Business owners must determine the type of workers they will utilize to operate successfully. In some cases, owners think they are hiring independent contractors but, in reality, those workers may actually be employees. Failure to properly classify workers can result in fines, penalties, and payment of back taxes, so it is important that business owners understand the legal distinctions between an independent contractor and an employee.
I. Federal Law
Federal law provides that an employer/ employee relationship exists “when the employee is subject to the will and control of the employer not only as to what shall be done but how it shall be done.” 26 CFR §31.3401(c)-1. The determination of whether an employer/ employee relationship exists will be “determined upon an examination of the particular facts of each case.” Id. If the relationship is truly that of employer/ employee, the parties’ description or characterization of the relationship as that of an independent contractor is irrelevant. Id.
II. IRS’ 20 Factors
The Internal Revenue Service (“IRS”) has identified 20 factors to guide business owners in determining whether a worker is an employee or independent contractor. See IRS Ruling 87-41. The degree of importance of each of these factors depends “on the occupation and the factual context in which the services are performed.” Id. Employers should give special care in analyzing the substance of the arrangement with their workers and consider whether the employer exercises sufficient control over the worker to classify that worker as an employee.
The factors set forth below are helpful in determining whether the worker is an employee or an independent contractor. If answered in the affirmative, these factors demonstrate the requisite control that supports an employer/ employee relationship.
- Instructions: worker must comply with instructions as to when, where, and how the work is to perform work.
- Training: business owner provides training to the worker by requiring an experienced worker to work with him or her, and requiring the less-experienced worker to attend meetings.
- Integration: integration of worker’s services into the owner’s business operations.
- Services Rendered Personally: services are rendered personally by the worker (indicating business owner is interested in the methods and results in accomplishing work).
- Hiring, Supervising and Paying Assistants: business owner has the right to hire, supervise and pay assistants.
- Continuing Relationship: continuing relationship between the worker and the person or persons for whom the services are performed.
- Set Hours of Work: the person for whom services are provided sets the workers hours of work.
- Full Time Required: the worker devotes substantially full-time to the business for whom the services are performed, and the person has control over the amount of time the worker spends working and impliedly restricts the worker from doing other gainful work. An independent contractor is free to work when and for whom he or she chooses.
- Doing Work on Employer’s Premises: the work is performed on the premises of the person for whom the services are performed.
- Order or Sequence Set: the worker is required to follow the established routines and schedules of the person for whom the services are performed.
- Oral or Written Reports: the worker is required to submit regular or written reports to the person for whom the services are performed.
- Payment: worker paid by the hour, week or month. However, payment made by the job or straight commission generally indicates an independent contractor arrangement.
- Payment of Business and/or Traveling Expenses: worker’s expenses paid for by another.
- Furnishing of Tools and Materials: provided by someone other than the worker.
- Significant Investment: lack of worker investment in facilities where the services are performed.
- Realization of Profit or Loss: worker does cannot realize a profit or loss as a result of his or her services.
- Working for More than One Firm at a Time: worker does not perform services for a multiple of unrelated firms at the same time.
- Making Service Available to General Public: worker does not make his services available to the general public on a regular and consistent basis.
- Right to Discharge: worker can be discharged. An independent contractor cannot be fired, so long as the independent contractor produces a result that meets the contract specifications.
- Termination: worker has the right to terminate his or her relationship with the person for whom the services are performed anytime.
III. Employment or Independent Contractor Agreement
In some cases, the business owner will execute an independent contractor agreement with the worker thinking that, because of the title of the agreement and because the business owner is not paying taxes on the worker, the parties have such an independent contractor relationship. This approach is incorrect.
The employer should carefully analyze the factors set forth above, and assuming the worker qualifies as an independent contractor, the agreement should spell out the rights and obligations of the parties. The agreement should also specify that the worker will not be treated as an employee for federal tax purposes with respect to the services performed, and that the worker is required and responsible for paying his or her own estimated income tax payment, self-employed taxes, occupational taxes and other taxes, if any, to the appropriate governmental entities. The agreement should also clarify that the business owner will not withhold any taxes or compensation due to the worker, nor provide workers’ compensation insurance. Finally, the agreement should state the worker will not be provided any minimum salary, vacation pay, sick leave or any other fringe benefit.