Using “contractors” rather than hiring employees has become a trend for many employers. There are numerous laws that define the employment relationship. Frequently, the individuals designated as “contractors” have been misclassified and should instead be treated as employees to avoid the penalties imposed by these laws.
There are three laws in particular that should be of most concern when determining whether or not the individual who’s been engaged to write that computer program, clean those offices, engineer a part, etc. is truly a “contractor”. Those laws include:
1. Fair Labor Standards Act – This law governs the payment of minimum wage and overtime to individuals and requires employers to keep specific records including time sheets. If companies haven’t properly classified individuals as employees, there could be liability for overtime compensation, penalties for not maintaining proper records, etc. According to the FLSA Fact Sheet defining the Employer/Employee Relationship, “in the application of the FLSA an employee, as distinguished from a person who is engaged in a business of his or her own, is one who, as a matter of economic reality, follows the usual path of an employee and is dependent on the business which he or she serves. The employer-employee relationship under the FLSA is tested by “economic reality” rather than ‘technical concepts.’” The Fact Sheet goes on to list the factors the U.S. Supreme Court has determined to be relevant when evaluating the contractor relationship:
- The extent to which the services rendered are an integral part of the principal’s business.
- The permanency of the relationship.
- The amount of the alleged contractor’s investment in facilities and equipment.
- The nature and degree of control by the principal.
- The alleged contractor’s opportunities for profit and loss.
- The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor.
- The degree of independent business organization and operation.
The Department of Labor has become very aggressive in pursuing employers who have improperly classified individuals as “contractors.”
2. Internal Revenue Code – The IRS guidelines are the most comprehensive. Generally, if an individual meets the IRS standard for being an independent contractor, it is likely he or she will meet the standard for any other law. The IRS publishes a pamphlet defining the following:
- Behavioral Controls – Does the company control or have the right to control what the worker does and how the worker does his or her job;
- Financial Controls – Are the business aspects of the worker’s job controlled by the payer? (These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.); and
- Type of Relationship – Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
The company’s risk in improperly classifying an individual as an independent contractor is that it could be responsible for paying the income tax and FICA that should have been withheld from the employee’s pay along with fines/penalties. More information about the IRS’ take on an independent contractor can be found at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Independent-Contractor-Self-Employed-or-Employee.
3. Workers’ Compensation Law – In most states, all but the very smallest of employers must carry Workers’ Compensation insurance to cover medical and wage loss expenses for employees who experience on-the-job illnesses and injuries. Each state will define the employee/employer relationship.
For example, Florida Statutes specifically define who is an employee. At least 4 of the following criteria must be met in order for a company to classify an individual as an independent contractor:
- The independent contractor maintains a separate business with his or her own work facility, truck, equipment, materials, or similar accommodations;
- The independent contractor holds or has applied for a federal employer identification number, unless the independent contractor is a sole proprietor who is not required to obtain a federal employer identification number under state or federal regulations;
- The independent contractor receives compensation for services rendered or work performed and such compensation is paid to a business rather than to an individual;
- The independent contractor holds one or more bank accounts in the name of the business entity for purposes of paying business expenses or other expenses related to services rendered or work performed for compensation;
- The independent contractor performs work or is able to perform work for any entity in addition to or besides the employer at his or her own election without the necessity of completing an employment application or process; or
- The independent contractor receives compensation for work or services rendered on a competitive-bid basis or completion of a task or a set of tasks as defined by a contractual agreement, unless such contractual agreement expressly states that an employment relationship exists.
NOTE: Florida Workers’ Compensation statutes regard independent contractors working or performing services in the construction industry as employees.
Workers’ Compensation insurers are looking more closely at those individuals classified as independent contractors. They are asking to see affidavits signed by those contractors confirming they truly are an independent contractor. Misclassification could result in 1) the company becoming liable for paying any medical expenses incurred as a result of a work-related injury; 2) the WC insurance company could drop the employer’s coverage; and/or 3) the company could be accused of insurance fraud.
State Law – Numerous states have adopted laws regarding the analysis of how employees v. independent contractors are defined. Many of those states have adopted the “ABC Test” to determine whether or not someone is an independent contractor or employee. Under the ABC Test, a worker is considered an employee unless all three of the following conditions are met:
- The worker is free from the employer’s control or direction in performing the work.
- The work takes place outside the usual course of the business of the company and off the site of the business.
- Customarily, the worker is engaged in an independent trade, occupation, profession, or business.
Here are some tips for minimizing liability with respect to using independent contractors:
- Make independent contractors the exception rather than the rule. Most individuals in our employ should be employees.
- Ensure a worker satisfies the independent contractor tests under various laws…especially the laws described in this article.
- Use contractors for short-term, discrete projects that are generally not performed by a regular employee.
- Maintain signed, independent contractor agreements. (Seek legal counsel for assistance.)
- Ideally, contractors should be set up as a business entity (e.g., corporation, LLC, etc.).
- Require contractors to provide proof of business insurance. This should include proof of workers’ compensation insurance unless the contractor can show proof of exemption from state requirements.
- Require contractors to submit invoices for their fee and pay on a project rather than hourly basis.
- Do not provide contractors with company benefits such as insurance, retirement, vacation, etc. or pay any employment taxes associated with the contractors’ work (but make sure they do).
- Do not reimburse for expenses.
- Have contractors supply their own equipment.
- Allow contractors to determine their own hours and methods of accomplishing the end result.
- Make sure the contractor works at least part of the time away from your company premises.
- Review your policy against harassment with the contractor and ensure that he or she understands that the policy also applies to him/her.
No one factor determines whether an individual is an employee or an independent contractor. However, strong weight is given to whether the company or the individual controls the job and whether the contractor is responsible only for the end result and not the method used to perform the task. Carefully evaluate the relationship before determining an individual is an independent contractor.
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