Analysis: Working with Independent Contractors

From: Staffing

It is critical that employers correctly determine whether individuals providing services are employees or independent contractors. Independent contractors are workers who have contractual agreements to complete jobs and who have complete control over their job performance.

This article considers some of the advantages to using independent contractors, outlines ways to distinguish between employees and independent contractors, and reviews legal issues that may be of concern to employers with independent contractors.

Department of Labor Misclassification Initiative

Before getting into a discussion of independent contractors, it is important to note that both the federal government and state governments have been cracking down on employers who wrongly classify employees as independent contractors.

The misclassification of employees as independent contractors presents a serious problem for affected employees, employers, and to the entire economy. Misclassified employees are often denied access to critical benefits and protections — such as family and medical leave, overtime, minimum wage, and unemployment insurance — to which they are entitled. Employee misclassification also generates substantial losses to the Treasury and the Social Security and Medicare funds, as well as to state unemployment insurance and workers’ compensation funds.

The Department of Labor’s Misclassification Initiative is designed to prevent, detect, and remedy employee misclassification. As a result of the initiative, a worker who is classified as an independent contractor does not have to bring a claim against his or her employer alleging misclassification. Instead, the Department of Labor, Internal Revenue Service (IRS), and/or state agency may initiate a directed investigation which is essentially an unfettered investigation into an employer’s classification of its workers and, potentially, all of the employer’s payroll practices.

Many states have entered into Memorandums of Understanding (MOU) with the Department of Labor and the IRS. These memorandums enable the Department of Labor and IRS to share information and coordinate enforcement with the participating states.

Check here to find out if your state has entered into a MOU.

Benefits of Independent Contractors

By using independent contractors, employers can:

Avoid paying FICA and FUTA taxes, contributions to employee pension plans, payments of premiums for employee health-insurance programs, and workers’ compensation insurance costs.
Obtain qualified and experienced personnel with specialized skills without the cost of training, developing, and maintaining those specialized skills among their own employees.
Reduce human resource, payroll, and bookkeeping expenses associated with employees.
Reduce the overall number of employees in the workforce, which could eliminate an employer’s need to comply with certain statutes that apply to employers with more employees.
Be free of the obligation to comply with a variety of employment-related statutes and regulations applying only to actual employees.

Legal Issues

Courts and agencies have increasingly declared independent contractors to be employees because of federal income tax, state unemployment taxes, and workers’ compensation laws, thus exposing employers to unexpected liabilities and penalties. The proper determination and classification of independent contractor status is critical because many employment statutes and regulations apply only to actual employees and not independent contractors.

The following is a partial list of state and federal employment-related statutes that may apply only to employees and not to independent contractors:

State wage laws and the federal Fair Labor Standards Act (FLSA).
Federal and state income tax.
Unemployment tax.
State and federal discrimination statutes.
State safety regulations.
The federal Family and Medical Leave Act (FMLA).

Workers’ compensation laws and various protective statutes may also apply solely to employees and not independent contractors. Workers injured on the job may challenge their status as independent contractors to receive workers’ compensation benefits. The first step in determining whether an individual is an employee or an independent contractor under state workers’ compensation law is to properly classify the individual’s occupation, including the criteria for that occupation.

In some states, statutory employee provisions cover workers who are classified as nonemployees. Likewise, employee protection statutes, such as the FLSA, Title VII of the Civil Rights Act of 1964, the Americans with Disabilities Act (ADA), and the Age Discrimination in Employment Act (ADEA) may review the validity of the independent contractor relationship when an issue of enforcement arises.

The courts and administrative agencies charged with administering and enforcing these employment statutes use a variety of tests to determine whether an individual is an employee or an independent contractor. Employers should not reach their own conclusions about whether an individual is an employee or an independent contractor without first reviewing applicable statutes, accompanying regulations, and any interpretative case law.

Determination of Status: Employee vs. Independent Contractor

State law may consider several factors in deciding whether an individual is working as an employee or an independent contractor. A significant consideration is whether either the employer or the individual has the right to control the means and manner of performance.

NLRA: Common Law Agency Test

The National Labor Relations Act (NLRA) excludes independent contractors from its employee definition. However, labeling a worker an independent contractor does not necessarily mean that the worker is an independent contractor.

The National Labor Relations Board (NLRB) uses common law agency principles to decide whether a worker is an employee or an independent contractor within the meaning of the NLRA. Under the common law agency test, several factors determine whether an employee or independent contractor relationship exists.

Among the significant factors that indicate the existence of an employee relationship are the following:

An employer controls the details of work performance.
An employer provides work supplies and a place to work.
A permanent working arrangement exists with the employer that will ordinarily continue as long as performance is satisfactory.
The work performed is a part of the employer’s regular business.

Significant factors that indicate the existence of an independent contractor relationship include the following:

Workers are engaged in a separate business or occupation, particularly if they are professionals.
A specialist does the job without supervision at the workplace.
The worker defines the time required for a workday rather than abiding by a typical company workday.
The job requires a high level of skill.
The employer pays the worker for each, individual job completed.
The worker is engaged in a personally owned business.

The NLRB warns that these factors do not apply to every situation. The facts of each relationship must be reviewed using the appropriate common law principles.

The Fair Labor Standards Act: Economic Realities Test

The FLSA and state wage laws may apply only to workers designated as employees and not to independent contractors. Thus, the proper classification of workers is critical to determine the application of these laws.

According to the Wage and Hour Division of the U.S. Department of Labor, the employer-employee relationship under the FLSA is tested by economic reality rather than technical concepts. It is not determined by the common law standards relating to master and servant. State courts often use the same test to determine an individual’s employment status under state law, as federal courts have developed to determine whether an individual is an employee or an independent contractor under the FLSA. Under this test, the courts examine factors focusing on the total activity or situation of the relationship. An employee is one who is dependent upon the business to which the individual renders service.

Significant factors include all of the following:

The extent to which the services rendered are an integral part of the principal’s business.
The permanency of the relationship.
The amount of the worker’s investment in facilities and equipment.
The nature and degree of control by the principal.
The worker’s opportunities for profit and loss.
The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
The degree of independent business organization and operation.

According to the division, there are certain factors which are immaterial in determining whether there is an employment relationship. Such facts as the place where work is performed, the absence of a formal employment agreement, or whether an alleged independent contractor is licensed by state/local government are not considered to have a bearing on determinations as to whether there is an employment relationship. Additionally, the U.S. Supreme Court has held that the time or mode of pay does not control the determination of employee status.

Unemployment Compensation Coverage: The ABC Test

In order to determine whether an employer is required to provide unemployment insurance coverage to an individual, some state unemployment insurance statutes use the ABC Test. Under applicable statute and case law, an employment relationship will exist (unemployment insurance coverage is required) unless and until the employer is able to demonstrate that all three parts of the ABC Test are met.

Under the ABC Test, work performed for payment will be treated as wages and taxed by the state and federal government unless the following factors exist:

A. The employer does not and will not control or direct the worker’s performance, under both contract of service and in fact.
B. Work is performed off the premises of the employer or the work is done outside the usual course of the employer’s business.
C. The individual customarily works in an independently established trade, occupation, profession, or business of the same type in which the work is performed.

Liability

An employer is responsible for injuries caused by employees. However, an employer is typically not responsible for injuries caused by independent contractors.

Note: To sue an organization, a third party that is injured by an independent contractor may contest the legal status of the independent contractor.

Federal and State Income Tax

The first step in determining independent contractor status for state or federal income tax purposes is to examine the criteria of the particular individual’s occupation. State tax withholding obligations are usually consistent with the federal tax withholding obligations.

The status of an individual as an independent contractor or an employee for purposes of the federal tax laws is determined, with few exceptions, under the common law tests for determining whether an employment relationship exists.

The Internal Revenue Code (IRC) provides that individuals who perform work as qualified real estate agents and direct sellers will not be treated as employees for federal employment tax purposes (such as FICA taxes, FUTA taxes, and income tax withholding). The IRC classifies certain employees as statutory employees as an option to the category of independent contractor. This subject is discussed further in the section Taxable Independent Contractors.

According to the IRC, the following statutory employees are treated as employees solely for FICA tax purposes, but not for income tax withholding:

Agent-drivers or commission-drivers.
Full-time life insurance salespeople.
Home workers.
Full-time traveling or city sales representatives.

Note: Federal and state income tax rates are subject to changes annually. Employers should consult with the Internal Revenue Service (IRS) or other applicable legal entity for current rates and scheduled changes.

Common-Law Employee Status

The federal employment tax regulations (such as FICA, FUTA, and income tax withholding) provide that an individual is an employee if, under the usual common-law tests, the relationship between the individual and the person for whom an individual performs services is the legal relationship of employer and employee.

Such a relationship generally exists if the person for whom the services are performed has the right to control and direct the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer as to not only what must be done, but also how it must be done.

The regulations state that the determination is to be based upon the particular facts in each case and warn that the designation or description of the relationship by the parties will not be determinative when facts prove otherwise.

IRS Common-Law Factors

According to the IRS, in determining whether the person providing service is an employee or an independent contractor, all information that provides evidence of the degree of control and independence must be considered. Facts that provide evidence of the degree of control and independence fall into the following three categories:

Behavioral Control. Evidence in this category includes facts regarding whether the business has the right to direct or control how the worker performs the specific tasks for which the worker is hired. A worker is an employee when the business has the right to direct and control the worker. The business need not actually direct or control the way the work is done — so long as the employer has the right to direct and control the work.

Facts that show behavioral control include the type and degree of instructions given to the worker, evaluation systems, and the training the business provides the worker. For instance, if the business provides the worker with training on how to do the job, this indicates that the business wants the job done in a particular way. This is strong evidence that the worker is an employee.

Financial Control. Evidence in this category includes facts regarding whether the payer has a right to direct and control the business aspects of the worker’s activities. Facts that show financial control include how the worker is paid, whether expenses are reimbursed, and who provides tools/supplies.
Relationship of the Parties. Evidence in this category includes facts that illustrate how the parties perceive their relationship to each other.

Relevant facts include those that show the intent of the parties with respect to their relationship and whether the parties were free to terminate their relationship at-will. The permanency of the relationship between the worker and the business is also relevant in assessing the relationship. For instance, if a worker was hired with the expectation that the relationship would continue indefinitely, rather than for a specific project or period, this would demonstrate that the general intent of the parties was to create an employer-employee relationship.

Note: In each case, employers must consider all the facts and factors because no single fact will provide an absolute determination as to whether a worker is an independent contractor or an employee.

Federal Tax Penalties for Misclassification

The IRC generally limits an employer’s liability for federal employment taxes with employees who have been misclassified as independent contractors. In addition, the IRS has established several audit settlement programs under which the IRS, depending on the circumstances, may reduce or eliminate an employer’s liability for the employment taxes for misclassified workers. However, employers who intentionally disregard reporting requirements incur greater liability.

Taxable Independent Contractors

Statutory Employees

Although certain individuals may not be common law employees, they may be considered employees by statute for Social Security, Medicare, and FUTA tax purposes under certain conditions. According to the IRS, the following workers are statutory employees:

A full-time traveling or city salesperson who solicits orders from wholesalers, restaurants, or similar establishments on behalf of a principal. The merchandise sold must be for resale (for instance, food sold to a restaurant) or for supplies used in the buyer’s business.
A full-time life insurance agent whose principal business activity is selling life insurance and/or annuity contracts for one life insurance company.
An agent-driver or commission-driver engaged in distributing meat, vegetables, bakery goods, beverages (other than milk), or laundry or dry cleaning services.
A home worker performing work on material or goods furnished by the employer. However, in 2009, employers paying household employees paid cash wages of greater than $1,700 are required to report and pay Social Security and Medicare taxes on the employee’s wages.

An employer should indicate on the worker’s Form W-2 whether the worker is classified as a statutory employee. Statutory employees report their wages, income, and allowable expenses on Schedule C (or Schedule C-EZ), Form 1040. Statutory employees are not liable for self-employment tax because their employers must treat them as employees for Social Security tax purposes.

Untaxed Employees

Employers may be relieved of all taxes for two types of employee salespersons — real estate agents and direct sellers (that is, individuals who sell consumer products to consumers or to buyers for resale at a place that is not a permanent retail establishment) — if the following are true:

Substantially all of the compensation these individuals receive is directly related to sales or other output, rather than to the hours they work.
The salespeople are subject to written contracts indicating that they will not be treated as employees for federal income tax purposes.

Statutory Safe Harbor Relief from IRS Reclassification (Safe-Haven Rule)

The safe-haven rule under § 530 of the Revenue Act of 1978 protects an employer from liability for federal employment taxes.

Requirements for Safe-Haven Rule

The employer must have a reasonable basis for not treating the individual as an employee.

The safe-haven rule provides that a reasonable basis exists when an employer relies on any one or more of the following safe havens:

Judicial precedent or published rulings whether or not relating to the employer or IRS technical advice or letter ruling issued with respect to the employer.
Past IRS audit of the employer in which there was no assessment of employment taxes attributable to the treatment of workers holding positions substantially similar to the position held by the individual in question. (The audit need not have been conducted for employment tax purposes.)
Long-standing recognized practice of a significant segment of the industry.

An employer that fails to meet any of the three safe-haven components may still be entitled to the safe-haven rule if the employer can demonstrate, in some other manner, a reasonable basis for not treating the individual as an employee.

The employer must consistently treat the individual and any other individual holding a substantially similar position as an independent contractor at all times. For this purpose, consistency is determined by whether the employer has timely filed Form 1099s for all tax periods, the employer has not withheld federal income taxes or FICA taxes for any tax periods, and filed federal employment tax returns for any tax periods.

Burden of Proof

If the taxpayer establishes that it was reasonable not to treat the individual as an employee and the taxpayer has fully cooperated with reasonable requests from IRS, then the IRS has the burden of proving that a taxpayer is not entitled to relief under the safe-haven rule.

Effect of the Safe-Haven Rule

The safe-haven rule terminates an employer’s liability for federal employment taxes attributable to the erroneous classification of an individual as an independent contractor. In addition, the following apply:

The safe-haven rule prevents retroactive employment tax assessments against the employer.
As long as the requirements of the safe-haven rule are met, the IRS is prevented from making future employment tax assessments against the employer with respect to such individuals.
The safe-haven rule applies solely for federal employment tax purposes.
The safe-haven rule does not prevent an individual’s classification as an employee for all other purposes under the IRC. For example, an individual may be treated as an employee for purposes of the tax qualification requirements applying to retirement plans and various other employee benefits and nondiscrimination requirements under the IRC.

Note: Where an employer’s treatment of workers is based on something similar to the provisions discussed, employers may still qualify for the safe-haven rule. However, an employer would not qualify if some workers were treated as independent contractors and others in similar positions as employees. An employer trying to convert a worker previously treated as an employee any time since 1977 to independent contractor status would also not qualify for safe-haven rule protections. When workers do not satisfy the requirements of the safe haven, the common-law test of their employment status is applied.

Exceptions

The following considerations add to the problem of distinguishing employees from independent contractors:

Some independent contractors who perform certain types of duties are taxable as employees.
Some individuals may be statutorily exempted from federal employment-withholding taxes.
The employer may be exempt under the safe-haven rule from withholding taxes for individuals who normally would be classified as employees.
Employed family members are exempt from certain taxes as employees.

IRS Limited Amnesty Program

On September 21, 2011 the Internal Revenue Service (IRS) launched a new program that will enable many employers to resolve past worker classification issues and achieve certainty under the tax law at a low cost by voluntarily reclassifying their workers. The new program will allow employers the opportunity to get into compliance by making a minimal payment covering past payroll tax obligations rather than waiting for an IRS audit.

The new Voluntary Classification Settlement Program (VCSP) is designed to increase tax compliance and reduce burden for employers by providing greater certainty for employers, workers, and the government. Under the program, eligible employers can obtain substantial relief from federal payroll taxes they may have owed for the past, if they prospectively treat workers as employees. The VCSP is available to many businesses, tax-exempt organizations, and government entities that currently erroneously treat their workers or a class or group of workers as nonemployees or independent contractors, and now want to correctly treat these workers as employees.

To be eligible, an applicant must:

Consistently have treated the workers in the past as nonemployees.
Have filed all required Forms 1099 for the workers for the previous three years.
Not currently be under audit by the IRS, the Department of Labor, or a state agency concerning the classification of these workers.

Interested employers can apply for the program by filing Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before they want to begin treating the workers as employees.

Employers accepted into the program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years. Participating employers will, for the first three years under the program, be subject to a special six-year statute of limitations, rather than the usual three years that generally applies to payroll taxes.

Important Forms

IRS Form SS-8

If the employer is unsure as to the status of its workforce, the employer may request an IRS determination by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. This form is supplemented with additional information about the employment relationship between employer and worker. For example, a description of the nature of the supervision and method of payment can be found on the form.

Form 1099-Misc.

If an employer makes payments in excess of $600 to a worker who is not considered an employee, the employer must prepare Form 1099-Misc. Copies of this form must be provided to the worker and the IRS. The IRS compares the payments shown on the information returns with each recipient’s income tax return to see if the payments were reported as income.

Form 1096

If Forms 1099 are being sent to the IRS on paper, they must be transmitted with a Form 1096, Annual Summary and Transmittal of U.S. Information Return. Form 1096 reflects the totals from all of the Forms 1099-Misc. that the employer issued. If the Form 1099-Misc. information is being transmitted to the IRS electronically then a Form 1096 is not required.

Independent Contractors, Discrimination, and Safety Standards

Employers with independent contractors as workers must be aware of the various laws concerning discrimination in employment and safety in the workplace.

Federal Statutes

Discrimination Statutes

The Equal Employment Opportunity Commission (EEOC) defines an employee as someone with whom the employer has an employment relationship. An individual may have more than one employer. The question of whether an employer-employee relationship exists is fact-specific and depends on whether the employer controls the means and manner of the worker’s work performance. This determination requires consideration of all aspects of the worker’s relationship with the employer.

Factors indicating that a worker is in an employment relationship with an employer include, but are not limited to, the following:

The employer has the right to control when, where, and how the worker performs the job.
The work does not require a high level of skill or expertise.
The employer furnishes the tools, materials, and equipment.
The work is performed on the employer’s premises.
There is a continuing relationship between the worker and the employer.
The employer has the right to assign additional projects to the worker.
The employer sets the hours of work and the duration of the job.
The worker is paid by the hour, week, or month rather than the agreed cost of performing a particular job.
The worker does not hire nor pay assistants.
The work performed by the worker is part of the regular business of the employer.
The employer is in business.
The worker is not engaged in a personally owned distinct occupation or business.
The employer provides the worker with benefits such as insurance, leave, or workers’ compensation.
The worker is considered an employee of the employer for tax purposes (for example, the employer withholds federal, state, and Social Security taxes).
The employer can discharge the worker.
The worker and the employer believe that they are creating an employer-employee relationship.

This list is not exhaustive because other aspects of the relationship between the parties may affect the determination of whether an employer-employee relationship exists. Importantly, to be considered an employee, not all or even a majority of the listed criteria need be met. Rather, the determination must be based on all of the circumstances in the relationship between the parties, regardless of whether the parties refer to it as an employee or as an independent contractor relationship.

Occupational Safety and Health Administration

In general, the Occupational Safety and Health Administration (OSHA) imposes responsibility on employers with respect to the safety of their employees. However, independent contractors may or may not be deemed an employee for OSHA purposes.

In determining responsibility for employee safety, OSHA goes beyond the generalized definition of an independent contractor relationship. OSHA regulations scrutinize the substance of the working arrangements to determine whether the one who contracted the services or a subcontractor may be considered the employer.

State Regulations

Human Rights Act

State antidiscrimination laws often define employees in much the same way as the federal discrimination statutes. Thus, most state courts will apply the factors as previously listed for the federal discrimination statutes to determine an individual’s employment status under the state law.

Drug and Alcohol Testing in the Workplace

State drug-testing laws may define employee to include independent contractors and persons working for the independent contractor.

Therefore, any worker, including independent contractors and their employees, who is tested for drugs and alcohol, must be provided the rights as determined by state law.

Occupational Safety and Health Laws

Many states have altered the standards applied to independent contractors in the context of occupational health and safety. Many state standards require independent contractors to comply with state safety and health laws. For example, independent contractors working in building construction or improvements in the public or private sector may be required to comply with the state’s OSHA standards for employers and employees.

Contingent Workers

Many employers rely on contingent workers to meet workforce needs. Contingent workers refer to independent contractors, subcontractors, and workers from temporary agencies and leasing companies. Contingent workers not receiving benefits — for example, health and retirement benefits — from other sources may seek coverage from the contingent employer.

To determine whether the organization should or should not provide such coverage, an employer may:

Maintain a contractual relationship with the contingent worker that cannot be construed as enforcing direction or control over the work to be completed.
Review all benefit plans for definitions of employee, eligible employee, creditable hours, and classes of employees that can be included or excluded. Make sure these definitions are consistent within plans, contracts, and policies so they are interpreted in the same way.
Make sure all benefit documents give discretion to the plan administrator to interpret plan provisions.
Have clear contracts with independent contractors, temporary agencies, leasing companies, and subcontractors. Include indemnification provisions in case an employee of one of these firms (or an independent contractor) makes a claim for benefits.
Include language in benefit plan documents excluding independent contractors, leased employees, and temporary workers from coverage to the extent permitted by the IRC and regulations.
If a contingent worker makes a claim for benefits, analyze and document the plan administrator’s decision about benefits eligibility. Do not automatically refuse to give the worker the requested documents. Even a nonparticipant may be entitled to plan information.
Before entering into contingent work arrangements, seek competent advice, conduct a thorough analysis of benefit plans and policies, and make changes to reflect the intended status of the workers.