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Independent Contractor or Employee? Answering Incorrectly Can Prove Costly
By The Human Equation, Inc.



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Determining whether a new worker should be classified as an employee or an independent contractor has always been an important decision. The choice is not always an easy one, and the absence of a clear-cut rule of universal application often leads to inadvertent misclassifications. Moreover, the lack of a clear rule, coupled with the potential organizational benefits resulting from classifications of convenience, also open the door for manipulation and abuse.

Classifying a worker as an independent contractor rather than an employee may benefit an organization in various, often significant, ways. For example, an employer must generally withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment taxes on wages paid to an employee. Since these obligations do not generally carry over to independent contractors, a business can experience significant cost reductions by classifying individuals as independent contractors rather than employees. Additionally, since amounts paid to independent contractors are not typically included in payroll calculations, a business can effectively reduce its workers' compensation insurance premiums by classifying employees as independent contractors. Thus, the decision to classify an employee as an independent contractor can result in significant financial benefits.

The deliberate misclassification of employees as independent contractors in order to reap these benefits is tantamount to theft in the form of unpaid taxes. Since the amount of lost revenue is significant, the federal government is undertaking aggressive initiatives designed to catch those organizations participating in employee misclassification.

One report suggests that the federal budget assumes the government will collect approximately $7 billion over the next ten years through a federal crackdown on employee misclassification. The budget also allocates approximately $12 million and 90 new investigators for the express purpose of catching violators. Additionally, the Internal Revenue Service announced that it is planning to randomly audit thousands of employers to prevent misclassifications and, more importantly, collect unpaid taxes, fines, and penalties.

Given this increased scrutiny, it has never been more important for businesses to properly classify their workforce. Unfortunately, a simple rule or standard does not exist for making this determination. Rather, the nature of the relationship must be considered on a case-by-case basis by looking at all the facts of a particular situation.

The first step is to know the difference between an employee and an independent contractor. According to the IRS, anyone who performs services for a business is an employee if the employer can control what will be done and how it will be done. This is true even if the employee has freedom of action. What matters is that the employer has the right to control the details of how the services are performed. By contrast, a person is an independent contractor if the business for which the services are performed has the right to control and direct only the result of the work and not the means and methods of accomplishing the result.

Thus, the degree of control and independence are the critical factors for determining the nature of the relationship. According to the IRS, evidence of the degree of control and independence fall into three categories.

  1. Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job? One element to this category involves examining the type and degree of instructions that the business gives to the worker. Employees are generally subject to instructions about when, where, and how to work. Instructions may detail when and where to do the work, what tools or equipment must be used, where to purchase supplies/services, and what order the work must be done. Employees may be trained to do the job, whereas independent contractors ordinarily use their own methods. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.

  2. Financial. Are the business aspects of the worker's job controlled by the payer? Facts that show whether the business has a right to control the business aspects of the worker's job include: the extent to which the worker has unreimbursed business expenses (independent contractors are more likely to have unreimbursed expenses); the extent of the worker's investment (independent contractors often have a significant investment); the extent to which the worker makes his services available to others (independent contractors often work for others and advertise); how the business pays the worker (employees generally get a guaranteed wage whereas independent contractors usually get a flat fee); and the extent to which the worker can realize a profit or loss (an independent contractor can make a profit or a loss on a job).

  3. Type of Relationship. Are there written contracts or employee type benefits? Additionally, relevant facts include the permanency of the relationship and whether the services performed by the worker are a key aspect of the regular business of the organization.

Businesses must weight all these factors when determining whether a worker is an employee or independent contractor. While some factors may indicate an employment relationship, others may suggest that the worker is an independent contractor. Unfortunately, there is no magic combination or set number of factors that make a worker one or the other. Since it is the entirety of the circumstances that must be considered, no one factor stands alone. Moreover, since each situation is specific, factors which may be relevant in one case may not be relevant in another.

This analysis must be undertaken for each individual worker or category of worker. Since different circumstances can affect the relevancy of any specific fact, it is very difficult to develop a one-size-fits-all approach to making this determination. The key is to look at the entire relationship, including any specific or unique facts, and consider the degree or extent of the right to direct and control.

Given the severity of the consequences for improperly classifying a worker, it may be necessary to seek the assistance of a licensed professional. Alternatively, a business or a worker may request a determination by the IRS by submitting Form SS-8 to the IRS; however, it can take up to six months to get a response. In any event, guessing at the right answer, or even worse, deliberately misclassifying workers can result in severe consequences. And, given the government's renewed focus on finding violators, the chances of proceeding undetected have significantly decreased.

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