Employee misclassification has been a hot topic these days as as growing number of businesses increasingly turn to contract workers. From a company’s perspective, hiring independent contractors offers certain advantages compared to employees. They don’t have to offer benefits like health insurance, pay overtime, withhold federal income tax or pay the employer’s portion of the employee’s income tax (instead, the contractor pays self-employment tax to cover that amount).
But regulators have taken notice of this trend. For example, the Equal Employment Opportunity Commission, which enforces workplace discrimination laws, recently said there will be a specific focus from the agency on issues relating to independent contractors and other nontraditional employment relationships. The U.S. Department of Labor has also released guidance hoping to clear up confusion about the topic, warning employers that the definition of “employ” is very broad under federal wage laws.
With that in mind, it is as important as ever that business owners understand the legal distinctions between independent contractors and employees and make sure to properly classify their workers. Failure to do so can lead to fines and other penalties, including payment of back taxes.
Under federal law, an employer-employee relationship exists when the business has the “right to control and direct the individual who performs 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.” It isn’t necessary that the employer actually exercise that control – simply having the right to do so is enough. Other factors that are taken into consideration include whether the business supplies the person who performs the services with necessary tools and a place to work.
The general rule is someone is an independent contractor if the person paying them has the right to control or direct only the result of the work, and not what will be done or how it will be done. If a business tells someone when, where and how to work, the person is likely an employee.
Based on court cases and rulings, the Internal Revenue Service in 1987 developed a list of 20 factors to be examined when determining whether an employer-employee relationship exists. The degree of importance each factor varies on a case-by-case basis, but the list can be helpful for employers in analyzing their arrangement with a particular worker or group of workers.
The factors are as follows:
1. Instructions: If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status.
2. Training: Worker training (e.g., by requiring attendance at training sessions) indicates that the person for whom services are performed wants the services performed in a particular manner (which indicates employee status).
3. Integration: Integration of the worker’s services into the business operations of the person for whom services are performed is an indication of employee status.
4. Services rendered personally: If the services are required to be performed personally, this is an indication that the person for whom services are performed is interested in the methods used to accomplish the work (which indicates employee status).
5. Hiring, supervision, and paying assistants: If the person for whom services are performed hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.
6. Continuing relationship: A continuing relationship between the worker and the person for whom the services are performed indicates employee status.
7. Set hours of work: The establishment of set hours for the worker indicates employee status.
8. Full time required: If the worker must devote substantially full time to the business of the person for whom services are performed, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.
9. Doing work on employer’s premises: If the work is performed on the premises of the person for whom the services are performed, this indicates employee status, especially if the work could be done elsewhere.
10. Order or sequence test: If a worker must perform services in the order or sequence set by the person for whom services are performed, that shows the worker is not free to follow his or her own pattern of work, and indicates employee status.
11. Oral or written reports: A requirement that the worker submit regular reports indicates employee status.
12. Payment by the hour, week, or month: Payment by the hour, week, or month generally points to employment status; payment by the job or a commission indicates independent contractor status.
13. Payment of business and/or traveling expenses. If the person for whom the services are performed pays expenses, this indicates employee status. An employer, to control expenses, generally retains the right to direct the worker.
14. Furnishing tools and materials: The provision of significant tools and materials to the worker indicates employee status.
15. Significant investment: Investment in facilities used by the worker indicates independent contractor status.
16. Realization of profit or loss: A worker who can realize a profit or suffer a loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor.
17. Working for more than one firm at a time: If a worker performs more than de minimis services for multiple firms at the same time, that generally indicates independent contractor status.
18. Making service available to the general public: If a worker makes his or her services available to the public on a regular and consistent basis, that indicates independent contractor status.
19. Right to discharge: The right to discharge a worker is a factor indicating that the worker is an employee.
20. Right to terminate: If a worker has the right to terminate the relationship with the person for whom services are performed at any time he or she wishes without incurring liability, that indicates employee status.
More recently, the IRS identified three categories of evidence it feels might be relevant in determining if the requisite control for an employer-employee relationship exists under the common-law test: (1) behavioral control; (2) financial control; and (3) relationship of the parties.
As evidenced above, there are a number of factors to take into consideration when deciding whether someone qualifies as an independent contractor or employee. Businesses sometimes fall into the trap of thinking that they have an independent contractor relationship because they have an agreement that says as much and they aren’t paying taxes. But if an employee-employer relationship is found to exist, the business’ title for the worker is irrelevant.
Assuming an independent contractor relationship does exist, the agreement should specify the obligations of both parties, including that the worker is responsible for paying their own taxes, federal and otherwise. It should also make clear the business will not be providing workers compensation or employee benefits, like sick leave and vacation pay.
We’re Founders, so we Aren’t Employees, Right?
Most company founders are under the misconception that purely because they are executives or large stockholders, they are somehow either independent contractors or exempt employees and not subject to minimum wage, overtime and other wage and hour laws. Unfortunately, that is typically not true. If founders are paid at least 2x minimum wage and meet certain other requirements, they may be exempt (See https://www.dir.ca.gov/t8/11040.html).
Determining whether someone is an employee or an independent contractor is a very fact-specific inquiry requiring advice from an experienced professional. Just because founders are executives are large stockholders, don’t assume they can be classified as contractors or exempt employees.