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"Understanding Independent Contractor Classifications" - Mark A. Pihart & Megan M. Ruwe

This article appears in the summer edition of Human Resources 2008.

Understanding Independent Contractor Classifications


Don't become another headline! Know the distinctions between employees and independent contractors

In 2007, the IRS ordered Federal Express to pay approximately $319 million in back taxes and fines because the company had misclassified workers as independent contractors rather than employees (See Groom, N., Vorman, J., and Zieminski, N. IRS says Fedex owes $319 mln in back taxes-filing, Reuters, 24 Dec. 2007). As recently as March 10, 2008, House Oversight Chairman Henry Waxman called for a far-reaching federal inquiry into possible misclassifications of Blackwater Worldwide security personnel (See Karen DeYoung, Blackwater's Employment Investigated, Washington Post, March 11, 2008 at A16). This could happen to you, too, if you are not careful to distinguish between employees and independent contractors!
 
Businesses increasingly choose to hire certain workers as independent contractors rather than as employees. They do so for various reasons, such as the ability to hire workers with specialized skills to complete specific projects. Businesses that choose to use independent contractors must take care to ensure that workers are properly classified as independent contractors rather than employees. Federal and state governmental agencies are increasingly interested in whether businesses have properly classified workers as independent contractors versus employees, and the misclassification of workers can carry significant fines and penalties.
 
How can a business ensure that its practices concerning independent contractors comply with the law? Unfortunately for businesses, workers are not considered independent contractors simply because they sign agreements that label them as such. Typically, no single aspect of a work relationship is determinative. Nevertheless, the element of control a business exerts over a worker – whether and how the business controls a worker's performance – is usually a key to the analysis. Generally, independent contractors retain significant control over their own work, while employees are subject to the business' control.
 
To aid businesses in determining whether an individual is an independent contractor or an employee, federal and state agencies, including the IRS and the U.S. Department of Labor (DOL), have developed lists of several factors that serve as guidance. This chapter will focus on the two most common lists: (1) the factors the IRS uses for federal tax purposes; and (2) the DOL's “Economic Realities Test,” used to determine whether an individual is an employee under the federal Fair Labor Standards Act (FLSA). Employers should also check state and local laws to ensure compliance with any other applicable tests, including those used to determine eligibility for workers' compensation and unemployment benefits.
 
IRS Factors
In determining whether a worker should be classified as an independent contractor or an employee for federal tax purposes, the IRS examines the relationship between the business and the worker, with particular focus on the degree of control the business exerts over the worker. Historically, the IRS relied on a list of 20 factors common to most work situations in evaluating the amount of control a business holds over a worker (the 20-factor test). (See Internal Revenue Service Manual, 4600 Employment Tax Procedures, Exhibit 46401.) In recent years, the IRS has attempted to simplify the 20-factor test by consolidating the 20 factors into 11factors that fall into three distinct categories: (1) behavioral control; (2)financial control; and (3)the type of relationship between the two parties (collectively, the IRS Categories). (See IRS Publication 15-A (Rev. 2008).) Although the 20-factor test remains applicable, a business should first evaluate positions according to the three IRS categories. Explanations of the three IRS categories and the 20-factor test follow.
 
According to the IRS, all evidence of the degree of control and independence associated with a position falls into one of the three IRS categories. Elements in the behavioral control category examine the extent to which a business maintains control or direction over the tasks a worker performs. The financial control category includes factors related to how workers are paid for services rendered, and the relationship of the parties category considers evidence regarding how the worker and the business define their relationship. No one category or factor controls the analysis, and the degree of importance of each category/factor may vary depending on the tasks assigned to a worker. The IRS looks at the totality of analyses of each of the following factors in determining whether a worker is an independent contractor or an employee.
 
Behavioral Control
In this category, the key question for a business is whether it has a right to direct and control how a worker performs tasks for the business. Generally, the more control a business maintains over a worker, the more likely the individual is an employee and not an independent contractor. The following factors may help a business determine the extent of its control over a worker:
 
Instructions that the business gives to the worker. If a worker is subject to instructions about when, where and how to conduct an assigned task, he or she is likely an employee. Specifically, a worker is more likely an employee if the business controls:
 
  • when and where the individual may perform the work;
  • what tools or equipment the individual may use;
  • which workers to hire or to assist with the work;
  • where to purchase supplies and services the worker will use;
  • what tasks a specified worker may perform; and
  • the order or sequence to follow in performing various tasks.
     
The amount of instruction needed may vary depending on the nature of the worker's duties. Even if a business does not provide a worker with any instructions, sufficient behavioral control may exist, and a worker may be considered an employee, if the employer has the right to control how the work gets done. The key consideration is whether the business has retained the right to control the details of a worker's performance or has instead given up that right to the worker.
 
Training the business gives to the worker. Independent contractors usually rely on their own methods, training and experience rather than those the business provides. An employee, on the other hand, will likely be trained to perform services in a particular manner according to the company's practices.
 
Financial Control
The key questions for a business under this category are whether and to what extent the business has the right to direct or control the financial aspects of a worker's business-related activities. As with the behavioral control category, the more control a business maintains over a worker's financial situation, the more likely the worker is an employee and not an independent contractor. Businesses should consider the following as possible evidence of financial control:
 
How the business pays the worker. A worker is typically considered an employee if he or she is compensated with a specified wage for a certain period, such as on an hourly, weekly or monthly basis, even if the employee also receives a bonus or commission. An independent contractor, on the other hand, is usually paid a flat fee per job, though hourly pay rates have become increasingly common and accepted for contractors.
 
The extent to which the worker has unreimbursed business expenses. Independent contractors are usually more likely than employees to have unreimbursed expenses. For example, fixed, ongoing costs a worker incurs regardless of whether work is performed typically suggest that a worker is an independent contractor. Employees are generally reimbursed for work-related expenses.
 
The extent to which the worker can realize a profit or loss. This factor is often a very important part of any independent contractor analysis. For purposes of this analysis, words “profit” and “loss” mean more than just an individual's ability to earn a larger bonus or commission. The analysis requires an examination of how closely a worker's ability to earn any income is tied to the success of a project. Often an independent contractor stands to make a profit or suffer a loss based on whether he or she successfully completes a project. Employees, on the other hand, usually receive some form of earnings in a manner that does not require them to risk a profit or loss, based on the success of the work. Bonus or commission payments that supplement regular wages in and of themselves usually are not evidence of an independent contractor status.
 
The extent of the worker's investment. An independent contractor often has a substantial investment in the facilities and supplies he or she uses in performing services for a business and will furnish tools and equipment that are generally more expensive and critical to the successful completion of a task, such as computers or other specialized equipment. An employee, on the other hand, will have a more casual investment, if any, in the supplies he or she uses to perform his or her duties.
 
The extent to which the worker makes his or her services available to the relevant market. An independent contractor generally is free to seek business opportunities and often advertises, maintains a visible business location and is available to provide the same type of services to several entities at any given time. An employee usually does not provide services to more than one entity at any time.
 
Relationship of the Parties to Each Other
The IRS is also interested in determining how a business and a worker perceive their relationship. This involves examining the following:
 
Written contracts describing the relationship of the parties. The IRS will give some weight to the parties' intent and look at whether they entered into an employment agreement or an independent contractor agreement. However, this may not be determinative. Businesses should ensure that independent contractor agreements address most, if not all, of the IRS factors as evidence that the worker is not an employee.
 
Whether the business provides the worker with benefits usually reserved for employees. Businesses typically offer benefits such as health insurance, a pension plan, vacation pay or sick pay only to employees, though they may be offered to independent contractors as bargained-for consideration for services rendered in some rare situations. Generally, the IRS will treat workers as employees if they receive the same type of benefits offered to a company's regular employees.
 
The permanency of the relationship. If a business engages a worker with the expectation that the relationship will continue indefinitely – rather than only for the duration of a specific project or period – the IRS will consider the time period as evidence that the parties intended to create an employer-employee relationship. If the parties intend for their relationship to have a definite ending, such as a specific end date or upon completion of the project, the worker looks more like an independent contractor.
 
The extent to which services the worker performs are a key aspect of the company's regular business of the company. If a worker provides services that are a key aspect of the business, it is more likely the businesses will direct and control the worker's activities, which suggests the worker is an employee and not an independent contractor. For example, if an accounting firm hires an accountant, it is likely the firm will direct and control the individual's work and will present the accountant's work as its own, suggesting the worker is an employee. Alternatively, if the accounting firm hires a maintenance worker to provide janitorial services that are not central to the firm's business scheme, the maintenance worker is less likely than the accountant to be the firm's employee (IRS Publication 15‑A (Rev. 2008).
 
If, after examining all factors within the IRS categories, a business is still unable to determine whether a worker should be classified as an independent contractor or employee for federal tax purposes, the business may wish to consider the additional factors listed in the 20-factor test.
 
The 20-factor Test
Like the factors listed in the IRS categories, the 20-factor test is intended to be used as a guideline, not a strict set of rules. Although many of these factors are in the IRS Categories discussed above, some are not and are discussed below for the first time in this chapter. Each factor's likely applicability will vary, depending on the worker's duties and the circumstances under which the individual works. No single factor controls, and in certain situations, some may not be applicable. When using the 20-factor test, a business should consider each of the following factors, not listed in order of importance. For summary purposes, see the checklist at the end of this chapter.
 
1) Instructions
If a business provides a worker with little or no instructions regarding how a job must be accomplished, the worker probably is an independent contractor. Alternatively, if a business controls several or all aspects concerning how a worker completes a task, the worker is likely an employee.
 
2) Training
If a worker receives training from a business regarding the task(s) to be performed, the worker is likely an employee. Independent contractors typically get little or no training.
 
3) Integration of Services
If a worker provides services that are essential and critical to an employer's business operations, he or she is likely an employee. If the business does not depend on the worker's services for its core operations, the worker is probably an independent contractor.
 
4) The Manner of Rendering Services
Many independent contractors work for themselves and may employ others to assist them in providing their specialized services; they are not required to provide services personally. Employees, on the other hand, usually perform assigned tasks personally.
 
5) Assistants
Independent contractors may hire, supervise, pay and otherwise control the work activities of workers they hire. Employees hire, supervise and pay assistants on behalf of the employer rather than themselves.
 
6) The Nature of the Relationship
Employees typically expect a continuing relationship with a business, while independent contractors do not. Independent contractors may, however, engage in several separate but frequent engagements with a business.
 
7) Work Hours
A business usually does not set the hours during which independent contractors will work but does so for employees.
 
8) Time to Pursue Other Work
If a business requires a worker to devote full attention to the business on a full-time basis with set work hours, the worker is likely an employee. Independent contractors generally have more freedom to work the hours they choose and pursue other work at the same time.
 
9) Job Location
Usually, an employee is expected to perform work at the employer's work site. Independent contractors may choose where they perform services, unless the work can be performed only at the employer's location.
 
10) Requirements Regarding the Order or Sequence of Work
Employees generally perform work in a certain order or according to procedures the employer establishes. Independent contractors are not typically required to follow such orders and may determine the order in which they perform certain duties as they work toward final completion of a project.
 
11) Reports
Employees often must complete and submit internal reports to detail their progress on a task. Businesses usually do not ask independent contractors to submit such reports; the independent contractor is responsible only for completing a project.
 
12) Payment
If a business pays a worker a specified amount on a regular basis, such as on a weekly, bi-weekly, or monthly basis, the worker is likely an employee. If a business pays a worker only upon the completion of an assigned task, the worker is probably an independent contractor.
 
13) Business Expenses
Employees are usually reimbursed for business and/or traveling expenses associated with the performance of their job duties, while independent contractors are usually responsible for their own incidental expenses.
 
14) Tools
Independent contractors provide the equipment and tools they use to provide services. Employees, on the other hand, rely on a business to provide the tools necessary for their work.
 
15) Degree of Investment
An independent contractor usually has a significant and bona fide investment in his or her trade, while an employee will lack that major investment in the facilities used to perform services.
 
16) Possibility of Profit or Loss
An independent contractor stands to risk making a profit or suffering a loss based on whether he or she sufficiently completes a project. An employee receives earnings in a manner that does not require any risk of profit or loss.
 
17) Ability to Work for Additional Entities
Independent contractors may work for more than one entity at any given time, while employees are typically expected to work for only one employer.
 
18) Services Available to the Public
If a worker is able to make his or her services available to the public, the worker is likely an independent contractor. A worker who is expected to provide services only to one business probably is an employee.
 
19) Right to Discharge
An independent contractor who has signed a contract is not terminable at will but may be terminated only for a failure to comply with the contract terms. Unless a contract or state law requires otherwise, an employee may be discharged at any time, with or without prior notice.
 
20) Right to Quit
Employees may resign at any time without incurring any liability, while independent contractors usually must complete an agreed-upon project and are liable for any failure to complete it satisfactorily.
 
Depending on the worker's duties and the circumstances surrounding each project, some factors may be more important than others in determining whether a worker is an independent contractor or employee for federal tax purposes. Because the analysis is fact-intensive and may vary for each worker, a business should carefully examine all of the factors in the three IRS categories and the 20-factor test before deciding whether to classify him or her as an independent contractor or an employee. In addition, businesses should be mindful that the IRS categories and 20-factor test apply only when determining a worker's status for federal income tax purposes. Separate factors may apply for state income tax purposes, and employers should check applicable state and local laws to ensure compliance.
 
The Economic Realities Test
The FLSA, which governs wage and hour issues, applies only to individuals considered a business' employees. The DOL enforces the FLSA. To determine whether a worker is an “employee” under the FLSA, the DOL applies an economic realities test that focuses on whether a worker is economically dependent on the business for which services are provided. (See Knight v. United Farm Bureau Mut. Ins. Co., 950 F. 2d 377, 380 (7th Cir. 1991); Rutherford Food Corp. v. McComb, 331 U.S. 722, 726-28, 730 (1947)).
 
Although most of the factors listed in the economic realities test are similar to the factors discussed in the IRS categories and under the 20-factor test, the economic realities test does not focus on the worker's behavior and, therefore, contains fewer factors than the IRS categories and 20-factor test. This streamlined test places a greater emphasis on whether a worker is economically independent from the business. It is often more difficult for a business to demonstrate that a worker is not financially dependent on its operations, so businesses generally find it more difficult to classify a worker as an independent contractor under the economic realities test than under either of the two IRS tests.
 
The economic realities test is based on the following factors:
 
1) The Extent to Which the Services in Question Are a Part of the Company's Business
Similar to how the parties view their relationship under the IRS test, this factor of the economic realities test considers whether a worker's duties are central to a business. If a worker provides services that are not considered part of the company's core business, he or she is likely to be an independent contractor. On the other hand, a worker is likely an employee if he or she provides services that are a part of the company's core business model.
 
2) The Amount of the Worker's Investment in the Company's Facilities and Equipment
A worker who has no investment in the facilities and equipment used to perform his or her duties is likely an employee, while a worker who has a substantial investment, such as ownership in the facilities and equipment used to perform a task, will likely be considered an independent contractor.
 
3) The Individual's Opportunity for Profit or Risk of Loss
Generally, if a worker can make a profit from a project's success or risks a loss from the failure of the project, he or she is an independent contractor. An individual who has no opportunity for personal profit or loss based on the outcome of a project is likely an employee.
 
4) The Expected Duration of the Relationship
As with the IRS categories and 20-factor test, workers whom a company engages for an indefinite period likely are employees, while those retained for a specified period are more likely to be classified as independent contractors.
 
5) The Amount of Initiative, Skill or Judgment Required
These qualities are indicative of an independent contractor status, as businesses likely will not hire an inexperienced worker to perform a specific task. A contractor's work usually requires very specific skill, judgment or initiative, while an employee's job duties may not.
 
6) The Nature and Degree of Control the Company Retains Over How the Work is Performed
Generally, the greater the control an employer exerts over a worker, the more likely the worker is an employee, not an independent contractor. If a company controls how work will be performed, the worker will probably be considered an employee. A worker may, alternatively, be an independent contractor if he or she – not the business – controls the processes used to complete a task.
 
How to Avoid Misclassifications of Workers
Businesses should carefully review each of the tests discussed above to assess how the IRS and DOL will interpret a decision to classify a worker as an independent contractor. If, after analyzing these, a business determines that a worker should be classified as an independent contractor, the business should consider entering into a written agreement with the independent contractor. Although a written agreement alone is not sufficient proof of a worker's independent contractor status, a carefully drafted agreement that follows the IRS and DOL guidelines explained earlier will provide important evidence of a worker's status. The business must also take care to follow the terms and conditions in the independent contractor agreement.
 
Uniforms, Badges and Policies
Businesses should not require independent contractors to wear uniforms or carry badges that only employees typically uses, as this may suggest the worker is an employee rather than an independent contractor. If a business must supply independent contractors with access/identification badges for security reasons, the business should consider creating contractor-specific identification badges that denote the worker's status. Businesses should avoid providing independent contractors with policies and procedures that apply only to employees, such as those that address vacation, health insurance or other employee benefits. Only those workplace policies and procedures that may apply equally to contractors and employees should be provided to contractors. If, for example, a business wishes to show its anti-harassment policy to an independent contractor, it should remove the policy from the handbook and provide a copy of only that policy to the contractor.
 
Conclusion
Businesses that hire independent contractors should be familiar with the factors used by the IRS and DOL to determine a worker's status. A careful analysis of the three IRS categories, the 20‑factor test, and the DOL's economic realities test serves as a useful guide in avoiding mistakes. Although determination of the proper classification may depend on which test is applied and the purpose for which the analysis is conducted (federal income taxes, wage and hour issues, or other reasons), the prevailing factor will be the level of control the business has over the worker. To avoid misclassifying a worker, a business should closely examine all relevant factors under applicable federal and state laws for each position and adhere to them throughout their relationship with the worker.
 
 

Checklist of Factors to Determine Whether a Worker Should
Be Classified as an Employee or an Independent Contractor
Factor
Employee
Independent Contractor
Instructions
Must follow employer's instructions
Receives little or no instructions from a business
Training
Trained by employer
Receives little or no training from the company
Integration of Services
Performs services integral to employer's business
Performs work not integral to company's core business
Manner in Which Services Are Rendered
Performs services personally
Usually has right to hire others
Assistants
May hire, supervise or pay assistants, per employer's instructions
Can decide to hire assistants or not to hire assistants
Relationship
Has continuing relationship
Has no set relationship – often works on-call or on a project basis
Set Hours of Work
Follows set hours
Free to choose own hours
Full-time Required
Works on a full-time basis
Has control over the hours worked to accomplish a task
Doing Work on Employer's Premises
Usually is expected to work at the employer's work site
Can choose where to work, unless work can only be done at employer's site
Order or Sequence Set
Perform tasks in order chosen by employer
Controls how result is accomplished, including order and sequence
Oral or Written Reports
Regularly submits reports to the employer
Not required to submit reports
Payment by the Hour, Week, or Month
Paid according to established schedule
Typically paid by the job
Payment of Business and/or Travel Expenses
Employer pays or reimburses expenses
Generally pays own incidental expenses
Furnishing of Tools and Materials
Provided with tools/supplies by employer
Generally uses own equipment and tools
Significant Investment
Has not invested much in facilities used to perform the service
Has made significant investment in trade
Realization of Profit or Loss
Receives earnings, not profit or loss, from services
Earns profit or risks loss based on price agreed upon to achieve result
Working for More Than One Firm at a Time
Generally works for one employer at a time
May work for several companies at any given time
Making Services Available to the General Public
Works only for one employer
May offer services to the general public
Right to Discharge
Can be discharged at any time
May not be discharged if performing under terms of contract as specified
Right to Quit
Can quit without penalty
May be liable if job not completed as specified
 

Article Citation
"Understanding Independent Contractor Classifications." Human Resources 2008 Answers To Your Top 25 Questions. Summer ed. Belmont: Thompson, 2008. 85-94.
 
For More Information
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Direct: (612) 604-6688
 
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