Many companies in the technology industry pay workers as “independent contractors” or “1099 workers.” In theory, classifying individuals as independent contractors rather than employees can bestow significant economic benefits on a company. This option may be very attractive to a start-up who may be short on cash to pay salaries and fringe benefits.

When independent contractors do the work, your company is not responsible for tax withholdings, is not responsible for workers’ compensation or unemployment insurance, and does not need to pay minimum wage or overtime. That’s the good news. However, when not done correctly, independent contractor classification is fraught with risk and lots of potential legal liability.

In addition to the federal government’s monitoring and enforcement of possible misclassification through both the U.S. Department of Labor (DOL) and the Internal Revenue Service, companies may also be subject to civil lawsuits under the Fair Labor Standards Act or “FLSA” (which governs wage and overtime payment) and/or state employment law.

Recent developments have significantly increased the risks faced by companies that “get it wrong” when classifying employees as independent contractors.

The Department of Labor Does Not Like Independent Contractors

On July 15, 2015, the DOL issued a 15-page “administrator’s interpretation” in which the government expressed its position that most workers are legally employees – not independent contractors. The bulletin claims that the vast majority of workers classified as independent contractors are invalidly classified and that companies are violating the law by improperly classifying workers as independent contractors.

Even more concerning to companies, the bulletin made clear that cracking down on independent contractor classifications will be a priority of the administration. Many state governments are becoming equally aggressive as they seek to ensure a steady stream of payroll taxes and funding for their unemployment compensation systems.

What is an Independent Contractor?

How do you know if you are properly classifying individuals in your workforce as independent contractors or employees?

Unfortunately, there is no clear answer as to whether an individual is an employee or independent contractor under the wage and hour law. According to the recent bulletin, and many court cases, the key is an “economic realities test.” The economic realities test asks whether a worker is legitimately in business for himself or herself (making him or her a genuine independent contractor) or is economically dependent on the company engaging him or her for work (making him or her an employee).

Courts analyzing independent contractor status will therefore look at the totality of a variety of factors, including:

  • What is the degree of control exercised by the employer over the worker?
  • What are workers’ opportunities for profit or loss and their investment in the business?
  • What degree of skill and independent initiative is required to perform the work?
  • What is the permanence or duration of the working relationship?
  • What is the extent to which the work is integral to the employer’s business?

If You Do It, Do It Right!

The safest course of action is to simply not use independent contractors. However, terminating them, or converting them to regular employees may create unintended consequences.

Although there is no one-size-fits-all, definitive way to ensure proper independent contractor classification, the following steps can help sway the “economic realities test” in favor of true independent contractor status.

Written Independent Contractor Agreements

Whether styled as an independent contractor agreement, a consulting agreement or a vendor agreement, make sure to have and maintain arms-length written business agreements with all independent contractors. These agreements should not merely be your typical employment contract with “contractor” copied and pasted to replace “employee.” Instead, clarify the scope of the relationship and explicitly carve out areas where the contractor is expected to maintain significant amounts of control. While not a cure-all, if you do not have such an agreement it will be exceedingly difficult to argue that the persons at issue are not true employees. Just because you have a well-drafted contract does not mean you will prevail over the DOL or win a lawsuit challenging your classification.

Language is Important: Banish “Employee” from Your Vocabulary

Never refer to your contractors as employees and don’t let them refer to you as their “supervisor,” either in writing or verbally. “Employee” should never appear in your contractor agreements; it should not appear in policies you provide to independent contractors; it should not be casually interjected into emails. Worse yet, it’s an oxymoron to have someone with a corporate officer title classified as an independent contractor.

Be Prepared to Give Up Control

Enjoying the benefits of independent contractor status comes with a price — a true independent contractor is not your employee, and you cannot exercise the same degree of control over an independent contractor as you would over a bona fide employee.

As a result, you should not:

  • set specific work hours
  • address poor performance via employee discipline forms or similar documents;
  • ask contractors to supervise your regular employees; or
  • overly restrict your contractors’ ability to perform work for other businesses.

It is almost always a good move to require that your contractors incorporate or set up some other formal business entity.

This does not mean you have no say in terms of how and when the independent contractor performs their work.

Walk the Walk: Don’t Treat Independent Contractors Like Employees

While written agreements and policy documents are helpful, a company engaging independent contractors needs to ensure that its managers and other employees are aware of independent contractors’ status and do not treat such individuals the same as employees. For example:

  • do not invite independent contractors to office holiday parties and similar events;
  • do not provide employee benefits to your independent contractors;
  • do not invite independent contractors to your employee training sessions; and
  • require that independent contractors provide you with invoices for services performed (i.e., they should not be punching your time clock along with your regular workforce).

Don’t Be Afraid to Seek Help

Multiple laws and government agencies are involved in independent contractor status determination. Not only do the FLSA and federal tax laws come into play, but businesses must also worry about compliance with numerous state laws, including not only wage and hour enforcement but also workers’ compensation and unemployment insurance requirements.

Each of these issues is highly nuanced. Independent contractor status for tax purposes, for example, may have some different considerations than independent contractor status for state wage and hour law purposes. When in doubt, be ready to seek legal advice.