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Employee or Independent Contractor? What Makes the Difference?

Posted on 6/10/2014 by in Liability Business Contractor Employee Test Tax

Most businesses understanding that independent contractor’s receive 1099’s and employee’s receive W-2s, but there are many misunderstanding about who actually qualifies as an independent contractor. The wrong classification can have serious legal ramifications, and could leave the employer vulnerable to liability for: failure to withhold and pay payroll taxes; failure to pay employee benefits; hourly wage violations; discrimination suits and more. The classification is also associated with your rights to intellectual property, involving elevated risks where in certain situations you are licensing the use of your trademark without conditions.

There are various occupations such as doctors, insurance agents, and drivers which have been subject to extensive, on-point litigation determining an individual’s status. That being said, there is no bright-line rule or exact definition of who qualifies as an independent contractor. To determine classification, there are several tests, the most relevant are:  the common law test,  the Fair Labor Standards Act test and the IRS guidelines. The overarching theme in all the tests is the employer’s level of control over the individual; an independent contractor must retain a high level of control over how, when, and where she/he renders services. 

The common law test: 

Under the common law test, the court considers the hiring parties right to control the manner and means by which the product is accomplished. The court considers factors such as skill required, source of tools, location of work, duration of the relationship, the parties right to assign its responsibilities, the parties discretion over time and date of performance, the method of payment, the hiring parties classification, the nature of the work, the parties access to benefits, and the tax treatment of the hired party.  

The Fair Labor Standards Act Determination:

The Fair Labor Standards Act sets the standards, regulations, and requirements for minimum wage, overtime pay, record keeping and child labor. A wrong classification under this Act would leave the employer liable for damages stemming from wage requirements.  The Act also happens to have the most inclusive standard, defining employees as “any individual employed by an employer” and employ as “suffer or permit to work.” Under the act one must consider the degree of the employers control of the manner in which work is preformed, the employees ability to control his profit and loss through management, the employees ownership of equipment required to perform, the employees special skills, and the nature of the relationship between employers business and employees work.  No factor is controlling, and courts focus on the “economic realities” rather than form or specific contract.   

The Internal Revenue Service Guidelines:

The IRS had a 20-factor test interpreting the common law test, but has recently revised its test, identifying three primary criteria: behavioral control, financial control, and relationship of parties. 

In evaluating behavioral control, one must focus on the employer’s right to control the method of performance. Factors including evaluating control over how when and where a worker performs, who provides the tools of the trade, ability to delegate duties, choice in purchase of supplies, and who provides training for the job. The more control over these factors an employer has the more likely the other party is an employee. 

In evaluating financial control, one must focus on the business end of the relationship. Factors include evaluating the workers own investment in the work, ability to control own profit and loss, and responsibility for expenses. 

In evaluating the type of relationship, one must focus on the contractual form and economic realities of the relationship. Factors include whether the employee receives benefits, paid time off, the existence and terms of a contract. 

The takeaway here should be that if you do not have a strong contract, and you control how an individual is doing the work, chances are they are an employee. The risk involved in wrong classification far outweigh any perceived benefit  involved in cutting corners with reporting and taxation. If you believe you have been wrongly classifying employees, the IRS has programs in place for reclassification that involve waivers of portions of back due taxes to help individuals start reporting correctly.