When Is An Independent Contractor Really An Employee?

In our blog last week, we explored the general problem of employee misclassification.  This week we're taking a closer look at independent contractor versus employee status.

If your company relies on independent contractors, you could be in for a shock if one of them (or worse, the IRS) tells you they’re actually an employee, entitled to overtime and benefits. Nothing to worry about, you might think - your company has always used contractors and your entire industry does the same thing!  All of your contractors sign agreements stating they are independent contractors and you send them 1099-MISC forms. Those things may all be true, but they might not mean he’s classified correctly as an independent contractor. He just might be your employee after all.

Independent contractor misclassifications are extremely common and are coming under increasing scrutiny from the Department of Labor (DOL) and the Internal Revenue Service (IRS). Penalties for accidental and intentional misclassification can hit hard. It’s hard to find exact, current numbers of how many workers are misclassified as independent contractors, but sources like the National Employment Law Project (NELP) cite state-level reports finding 10% to 30% of workers are misclassified, which could mean millions nationwide. Industries like transportation, delivery, home care, construction, real estate and janitorial services are especially hard-hit, but misclassification can happen anywhere.

Winners and Losers

Because independent contractors are not considered employees, companies generally save on payroll expenses like overtime pay, Social Security, Medicare and payroll taxes and unemployment insurance. And the savings really add up: The IRS estimated in 2012 that employers can save around $3710 per employee (based on national average income of $43,007). In the business world, where saving money means competitive advantage, it’s pretty tempting to classify workers as independent contractors.

But, those contractors are “not covered by our most basic labor standards of minimum wage, overtime, and the fundamental proposition that one should be compensated for the hours they work,” - and they're also left out of numerous other rights and protections that come with employee status, says former DOL Wage and Hour Administrator David Weil .

Here’s what independent contractors stand to miss out on:

• Guaranteed minimum wage
• Overtime
• Employer-provided health insurance
• Retirement benefits
• Paid leave (e.g., sick, vacation)
• Anti-harassment and discrimination protections
• Worker’s compensation
• Unemployment insurance
• Social Security and Medicare coverage
• Protection under health and safety laws (e.g., OSHA)
• Equal opportunity rights and protections
• Family and Medical Leave Act provisions
• Rights to organize and bargain collectively

Misclassification hurts other businesses by creating an unfair advantage for firms that misclassify. “Employers who play by the rules are underbid and lose business [and] wages and labor standards are depressed across the board,” says the NELP’s Backgrounder report on misclassification. Tax revenues owed to federal, state and local governments are also lost.

Making the Determination

There’s a great deal of misinformation about independent contractor status, such as signing an agreement that says you're an independent contractor, sending workers a 1099-MISC form, working off-site or operating a franchise. The reality is -under the Fair Labor Standards Act (FLSA) and other laws, a worker may still be an employee and entitled to protections and benefits.

Under FLSA, the term “employ” is defined as, “to ‘suffer or permit to work’, representing the broadest definition of employment under the law because it covers work that the employer directs or allows to take place. What’s more, workers who are economically dependent on the business of the employer, regardless of skill level, are considered to be employees, and most workers are employees,” according to the DOL Wage and Hour Division. Does that mean that every worker you pay is automatically an employee?  Not necessarily.

The DOL and IRS provide tests to help you make the call. Be aware that you can’t look at any single factor alone: Always consider the entire employment relationship between the company and the worker.

“Economic Realities” Tests

The Wage and Hour Division (WHD) uses six “economic reality” tests to determine worker status.

1. How integral is the work to the employer’s business?
2. Does the worker’s skill in managing his/her work affect his/her opportunity for profit or loss?
3. How much have the worker and employer each invested in facilities and equipment? “The worker must make some investment compared to the employer’s investment (and bear some risk for a loss) in order for there to be an indication that he/she is an independent contractor in business for himself or herself,” WHD says.
4. Does the worker use independent business judgment and operate in open market competition with others?
5. Is the working relationship permanent or ongoing?
6. What control does the employer have over the worker? In WHD’s words, “who sets pay amounts and work hours and who determines how the work is performed, as well as whether the worker is free to work for others and hire helpers?”

“Common Law Rules”

IRS’s common law rules also help you examine the nature of the business relationship. The key is to understand the amount of control the company has in relation to the worker, in 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? This includes what instructions, if any, are given and in how much detail, evaluation of work done and the extent of training from the employer.
2. Financial: Are the business aspects of the worker’s job controlled by the payer? This includes worker investment in equipment, reimbursement of expenses, opportunities for the worker’s profit or loss, if the worker may open his or her services the larger market and how the worker is paid (e.g., hourly or fee-for-service).
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Is the worker entitled to benefits, is there an ongoing work relationship, and are the services provided by the worker key to the business’s activities?

Review Your Classifications Closely

“Underpayment of federal income taxes on self-employment income and the underpayment of self-employment taxes contribute $122 billion and $57 billion, respectively, to the ‘tax gap’ …  IRS will generally scrutinize the classification of workers as independent contractors, rather than employees, during income tax audits of firms, and assess taxpayers for the underpayment of employment taxes,” says CPA Claire Y. Nash in The Tax Advisor. So if you file IRS form 1099 regularly or have large numbers of independent contractors, your company could be under the microscope.

As we said last week, this is an issue you can't ignore. If you’re still not sure how to correctly classify your workers, consider consulting a payroll expert, or a CPA or tax attorney familiar with your business. You can also file Form SS-8 with the IRS to receive an official determination of worker status.

When it comes to worker classification, you can’t be too careful. Horizon Payroll Solutions can help you proceed with caution and confidence.