Are Your Independent Contractors Truly Independent?
While using independent contractors can help businesses contain
employee-related costs, misclassifying employees can result in
significant financial liability.
By Jordan W. Siev & Kirsten M. Eriksson
sing independent contractors to perform work once done by
traditional employees is widely recognized as an effective cost-cutting
measure. Independent contractors, or "temporary" workers, need not be
included in benefit plans, and they carry a lesser tax liability than
regular employees. Also, their numbers can be easily expanded and
contracted to meet changing needs. While this relationship can be
mutually advantageous, it also can subject the hiring company to
significant liability if the independent contractors should have been
classified as employees and awarded traditional benefits.
Does this seem like an unlikely scenario? Just
look at Time Warner and Microsoft, two of the best-known companies
involved in recent lawsuits challenging their treatment of certain
workers as independent contractors. Time Warner has been sued by the
U.S. Department of Labor, which is seeking to remove plan fiduciaries
and to require payments to workers excluded from benefit plans.
Microsoft was subjected to an IRS audit and forced to pay back taxes for
improperly classifying workers as independent contractors. The IRS also
could have required interest payments and imposed penalties on
Microsoft. Indeed, between 1988 and 1995, the IRS reclassified 500,000
"free-lancers" as employees, and levied $830 million in back taxes and
penalties against various entities.
The danger does not end with the government. After the IRS audit,
Microsoft was faced with an ERISA-based class action lawsuit by workers
who were not treated as employees and who successfully sought to obtain
employee benefits from which they were excluded. Such claims can result
in large payments of back benefits and steep statutory penalties.
Thus, to avoid the perils faced by Time Warner, Microsoft, and
others, lawyers should ensure that their own business entities and those
they counsel correctly classify workers as independent contractors. This
article examines the factors considered in determining whether a worker
is an independent contractor or an employee, and provides some practical
tips to help protect businesses from the dangers of
misclassification.
Employee or Independent Contractor: The Test
Many state and federal laws that require a determination of whether a
worker is an "employee" use the common law definition of employee.
The fundamental characteristic of employees under the common law is
that their employer has the right to control the manner and means by
which their work is performed. Obviously, a certain amount of control by
a company is inevitable in all employee and independent contractor
relationships. However, the determinative factor is whether, under all
the circumstances, the company has the right to control not only what
work is to be done, but how it is to be done. That the company does not
actually exercise this right is irrelevant; all that matters is that the
right exists.
The question of control, while simple in theory, is difficult to
assess in practice. One of the most complete analyses of the common law
test is contained in the IRS training materials, which are used as a
guide in this article. These materials focus on three categories of
evidence - behavioral control, financial control, and the relationship
of the parties. No one category or factor is determinative and, in many
cases, some factors pointing in both directions will exist. Ultimately,
whether a worker is an employee or an independent contractor will be
determined by balancing all of the factors in light of the relationship
as a whole.
Behavioral Control
Behavioral control - the extent to which a company directs or
controls how the specific tasks are performed by the worker - focuses on
the instruction and training provided by the company.
Instructions. Two types of instructions are
important - instructions as to what the final work product will be, and
instructions as to how to achieve the desired product. Generally, the
fewer details a company provides as to the completion of the work, the
less control appears to be exerted, and the less likely that the worker
is an employee. Thus, it is likely that an employer-employee
relationship exists if a company provides instructions as to the details
of the work, such as: when to do the work, where to do the work, what
tools or equipment to use, what workers to hire to assist with the work,
where to purchase supplies or services, what routines or patterns must
be used, or what order or sequence to follow. By contrast, because
businesses often require a uniform end product and a specific delivery
date of that product, instructions concerning matters such as these are
less indicative of control.
Training. Independent contractors should be workers
who neither need nor receive periodic or ongoing training from a
particular company. Such training, if provided, indicates an
employer-employee relationship. Moreover, if a company pays to train a
worker through a third party, such as paying for professional
development courses, an employer-employee relationship generally will be
found. However, companies commonly provide some limited training to
independent contractors, such as general orientation information or
information on new product lines. Again, as with the instruction
provided, the more detailed and comprehensive the training provided, the
more likely it is that control exists.
Financial Control
Financial control refers to whether a company has the ability to
direct or control the economic or business aspects of the worker's
activities. Factors to determine whether financial control exists are:
significant investment, unreimbursed expenses, services available to
others, opportunity for profit or loss, and method of payment.
Significant Investment. Workers
who purchase, rent, or lease their own equipment or office space to
perform a particular job are more likely to be independent contractors,
whereas employees generally have equipment and office space provided to
them by their employers.
Unreimbursed Expenses. Workers who pay for their own
supplies generally are independent contractors. Workers who receive such
materials from the company, or who have such costs reimbursed, are
likely to be employees.
Services Available to Others. Workers marketing
their services to the public are likely to be independent contractors.
Although employees who "moonlight" may have more than one employer,
workers with a regular practice of working for different companies
generally will be labeled independent contractors. This is particularly
true if a worker provides services to competing companies in the same
field, and even more so if a company has a policy prohibiting its
employees from providing services to competitors.
Opportunity for Profit or Loss. If the worker makes
decisions affecting his or her bottom line, the worker likely has the
opportunity for a profit or loss, and will be considered an independent
contractor. Examples of decisions that may affect a worker's bottom line
include the type and quantity of inventory to purchase, the amount of
capital investment, and where and whether to purchase supplies or
equipment.
Method of Payment. Generally, compensation by the
hour, day, or week is evidence of an employer-employee relationship,
while payment of a flat fee is evidence of independent contractor
status.
Relationship of the Parties
The final category of evidence examines what the parties intend their
relationship to be. It must be emphasized that the parties' intent,
while persuasive, is not controlling. Even if both parties agree in
writing that an independent contractor relationship exists, a court or
the government could find otherwise.
A written agreement setting forth the terms of the independent
contractor relationship is one of the clearest indicators of the
parties' intent. Similarly, the worker's incorporation of his or her
business, even if the worker is a sole proprietor, demonstrates an
intent to be independent. Moreover, the exclusion of a worker from
employee benefit plans and the provision of a Form 1099 rather than a
Form W-2 demonstrate the parties' intent to create an independent
contractor relationship.
In addition, the terms and length of the relationship may be
important factors. A company's absolute right to terminate the worker
without penalty, and a worker's right to quit, are generally evidence of
an at-will employer-employee relationship. Conversely, an independent
contractor relationship generally can be terminated only subject to
certain limitations, sometimes including payment of a penalty. Moreover,
independent contractor relationships generally exist for a definite
term. The longer and more indefinite the term of the relationship, the
more likely that an employer-employee relationship will be found.
Finally, if the work performed by the worker is part of a company's
integral business activity, it is likely that the worker is an employee.
"Integral" in this context means that the work or project is part of the
business's regularly conducted activity. For example, a store may retain
workers to install electricity and plumbing in its building. This work,
while necessary to the functioning of the store, is not the store's
regular business activity. These workers are independent
contractors.
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| Jordan W. Siev and Kirsten M. Eriksson are members of
the New York office of Anderson Kill & Olick P.C., whose practice
includes representing companies and fiduciaries in matters involving the
employee/independent contractor distinction. |
Some companies believe they can eliminate the problems created by
this issue by hiring their independent contractors through a temporary
help agency. This is only partly true. If the temporary agency is no
more than a shell with which the worker has little or no contact, and
the trappings of an employee-employer relationship exist between the
worker and the company, the relationship with the temporary agency may
be disregarded.1 To prevent this result, the
company should not recruit specific workers, but should use whatever
workers are provided by the agency. The company should not train the
workers extensively, and should not use the same workers for an extended
period. Finally, the workers should not be given additional tasks or
projects that go beyond their original assignments.
Conclusion
The use of independent contractors can be a valuable way for
companies to decrease costs. However, the use of independent contractors
is not without its dangers. Companies must be careful to ensure they do
not run afoul of the law and misclassify employees as independent
contractors. Companies should scrutinize their practices following the
above guidelines, periodically audit their independent contractor
relationships, and consult with a professional about any concerns of
misclassifying independent contractors.
Endnotes
1 See, e.g.,
Vizcaino v. U.S. District Court for the Western District of
Washington, 1999 U.S. App. Lexis 9057 (9th Cir. May 12, 1999)
(later proceeding in Microsoft holding that Microsoft can still
be employer of workers from temporary agency).
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