'Independent contractors' - what's in a name?

As appeared in Law360 on March 29, 2010.

"Consultants," "Contractors," "Freelancers," "Professional Talent" and "Advisers" ... companies have many creative and unique titles for workers who are classified as "independent contractors." However, it's not the title that businesses give someone that is determinative of their status as an "independent contractor" or "employee." Rather, it is the level of control over the work of these individuals and the nature of the relationship that matters in determining their proper status. Given the tough economic climate, companies are implementing strategies to cut costs without sacrificing productivity or their competitive advantage. Usually, the biggest bottom line costs for businesses are those attributable to the work force — wages, benefits, insurance and payroll taxes.

Companies are increasingly trying to lower these labor costs by classifying workers as "independent contractors." Individuals who are properly classified as "independent contractors" are not considered "employees" and, therefore, are not covered by the various federal and state employment laws; particularly, wage and hour laws and leave of absence laws.

In addition, independent contractors are not subject to income tax, Social Security and Medicare taxes, they do not qualify to participate in company-sponsored employee benefit plans, and they are not covered by workers' compensation insurance, unemployment or disability insurance programs.

Studies have shown that companies can save as much as 30 percent of payroll and related taxes by classifying workers as independent contractors.[2] Such savings can be very attractive now, but improperly classifying workers as independent contractors can come back to haunt the unwary business in the form of administrative audits, assessments, fines and penalties, and/or civil litigation — including class actions.

Recently, the federal and state agencies tasked with enforcing employment and labor laws and for collecting payroll taxes are cracking down on companies that improperly classify workers as independent contractors.

Based on recent studies, the Internal Revenue Service estimated that, for the tax year 2001 alone, lost tax revenue due to worker misclassification totaled approximately $1.6 billion and estimates that for the tax year 2006, this figure is likely to be much higher.[3]

In order to combat the perceived abuse of independent contractor status, President Obama's proposed budget for FY 2010-2011 includes $25 million for the U.S. Department of Labor to use solely to increase audits of and enforcement against companies who misclassify workers. In addition, the IRS and state agencies have jumped on this enforcement bandwagon.

Moreover, the federal and several state legislatures have proposed and enacted legislation which will make classifying workers as independent contractors more difficult. Sen. John Kerry, D-Mass., has introduced a bill, the "Taxpayer Responsibility, Accountability, and Consistency Act of 2009" (S. 2882), that would amend and limit the "safe harbor" provision contained in Section 530 of the Internal Revenue Code as it relates to independent contractors.

Now more than ever, it is crucial for companies to "get it right" and make the correct determination of whether the individuals who are providing services are employees or independent contractors. Unfortunately, since different federal and state laws utilize different standards to determine independent contractor status, it is possible that the same worker may be considered an employee for purposes of one law and be an independent contractor under another law.

While there is no single test that can be used to determine independent contractor status, most federal and state agencies follow the general rule that an individual is an independent contractor if the company has right to control or direct only the result of the work and not the means and methods of accomplishing the result.

However, there are several other factors that must be weighed and considered, and it is important to note that the determination of each worker's status must be made on a case-by-case basis.

The IRS guidelines (generally followed by most federal and state agencies) for determining the proper status of a worker looks at the following three categories to determine the degree of control and independence, and the nature of the relationship: 1) "behavioral;" 2) "financial;" and 3) the "type of relationship" between the parties.[4]

1) Behavioral Control

Behavioral control refers to whether the company has the "right to direct or control" how the worker does the work. The company does not have to actually direct or control the way the work is done — as long as the company has the right to direct and control the work, the worker will be considered an employee. Behavioral control factors are:

- Type of instructions given to the worker: Employees are subject to the business' instructions regarding when and where to do the work; what tools or equipment to use; what workers to hire or to assist with the work; where to purchase supplies and services; what work must be performed by a specified individual; and what order or sequence to follow when performing the work.

- Degree of instruction: Employees are provided with more detailed the instructions. Independent Contractors are provided with less detailed instructions which reflect less control over the worker. Even if no instructions are given (for example, where the business lacks knowledge in a highly specialized area), sufficient behavioral control may exist if the employer has the right to control how the work results are achieved.

- Evaluation systems: Employees' performance is formally evaluated by the business against management's expectations regarding the details of how the work is performed. Independent Contractors are not included in the companies' evaluation process and performance is measured by the end result.

- Training: Employees receive initial, periodic and/or on-going training on how to do the job, this indicates that the business wants the job done in a particular way. Independent Contractors possess all the requisite knowledge, experience and training to perform the assignment and they use their own methods to accomplish the assignment.

2) Financial Control

Financial control refers to facts that show whether or not the business has the right to control the economic aspects of the worker's job. For example, does the company determine and control how and when the worker is paid, whether expenses are reimbursed, whether tools and equipment are provided? If so, employee status may exist. The financial control factors are:

- Significant investment: Employees rarely have any significant investment in the equipment they use to perform the assignment. Independent Contractors may have significant investment in tools and equipment. There are no precise dollar amounts that must be met in order to have a "significant investment."

- Unreimbursed expenses: Employees are usually reimbursed for business expenses. In some states, reimbursement of employee business expenses is mandatory. Independent Contractors are more likely to have unreimbursed expenses.

- Opportunity for profit or loss: Independent Contractors have the opportunity to make a profit or the possibility of sustaining a loss from their efforts.

- Services available to the market: Independent Contractors are free to seek out business opportunities in the relevant market and perform services for other companies while working for the business.

- Method of payment: Employees are guaranteed regular wage payments on regular paydays. Independent Contractors are paid by a flat fee or rate for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.

3) Type of Relationship

Type of relationship refers to facts that show how the worker and business perceive their relationship to each other. The factors for determining the type of relationship between two parties are:

- Written contracts: Written contracts expressly defining a worker's status as an independent contractor are not determinative. However, the IRS is not required to accept a contract as proof of independent contractor status.

- Employee benefits: Independent Contractors are not eligible for employee benefits, like insurance, paid time off, leaves of absence or retirement, and disability insurance.

- Permanency of the relationship: Employees are generally "hired" for an indefinite period of time and are usually "employed" "at will." Independent Contractors are "retained" for a specific project or period and there are typically contractual provisions governing the manner in which the relationship can be terminated.

No one of these factors is determinative of a worker's legal status. ach factor must be placed weighed against the others to see which way the balance tips — employee or independent contractor.

Generally, where more factors weigh in favor of the business having significant control over the manner, means and results of the work performed, the worker will more likely be an employee.

You can also use the "duck test" to determine a worker's status. If it looks like a duck, walks like a duck and sounds like a duck, it's a duck. So if it looks like an employee, walks like an employee and sounds like an employee, it's probably an employee.