Defining Independent Contractors
Independent contractors can play a critical role in organizational staffing when hired and handled correctly. The lackluster rise in economic conditions has left in its wake a unique need for contractors. In cases of short-term assignments, especially when unique or specific skill sets are necessary, contractors fill a void that would otherwise entail high overhead costs such as benefits. Startup companies may utilize contractors while they are assessing long-term goals and what employment needs will likely be. Long-standing organizations may hire contractors to help with specialized project goals or to free up employees to devote their attention to other tasks. As this year, we mark 20 years of FMLA, it serves as a reminder of further cost savings contractors represent (they are not eligible).
While these cost savings are the main incentive behind this type of worker, employers should be aware of common mistakes and consequences. Avoiding hiring errors will save time and money that would otherwise be spent on various fees (ex. legal, back pay, taxes). The main area of concern is classification. Misclassifying those working as employees into the category of contractor is a simple mistake with a complicated resolution.
Guidelines on how to define the employer-employee relationship are explained in detail on the Department of Labor’s website. Stipulations are listed as:
The Supreme Court has said that there is no definition that solves all problems relating to the employer-employee relationship under the Fair Labor Standards Act (FLSA). The Court has also said that determination of the relation cannot be based on isolated factors or upon a single characteristic, but depends upon the circumstances of the whole activity. The goal of the analysis is to determine the underlying economic reality of the situation and whether the individual is economically dependent on the supposed employer. In general, an employee, as distinguished from an independent contractor who is engaged in a business of his own, is one who “follows the usual path of an employee” and is dependent on the business that he serves. The factors that the Supreme Court has considered significant, although no single one is regarded as controlling are:
(1) the extent to which the worker’s services are an integral part of the employer’s business (examples: Does the worker play an integral role in the business by performing the primary type of work that the employer performs for his customers or clients? Does the worker perform a discrete job that is one part of the business’ overall process of production? Does the worker supervise any of the company’s employees?);
(2) the permanency of the relationship (example: How long has the worker worked for the same company?);
(3) the amount of the worker’s investment in facilities and equipment (examples: Is the worker reimbursed for any purchases or materials, supplies, etc.? Does the worker use his or her own tools or equipment?);
(4) the nature and degree of control by the principal (examples: Who decides on what hours to be worked? Who is responsible for quality control? Does the worker work for any other company(s)? Who sets the pay rate?);
(5) the worker’s opportunities for profit and loss (examples: Did the worker make any investments such as insurance or bonding? Can the worker earn a profit by performing the job more efficiently or exercising managerial skill or suffer a loss of capital investment?); and
(6) the level of skill required in performing the job and the amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent enterprise (examples: Does the worker perform routine tasks requiring little training? Does the worker advertise independently via yellow pages, business cards, etc.? Does the worker have a separate business site?).
Basically, employers need to abide by “Duck Rule”: If it looks like a duck, swims like a duck, and quacks like a duck…it’s probably a duck. If your “contractor” has an assigned workspace, hours set by the employer, and receives the same type of compensation and/or benefits as other employees…they aren’t a contractor, they are an employee and should be designated as such.
The Employment Development Department (EDD) for the state of California lists various misconceptions employers have about why a certain individual should be classified as an independent contractor, as well as reasons why they actually shouldn’t be for each situation.
- If I issue an Internal Revenue Service (IRS) Form 1099-MISC, then the worker is an independent contractor.
NOT TRUE. An IRS Form 1099-MISC is simply a method the government uses to track and report certain types of nonemployment income. When you provide an IRS Form 1099-MISC to a worker for payment of services, it does not automatically make the worker an independent contractor.
- If I pay a worker less than $600 in a year, then the worker is not subject to payroll taxes.
NOT TRUE. The amount paid to a worker is not, by itself, a factor in determining whether a worker is an employee or independent contractor. The amount paid to a worker may determine if you should issue an IRS Form 1099-MISC. For information on the federal requirements, access the IRS Web site at www.irs.gov or contact the IRS at (800) 829-1040.
- The part-time, temporary, probationary, and substitute workers I employ are day laborers or casual laborers, not employees.
NOT TRUE. An employee may perform services on a less than full-time permanent basis. The law does not exclude services from employment that are commonly referred to as day labor, part-time help, casual labor, temporary help, probationary, or outside labor.
- If a family member works for me, he/she is not an employee.
NOT TRUE. Family members working for your business are employees and subject to California payroll taxes unless certain conditions are met.
- My worker and I have signed a written contract that makes my worker an independent contractor.
NOT TRUE. A written contract or agreement does not necessarily depict the actual relationship. The actual practices of the parties in a relationship are more important than the wording of an agreement in determining whether a worker is an employee or independent contractor.
- My competitors treat their workers as independent contractors; therefore, it is okay for me to treat my workers as independent contractors.
NOT TRUE. The law defines employment relationships, not you or the actions of your competitors. If you misclassify your workers as independent contractors, [you may be assessed] for the unpaid payroll taxes for any unreported employees.
- My worker performs similar work for other businesses, so the worker is an independent contractor.
NOT TRUE. Performing similar work for other businesses is not, by itself, a determining factor. The relationship the worker may have with the other businesses is not a controlling factor when determining the worker’s status as an employee or independent contractor with your business. The working relationship with each business is looked at separately.
- My worker has a city business license and business card, so the worker is an independent contractor.
NOT TRUE. A city business license and business card, by themselves, do not make a worker an independent contractor. All of the common law factors need to be reviewed and weighed with respect to the specific circumstances of the services provided by each worker.
- I pay my workers solely by commission; therefore, they are independent contractors.
NOT TRUE. The method of payment is not, by itself, a determining factor. All of the common law factors need to be considered and weighed to determine whether a worker is an employee. If the worker is an employee, then all remuneration for services (salary, hourly pay, piece rate, commissions, bonuses, stock options, vehicle, etc.) is wages.
Lifecycle management company Corporate United reports that, “In a survey by Staffing Industry Analysts of companies in various industries with 1,000 or more employees, fewer than 1 in 5 respondents said they are sure that their independent contractors (IC) are properly classified”. It’s this lack of knowledge that places employers at risk for fines when an audit turns up these costly misclassification mistakes. The IRS may not be aware that an organization has contractors that should be deemed employees, but all it takes is an unemployment or workers compensation filing as the trigger that sets an audit in motion.
In the end, though state guidelines may vary slightly from federal when it comes to classification, the overall burden is on the employer to ensure they have their workers classified correctly. Corporate United explains in a recent article that “the financial penalties alone can amount to up to 40 percent of the individual’s compensation…and the reality is the government is counting on those misclassification cases to raise funds. State and federal agencies are stepping up their enforcement activities and cracking down with penalties fees. Internal Revenue Services (IRS) penalties can hit a company hard, especially when you consider there is a three-year look-back period on any misclassified workers.”
IRS Penalties for Unintentional Misclassification
The possible penalties employers can face can quickly add up:
- 20% of FICA employee should have paid
- 1.5% of all wages paid to the misclassified worker
- 100% of FICA employer should have paid
- 100% of FUTA that should have been paid
- All federal income taxes that were not withheld
“It’s not just the IRS employers have to worry about”, states Corporate United, “it’s more common today for ex-contractors to sue their previous employers for denial of benefits, stock options or compensation such as overtime pay. A classic case is Vizcaino v. Microsoft, a $97 million settlement that favored long-time contractors who demanded equal benefits. These “perma-temps” were misclassified as independent contractors, and they worked alongside Microsoft employees who were making millions on stock options. The contractors wanted their piece of the pie, and so they retroactively sued—and won.”
Though the penalties can be hefty, independent contractors that are rightly classified bring a necessary value to many corporations and caution should be taken when hiring. A new trend for cash-strapped companies and start-ups is to offer stock options to contractors, bringing with this concept new risks for potential litigation. Step one: find a good lawyer.