Making the Right Distinction to Avoid Costly Mistakes
I often receive calls from business owners that go something like this: "I have this guy. He's an independent contractor.." Upon hearing those words, the skeptical lawyer voice in my head screams: "STOP!!!!" at the top of its lungs and then starts asking a million questions.
"Is he really an independent contractor?" "Do we have a written agreement with him?" "Does he bring his own tools to work?" "How long has he worked for us?" "Does he have his own business?" "What kind of work does he do?"
Before the caller can proceed, I simply must know whether the individual we are talking about is actually an independent contractor. Because if he's not, and he is really an employee, all of my answers will be different.
"What's the big deal?" you say? Well, the fact is that whether an individual is an employee or an independent contractor is one of the most significant legal distinctions faced by business owners big and small. It is also an area ridden with pitfalls and the potential for costly, even if innocent, mistakes. Many employment-related laws only apply to employers of employees, not independent contractors; and, failing to properly treat someone as an employee can have serious consequences.
For example, if a worker is treated as an independent contractor, the business owner will probably not withhold state or federal employment taxes for the worker. The owner will also likely not make efforts to ensure that the worker is being paid minimum wage or overtime for hours worked over forty in any given workweek. And making unemployment compensation and workers compensation insurance contributions for someone labeled an independent contractor? No way. All of these actions, if the worker actually turns out to be an employee as determined by the IRS or the Department of Labor, can result in litigation, time-consuming audits, and significant fines and penalties for the employer.
The first thing to understand about making the distinction between employee and independent contractor and avoiding the pitfalls of misclassification is that the label alone is meaningless. In other words, calling a worker an independent contractor does not make the worker an independent contractor. There's also no one definition for either type of worker and the definitions that do exist are about as clear as, um, what's on the other side of that clean-out drain in my basement. So how does a business owner (or a lawyer, judge or government agency, for that matter) make the right determination?
There are a handful of "tests" and definitions used by different entities to determine whether a worker is an independent contractor or employee. In most cases, the determination requires an analysis of individual facts and circumstances surrounding the nature of the relationship between the worker and the business. And in just about all of those tests, the most important element to consider is control. The more control a business exerts over a worker, the more likely it will be that the worker is an employee.
In many cases, the agency or court evaluating the relationship will use what is called the common law test. Those factors include:
- Does the business provide training to the individual? Or does the worker already have the requisite skills?
- Must the individual perform the work personally? Or may he or she hire someone else to do it?
- Does the individual have an ongoing relationship with the company? Or is it on a short-term, job-by-job basis?
- Does the individual do business in the company's name? Or does the individual have his or her own company and do business for others?
- Is the agreement between the parties unilaterally created by the business? Or do the two parties create the agreement together?
- Is the individual paid the same amount on a regular basis? Or is he or she paid based on the task or quality of the results?
- Does the company furnish equipment and materials? Or does the individual furnish them?
- Does the individual account to the company for sources and use of funds? Or does the individual pay his or her own expenses?
- Is the individual generally paid the same regardless of quality? Or does the individual have an interest in the quality of the work with opportunity for profit and the risk of loss?
- Does the company exercise supervision over the means and manner of the work? Or does the individual work without supervision?
- Do the words and actions used by the parties indicate an intent to create an employment relationship? Or is it clear that the parties intended an independent contractor relationship?
- Can the individual be terminated at will? Or does the agreement provide for termination upon certain circumstances?
- Do company employees perform the same type of work that the individual is performing? Or is the work different?
- Is the individual treated significantly the same as other employees? Or is the individual's situation and treatment unique?
For each of these factors, if the answer to the first question is "yes"--then that factor suggests the worker is an employee. If the answer to the second question is "yes"--then that factor suggests the individual is an independent contractor. Remember though that none of these factors are outcome determinative.
An alternative test, recently modified and used by the IRS, contains 11 factors broken into three areas: behavioral control; financial control; and type of relationship. These factors are similar to the common law test and the key component of the IRS test, like the common law test, is control.
Confidence in Your Classifications
If all of the individuals on your payroll are classified and treated as employees, you likely have nothing to worry about. However, if you find yourself regularly dealing with and paying "independent contractors" who help you to operate your business, you may want to consider whether those individuals might actually be better classified as employees.
For help making the distinction and the confidence that comes with knowing that you've classified your workers correctly, contact Kate Erdel in the Labor and Employment Practice Group at Bingham Greenebaum Doll, LLP by email at email@example.com or phone at 317-635-8900. For questions about other contract or litigation issues, contact Brad Wilt or Meg Christensen, attorneys in the Construction Law Practice Group, at 317-635-8900.