Whether it is to limit liability, reduce costs, or simply to condense operations, there are numerous reasons why organizations may prefer to treat individuals as independent contractors rather than employees. Indeed, with limited exceptions, organizations are not responsible for paying taxes, providing workers’ compensation, unemployment insurance or any employment benefits to independent contractors and can avoid liability for their negligent or wrongful acts. Nonetheless, the devil is always in the details when it comes to misclassification, and organizations who believe they are using independent contractors may actually have employees.

From a compliance standpoint, it is critical to understand the proper role of the independent contractor and the company in a vendor engagement in order to avoid the liabilities associated with an incorrect classification. If the independent contractor is really an employee, then the consequences can be expensive, and can include payment for wages, taxes, workers’ compensation and unemployment. Additionally, the employee will have all of the protections of the vast field of employment laws that apply to the employer, such as Title VII, ADA, FMLA, and wage and hour laws.

Courts consistently look beyond the label the parties place upon the employment relationship in order to determine its true nature. Whether the parties truly believe they are operating in an independent contractor engagement is immaterial; what matters is the substance of the relationship. A variety of multi-factor tests may apply to any given scenario, and many tests differ from state-to-state - one state’s independent contractor may be another state’s employee. The primary tests utilized are the IRS test and the “economic realities” test. The IRS test applies principally for determining whether or not taxes are due. The economic realities test is a judicial construction utilized for many other issues.

The IRS has adopted a three part-test (broken down into several subparts) for distinguishing between employees and independent contractors. Under this three part test, the IRS considers:

  1. the amount of behavioral control; 
  2. the amount of financial control; and 
  3. the general relationship between the parties.

Each of these categories has several subparts. For example, when analyzing behavioral control, the IRS will look to the manner in which the worker performs the tasks and the type and degree of instructions the worker receives. As for financial control, the IRS will take into account such factors as (1) the extent to which the worker has unreimbursed business expenses; (2) the extent of the worker’s investment; (3) the extent to which the worker makes services available to the relevant market; (4) how the worker is paid; and (5) the extent to which the worker can realize a profit or loss. Finally, when looking at the type relationship, factors such as (1) whether the parties have a written contract describing their relationship; (2) whether the business provides the worker with employee-type benefits; (3) the permanency of the relationship; and (4) the extent to which services performed by the worker are a key aspect of the regular business of the company are considered.

Generally, federal courts use a different test when evaluating whether an employment relationship exists for purposes of the Fair Labor Standards Act and other federal labor and employment laws. See, eg. Bartels v. Birmingham, 332 U.S. 126, (1947); Purdham v. Fairfax County Sch. Bd., 637 F.3d 421, 433 (4th Cir. 2011) (applying the economic realities test to the distinction between employees and volunteers); Lilley v. BTM Corp., 958 F.2d 746, 750 (6th Cir. 1992) (extending the test to cases under the Age Discrimination in Employment Act). This test, generally known as the economic realities test, focuses on the degree of economic dependence of the employee/independent contractor on organization. The more the worker financially relies upon the business, the more likely it is that an employment relationship exists. The courts will consider factors such as:

  1. the degree of the employer’s right to control the manner in which work is performed; 
  2. the degree of skill required to perform the work; 
  3. the worker’s investment in the business; 
  4. the permanence of the working relationship; 
  5. the worker’s opportunity for profit/loss; and 
  6. the extent to which the work is an integral part of the business.

Some states, however, distill these tests into a simple “right to control” analysis. Under this test, the employment relationship is determined by the amount of control an organization maintains over the mode, method, and manor of the employee/independent contractor’s work.

In a difficult economy, some special considerations should apply. As companies reduce headcount, they often keep a few key employees engaged as contractors, post separation, for “consulting.” In these situations, the employee turned independent contractor often performs the same work they performed when their employment was terminated. These arrangements are very rarely true independent contractor relationships. Likewise, as the economy improves, companies may wish to augment their permanent workforce with independent contractors before committing to hiring. In these situations, the independent contractor is often performing work that is integral to the business and not properly classified as an independent contractor relationship.

Ultimately, whatever test is used, control is the key. The more control the organization exercises over its workforce, the more likely it is that an employment relationship exists. This is especially true when the tasks being performed are an integral part of the organization’s overall business. It is clear that courts will not defer to the characterization of the relationship, and will instead look at the substance. Accordingly, before making the decision to classify certain workers as independent contractors, a careful evaluation of the proposed relationship should be undertaken and the relationship should be properly constructed to achieve the party's objectives while maintaining the required independence.