Fall 2015 Article
Employee or Independent Contractor? Importance of Properly Classifying the Relationship
Employers should be very careful when classifying a new hire as an employee or independent contractor to make sure they comply with applicable federal and state tax laws. Misclassification of an individual as an independent contractor may have a number of costly legal and tax consequences.
The amount of taxes that an employer withholds from an employee’s paycheck and that the employer pays is different depending on the classification of the worker. In fact, if a worker is an employee, the employer is responsible for paying Social Security, unemployment insurance, Medicare, and other costs, including overtime and workers' compensation insurance for the employee; at the end of each tax year, the employer is responsible for compiling all necessary payroll reports, including W-2 forms. If a worker is an independent contractor, the employer is not responsible for any of the above taxes or payments, but is responsible for issuing a 1099 form to the independent contractor at the end of the tax year.
The question whether a worker is an independent contractor or an employee is one that is determined through a review of the facts of any particular case, along with the application of law and regulations for worker classification issues.
I. WHAT IS THE DIFFERENCE EXACTLY?
The threshold difference between an employee and an independent contractor is that an employee is hired to provide services on a regular basis in exchange for a fixed compensation and is subject to the control of the employer in terms of working hours, location, and provision of tools to perform the job. Conversely, an independent contractor is a worker who contracts to provide specific services to a company according to contractual conditions, but is not subject to the same level of control as an employee of that company.
An Independent Contractor:
- Operates under a business name;
- Has his/her own employees;
- Maintains a separate business checking account;
- Advertises his/her business’ services;
- Issues invoices periodically, generally once a month, for work completed, as opposed to receiving a steady paycheck;
- Has more than one client;
- Has own tools and sets own hours;
- Keeps business records.
- Performs duties dictated or controlled by the employer;
- Is given training for work to be done; and
- Works for only one employer.
II. USEFUL GUIDELINES TO EMPLOYERS
For many years the Internal Revenue Service (“IRS”) used a twenty-factor test to determine whether an individual was an employee or independent contractor. However, more recently the IRS took the twenty-factor test test and combined the factors into three broad categories:
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- Financial: Are the business aspects of the worker’s job controlled by the payer? (These aspects include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee-type benefits (i.e., a pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
Upon a review of the elements above, if an employer is still not sure whether an individual should be classified as an employee or an independent contractor, either the employer or the individual can complete a form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Keep in mind that if there is the slightest doubt regarding the classification, it is recommended confirming the status with the IRS before a wrong classification is made to avoid high penalties and legal consequences.
The Economic Realities Assessment of the U.S. Department of Labor (“DOL”)
In July 2015, the DOL issued new guidance to assist employers in making the determination as cases of misclassification have increased substantially in the last few years. Well-known companies, such as Uber and FedEx, have been accused of misclassifying their employees and have entered costly settlements. Accordingly, the DOL reiterated the six-factor economic realities test of the Fair Labor Standard Act in determining if an individual is truly an independent contractor, as opposed to being “economically dependent” on the employer and, thus, an employee:
- Is the work an integral part of the employer’s business?
- Does the worker’s managerial skill affect the worker’s opportunity for profit or loss?
- How does the worker’s relative investment compare to the employer’s investment?
- Does the work performed require special skill and initiative?
- Is the relationship between the worker and the employer permanent or indefinite?
- What is the nature and degree of the employer’s control?
Courts on the Distinction Between Employee and Independent Contractor
Courts ask the following questions to determine work relationship in addition to an economic test:
- What is the degree of control over work and who exercises that control?
- What is each party's level of loss in the relationship?
- Who has paid for materials, supplies and/or equipment?
- What type of skill is required for work?
- Is there a degree of permanence?
- Is the worker an integral part of the business?
Those courts also use the “right to control” test. When the hiring party controls how the work is carried out and a product is delivered, the relationship between the parties is that of employer and employee. If an employer does not have authority over how a party accomplishes his or her work, but requests an outline, the relationship between the parties is that of principal and independent contractor.
III. WHY IS IT IMPORTANT TO PROPERLY CLASSIFY?
As we said above, misclassification of an individual as an independent contractor may have a number of costly legal consequences. If the independent contractor is discovered to be an employee, the employer may be required to:
- Reimburse the employee for wages that should have been paid under the Fair Labor Standards Act, including overtime and minimum wage;
- Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment;
- Pay any misclassified injured employees workers’ compensation benefits;
- Provide employee benefits, including health insurance and retirement;
- In addition, to any other penalties that are inflicted by the interested state where the misclassified employee works;
- Pay punitive damages, in the event the misclassification was willful.
If an employer is not sure about the proper classification, it should seek appropriate legal assistance to avoid harsh consequences and payment of high penalties.
This newsletter is of a general nature and is purely for information purposes. It is not intended to provide legal advice and does not create an attorney-client relationship.