Benefits
If a worker is covered under a business' liability insurance, workers compensation, health insurance, licenses and bonds, and is provided other benefits given to regular employees, the worker probably will be considered an employee. Failure to provide benefits is not strong evidence of independent contractor status, since benefits are not required to be paid to any workers.
Right to Fire
If a worker can be fired, for reasons other than unsatisfactory performance, then he or she looks like an employee. If a worker cannot be fired as long as he or she produces a result that meets the requirements of the contract, the worker might be considered an independent contractor.
Right to Quit
If a worker may quit without consequences, he or she looks like an employee. If a worker has an agreement with a business to complete a specific job and is responsible for its satisfactory completion, so that he or she would be liable for failure to complete it, the worker probably will be considered an independent contractor.
Continuing Relationship
An independent contractor's relationship with a business typically has an identifiable end when the job is completed. If a business engages a worker with the expectation that the relationship will continue for an indefinite period of time, the worker has little need to maintain a business presence and little likelihood of incurring the risk of profit or loss associated with an independent contractor, and he or she probably will be considered an employee.
Integration into Business Operations
The services provided by an independent contractor usually are not an integral part of a business' regular business activities. If a worker's services are a key aspect of a business' regular business functions, he or she probably will be considered an employee.
Less Significant Factors
Under recent IRS guidelines, the factors that will probably prove less useful in determining whether a worker is an employee or an independent contractor for tax purposes are "Part- Time or Full-Time Work," "Working for More that One Business at a Time," "Doing Work on Employer's Premises," and "Set Hours of Work." Recent court decisions in tax cases give these factors little, if any, weight. However, the Department of Labor and the courts may apply these factors, so it would be prudent to consider their possible application for purposes of employee-benefit-plan-coverage issues and wage-and-hour requirements.
Part-Time or Full-Time Work
In the past, full-time work suggested that the worker was an employee, and part- time work would have weighed in favor or independent contractor status. With cutbacks and downsizing, the IRS now recognizes that whether a worker performs services on a full-time or part-time basis is a neutral factor, since many companies are hiring workers on a part-time basis.
Working for More than One Business at a Time
The IRS used to believe that a person who worked for only one firm was more like an employee that a person who worked for multiple firms at the same time. Working for one business at a time is now considered consistent with either independent contractor or employee status. An independent contractor may work full-time for one business because the contract requires a concentrated effort, or because the contractor chooses to devote full attention to a particular project. In addition, many employees in today's economy choose to "moonlight" for a second business.
Doing Work on Employer's Premises
Whether work is performed on an employer's premises or at another location no longer has much bearing on determining a worker's status. The IRS considers off- site work consistent with either independent contractor or employee status in the modern economy.
Set Hours of Work
Modern communications have increased the ease of performing work outside normal business hours, and allowing flexibility in setting hours helps a business improve morale and retain valued workers. Accordingly, whether the business or the worker sets the hours or work is no longer important to the IRS.
Factors Not Mentioned in IRS guidelines
Several other factors are not being applied under any of the three basic areas of inquiry described in the recent IRS guidelines, including "Services Rendered Personally," "Hiring, Supervising and Paying Assistants," "Order or Sequence of Services Set by Employer," "Oral or Written Reports," and "Furnishing of Tools, Materials and Equipment." It is not clear what weight would be given to these factors by the IRS, but it would be helpful to review them for purposes of employee-benefit-plan-coverage issues and wage-and-hour requirements.
Services Rendered Personally
Generally speaking, requiring a worker a perform services personally indicates a right to control how the work is done. If a worker is allowed to hire a substitute or any other labor necessary to perform a job, he or she might be considered an independent contractor.
Hiring, Supervising and Paying Assistants
If a business hires assistants for a worker, than it appears that the business has the right to control the worker. If a worker is free to use such assistants as he or she may think proper and has full control over these assistants, the worker might be considered an independent contractor.
Order or Sequence of Services Set by Employer
An independent contractor determines the order in which he or she will accomplish a job. If a worker can be required to perform services in the order or sequence set by a business, this shows that the worker is subject to the business' direction and control and the worker might be considered an employee.
Oral or Written Reports
Because an independent contractor is responsible only for a completed product or task, he or she typically is not required to make reports. If a worker is required to submit reports to a business, this shows that the business maintains a degree of control and the worker might be considered an employee.
Furnishing of Tools, Materials and Equipment
A worker who has invested a substantial amount in tools, materials and equipment looks self-employed, like the owner of a small business. An employer normally provides an employee with any necessary tools, materials and equipment.
"Statutory" Employees and Non-Employees
Besides the foregoing factors applied under the common-law "right-to-control" test for determining a worker's status, the Internal Revenue Code, by statute, deems certain types of workers to have a different status than would otherwise apply under the common-law test. For example, any officer of a corporation is deemed by statute to be an employee for FICA, withholding, and unemployment tax purposes, unless the officer performs no more than minor services as an officer.
In addition, four other types of workers are deemed by statute to be employees for FICA purposes, but not for purposes of income tax withholding:
Agent-drivers or commission-drivers who distribute certain types of food products or cleaned items.
Full-time life insurance salespersons.
"Home workers" who perform work on products in their own home (or another place besides their "employer's" place of business) and then return the products to the "employer" or its designee.
Traveling or city salespersons whose full-time business is soliciting orders for a single "employer" from certain types of customers.
Some types of workers are deemed by statute not to be an employee. For example, licensed real estate agents, direct sellers of consumer products outside of a permanent retail establishment, and direct sellers engaged in the delivery or distribution of newspapers or shopping news are deemed not to be employees for all federal tax purposes if substantially all of their compensation is based on sales or other output rather than number of hours worked and there is a written contract with the business that specifies they are not employees for tax purposes. Furthermore, special statutory rules apply to workers for state and local governments for FICA purposes.
In summary, it is critical for businesses to recognize the importance of making the correct decision when classifying a worker as an employee or independent contractor. A business that makes the correct decision can prevent serious tax consequences, safeguard its employee benefit plans, and avoid the legal fees and other expenses that can result from an IRS or Department of Labor audit or a legal action by workers. A prudent business owner should examine the way the business classifies its workers and apply the legal tests do determine whether workers are properly classified as employees or independent contractors.
A business owner also should understand that the IRS, the Department of Labor or a court will strictly scrutinize any arrangements that are structured to achieve a particular tax or benefit goal. It is preferable to structure employment arrangements based on actual business needs. If there are any workers that fall in a "gray area" or appear to be misclassified, a business owner should seek professional advice from a tax or legal advisor to avoid or reduce any adverse consequences.
About the Author
Louis B. Meyer III is a partner with Poyner & Spruill practicing in the Raleigh office. He received his Bachelor of Arts and Juris Doctorate degrees from Wake Forest University where he was a member of the Wake Forest Law Review. Mr. Meyer practices in the firm's Health Care, Professional Liability and Employment Law Sections. He has extensive experience in cases involving independent contractors and departing employees, including enforcement of non-compete covenants, protection of trade secrets and litigation of other business disputes. Mr. Meyer is a certified mediator and a member of the North Carolina and Wake County Bar Associations. He may be reached at (919) 783-2810.
Mr. Meyer gratefully acknowledges the assistance of the following Poyner & Spruill attorneys in preparing this article:
David Dreifusis a partner in Poyner & Spruill's Litigation Department. Mr. Dreifus may be reached at (919) 783-2817.
Thomas H. Cook, Jr. is a partner in the firm's Tax Section and practices in the Raleigh office. He may be reached at (919) 783-2892.
Hugh W. Davis, II, a partner in Poyner & Spruill's Raleigh office, concentrates his practice in Employee Benefits and may be reached at (919) 783-2908.
Reprinted with permission from Louis B. Meyer III and Poyner & Spruill, L.L.P.