Classifying Independent Contractors and Employees – The $100 Million Dollar Question

Whether a service provider is correctly classified as an employee or an independent contractor has an important legal consequence: potential liability, both to misclassified employees and to regulators for fines. Many startup companies prefer hiring independent contractors rather than employees to avoid the headaches that come with having employees on the payroll. This is because employers do not have to provide independent contractors with benefits such as workers’ compensation insurance, unemployment compensation, or pay employment taxes such as Social Security and Medicare, or be concerned with wage and hour or worker leave laws. However, many startup companies wrongly classify employees as independent contractors, and doing so puts their companies at risk.

You have probably seen recent news stories about companies slapped with multimillion law suits for misclassifying workers or placing expectations on independent contractors that, under the law, would have given them rights as employees. The penalties and liabilities for violations under the Fair Labor Standards Act can have a crippling effect on a growing company. In a recent case, an on-demand house cleaning service was forced to shut down due to liabilities associated with its misclassification of workers as independent contractors instead of employees.

Who is an Independent Contractor?

Generally, an independent contractor is someone who is in business for themselves. This approach encompasses people who are in an independent trade, business or profession in which they offer their services to the general public, and may include consultants, IT professionals, web designers, contractors, subcontractors, accountants or programmers depending on the facts and circumstances. Some additional terms that have been used to describe independent contractors include freelancers, the self-employed, and even entrepreneurs and business owners.

An independent contractor is different from an employee in that they are given an outline of the project that needs to be done and the due date, and they determine how to accomplish it, on their own schedule. Independent contractors are also usually paid based on their results (i.e., a flat rate per job, or a per-unit-completed rate) rather than the time they put in. In addition, they are usually not eligible for company sponsored benefits such as health insurance or paid time off, they are not covered by worker’s compensation insurance, they are responsible for submitting their own income taxes to the IRS, and they must pay self-employment tax (SE tax) as well as income tax. SE tax is a Social Security and Medicare tax primarily for individuals who work for themselves.

Who is an Employee?

Generally, an employee is someone who performs services for the employer and whose work is controlled by the employer. The employee often undergoes training, and usually works for only one employer. In an employer-employee relationship, the employee can quit without substantial risk of loss (as compared to an independent contractor who can be sued for breach of the service contract), and the employer provides the employee with tools and a place to work.

Federal Employment Law

Federal laws such as the FLSA have their own definitions of what constitutes an employee versus an independent contractor relationship. Because the FLSA's requirements and wage mandates apply only to employees, companies often classify workers as independent contractors to lower administrative and labor costs. However, simply calling workers “independent contractors” does not mean that they will be seen as such in the eyes of the law. A worker’s status is determined based on a wide variety of factors, each driving at the issue of how “independent” that person truly is.

While there is no single test for determining if an individual is an independent contractor or an employee, under the FLSA (and under the Affordable Care Act), courts and federal agencies have come up with a generally accepted “economic realities” test, which the Department of Labor views as having six main criteria:

Is the work an integral part of the company’s business (meaning, the kind of work the company is in the business of doing);
Is the service provider’s potential profit or loss affected by his or her managerial skills (for instance, is hiring other workers, buying supplies, etc., controlled (and paid for) by the service provider?);
Does the service provider invest a lot in the job versus the employer (for instance, an office cleaner who is provided all materials to do the job by the company versus an office cleaner who supplies everything);
Does the work require special skills and initiative?;
How permanent or indefinite is the relationship (does the service provider only work for the company? Does the service relationship appear to be indefinite?); and
How much control does the company have over the service provider (such as work hours, place, etc.)?

It is important to note, however, that, in addition to these DOL guidelines, other agencies and the states may apply their own tests, some of which presume that a service provider should be classified as an employee by default.

IRS Three Factor Test

The IRS, which is focused primarily on worker classification for collection of employment related taxes, developed a 3 factor test that it uses to determine whether an employee-employer relationship exists (which is built on a somewhat ungainly 20-factor test it previously used). The degree of importance of each factor varies depending on each factual situation.

The three main groups of the IRS test are as follows:

1. Behavioral Control: Factors that show whether the company directs and controls the service provider and how they accomplish the task.

Instructions: Independent contractors are not required to follow, nor are they furnished with instructions to accomplish a job, the order or sequence to follow, nor are they typically provided with tools or equipment/supplies or instructions or limitations on when and where they do the work or hiring others to assist them.
Training: Independent contractors typically do not receive training.

2. Financial Control: Factors that show if the company controls the business aspects of the service provider’s work.

Significant Investment: Investment in facilities (equipment, tools, work location, etc.) used by the worker indicates independent contractor status.Payment by the Hour, Week, or Month: Generally indicates employment status.
Realization of Profit or Loss: A worker who can realize a profit or suffer a loss as a result of the services is generally an independent contractor.
Working for More Than One Employer at a Time: If a worker performs services for a number of unrelated companies at the same time, the worker is more likely an independent contractor.
Payment of Business and/or Traveling Expenses: If the company pays expenses, that may indicate employee status.

3. Type of Relationship: Factors that show the type of relationship between the company and the service provider.Other Benefits typically provided to Employees. Participating in company plans such as health and welfare plan benefits point toward employee status.Integration of the Work into the Company’s business. If the work done by the service provider is a key part of the company’s regular business, that suggests the service provider is an employee. The establishment of set hours for the worker indicates employee status.

Continuing Relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
Written contracts: Whether the parties have an agreement about the relationship (though this is not dispositive).

The IRS typically frowns on the use of independent contractors, in part because such workers are responsible for paying their own payroll taxes and it is much more difficult for the IRS to make sure they are doing so. Therefore, it is important for employers to properly classify workers. If an employee is mistakenly classified as an independent contractor and the employer has no reasonable basis for doing so, the employer may be held liable for employment taxes.

Best Practices to Avoid Misclassification Claims

Given the potential risk of misclassification, there are some steps companies can take to avoid misclassifying:
Draft detailed job descriptions for all positions, including roles filled by independent contractors.
Avoiding having independent contractors do the same or similar work as employees.
Do not provide independent contractors with supplies, tools or equipment.
Do not reimburse independent contractors for work-related expenses.
Be willing to give up some control. If you treat them like employees, they will be considered your employees.
Compensate independent contractors on a per-job basis rather than by hour or by week, and invoice them.
Fully discuss the nature of the relationship with prospective independent contractors, and reduce the understanding to writing.
Avoid the outward appearance of an employment relationship (company email address, company phone, etc.).
Regularly review the nature of the relationship, and reclassify workers as needed.