Employee or Independent Contractor? Avoiding a Costly Misclassification. Labor & Employment Client Alert. (September 2010)

At a time when most businesses are looking for ways to reduce costs and expenses, categorizing workers as independent contractors rather than employees may appear to be an appealing option. If a worker is an employee, then the business is required to pay Social Security and Medicare (FICA) as well as federal and state unemployment taxes on the employee’s wages, whereas if a worker is an independent contractor, the individual is responsible for paying his own income tax and self-employment tax. Misclassifications can have costly repercussions, however, and it is critical that businesses are fully informed before classifying a worker as an independent contractor rather than an employee. In the fall of 2009, the Internal Revenue Service announced its plans to launch employment tax audits in which worker classification is one area of focus. More recently, the Treasury Inspector General for Tax Administration released an audit report stating that the Internal Revenue Service should do even more to prevent the misclassification of workers by employers. Accordingly, now is a particularly good time for businesses to examine their existing classifications.

Employee or Independent Contractor?

Unfortunately, there is no litmus test. Rather, there are several tests with many factors that are commonly used to determine whether a person is properly categorized as an employee or independent contractor. What these tests have in common is the examination of the amount of control that a business has over an individual. The determination turns largely on a thorough examination of the facts of a particular situation.

The Internal Revenue Service examines three main categories: behavioral control, financial control, and the relationship of the parties. “Behavioral control” considers whether the business directs and controls how the individual does the work. Facts examined include whether the business gives extensive instructions to the individual on how, where or when to do the work, what tools or equipment to use, what assistants to hire, where to purchase supplies and services, and whether the business trains the employee on how to perform the work. “Financial control” examines whether the business has the right to direct the business aspects of the individual’s work, whether the individual has made a financial investment in his work, whether the business reimburses the individual’s expenses, whether the individual can realize a profit or incur a loss as a result of the work performed, whether the individual is free to seek out other business opportunities, and the method of payment to the individual. “Relationship of the parties” considers how the business and the individual perceive their relationship and examines whether the business provides insurance or benefits to the individual, whether the work performed by the individual is a key aspect of the business, and the permanency of the relationship.

Under the Fair Labor Standards Act, an “economic realities” test is used to determine if the individual is economically dependent on the business (employee) or, instead, is in business for himself (independent contractor). Five factors are considered: (1) the degree of control exercised by the business; (2) the extent of the investments by the individual and by the business in materials and equipment required for the work; (3) the degree to which the individual’s opportunity for profit or loss is determined by the business; (4) the skill and initiative required in performing the work; and (5) the permanency of the relationship.

State laws, including those such as laws governing unemployment benefits and workers’ compensation, may also proscribe tests.

The following chart contains examples of general indicators of whether an individual is likely an employee or an independent contractor:

EMPLOYEE

INDEPENDENT CONTRACTOR

Business controls how the work is performed.

Individual determines how the work is performed.

Business provides resources, equipment and supplies needed to perform the work.

Individual provides the supplies and equipment needed to do the work and often has made a significant financial investment in the supplies and equipment.

Works fixed hours, steady and reliable schedule.

Sets own hours of work; works on project-by-project or on-again-off-again basis.

Paid a set hourly wage or salary.

Paid by the job or project. Often sends an invoice to the business for payment for services.

If there is no employment contract, term of employment is indefinite. Employee can be terminated or can resign at any time.

Generally works only until the job or project at hand is completed.

Usually works for only one business.

Often performs work for more than one business.

Attends department, training or other meetings held by the business.

Does not attend meetings held by the business.

Is usually reimbursed by the business for business-related expenses. May deduct unreimbursed expenses on income tax return if employee itemizes deductions and they total more than 2% of adjusted gross income.

Is not reimbursed by the business for business expenses, particularly if the expenses are high. May deduct business expenses on Schedule C of income tax return.

Does not directly make a profit or incur a loss as a result of the work performed for the business.

Can realize a profit or incur a loss as a result of the work performed for the business.

Often provides a variety of services or has a number of responsibilities and duties.

Often provides a service that requires a specific and high degree of skill.

Business provides benefits, such as health insurance or paid time off, and worker’s compensation insurance.

Does not receive benefits from the business and provides own worker’s compensation coverage.

IRS Form W-2 is issued by the business to the employee.

IRS Form 1099-MISC is issued by the business to the independent contractor.

What consequences may a business face if it misclassifies an employee as an independent contractor?

Unpaid Compensation: An employer that misclassifies an employee as an independent contractor may be liable for all unpaid income and, potentially, for the value of benefits that the employer provides to its employees.

Tax Liabilities:If an employer unintentionally misclassifies an employee as an independent contractor and fails to deduct and withhold taxes, the employer’s liability may be 1.5% of the wages paid for federal withholding and 20% of the individual’s portion of FICA. Those percentages increase to 3% and 40%, respectively, if the employer also fails to meet certain reporting requirements.

If an employer intentionally misclassifies an employee as an independent contractor, the employer could be liable for the full amount of the individual’s income taxes that should have been withheld, the full amount of the business’s and the individual’s share of FICA, plus interest and penalties.

Civil Litigation: An individual who is misclassified as an independent contractor may also have legal claims against the business arising out of his employment. These can include claims under the Fair Labor Standards Act for unpaid minimum wage and overtime, claims under federal and state laws prohibiting discrimination and harassment, public policy violation claims, and virtually any other claim that an employee would be entitled to make.

Labor & Employment Practice Group Members
T. Christopher Bailey
Molly R. Batsch
Amy L. Blaisdell
Edward S. Bott, Jr.
Kathi L. Chestnut
Dennis G. Collins
Thomas F. Hennessy, III
Vanessa Robinson Keith
Jill K. Luft 
Kevin T. McLaughlin
Mary Beth Ortbals
Melanie A. Renken 
William A. Schmitt
Mary Ann L. Wymore

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