As state and Federal governments are more strapped for cash and in need of greater tax revenues, they are paying more careful attention to whether employers have properly classified their workers either as independent contractors or as employees. As important as the question is, often there is no simple answer. In fact, the IRS’ training manual on the subject, which it uses to educate its examiners, comprises over 160 pages of materials.
Misclassification can occur for a variety of reasons. Often it is a lack of knowledge of how to properly classify workers. Many times it is intentional in order to take advantage of tax breaks that are beneficial to the employer, but may not be strictly according to the law. In many instances, by following the basic rules, proper classification of workers is relatively straightforward. In other instances it is difficult to properly classify workers as independent contractors or as employees. What are the rules, why do employers misclassify workers and what are the ramifications of such misclassification to the employee and to the worker?
There are general guidelines that every employer can and should follow in order to properly classify its workers. These guidelines may be illustrated with some clear examples.
You hire Worker A to operate a particular machine in your factory. You train him or her in the use of the machine, and provide him or her with whatever safety and other equipment he or she will need to operate the machine. You tell him or her what hours to work, and when he or she may take meals and rest periods. You pay him or her a fixed hourly wage for his or her services. Worker A is clearly an employee.
You hire Worker B to write software for you. Worker B works from his or her home using his or her own computer. You do not have the ability to direct when or how he or she does his or her job, nor do you have to train him or her in how to write software. You pay a fixed fee for the successful completion of the services, no matter how long it takes to do the job. Worker B is clearly an independent contractor.
As these examples illustrate, worker classification is a matter of who has control over a worker’s behavior and who has the financial risk if the worker fails to perform. These two examples represent the extremes. In the case of Worker A, the employer controls the worker’s behavior. It tells him or her what to do, and when, where, and how to do it. In addition, you are obligated to pay the worker for every hour worked, whether he or she performs adequately or not.
Worker B, on the other hand, is on his or her own. You do not tell the worker when, where, or how to do the job. Moreover, Worker B may or may not make any money working for you. He or she makes the same amount of money no matter how long it takes to do the job, and if the worker fails to perform, you may not be obligated to pay the worker.
So far, worker classification is relatively easy, but remember, these are the clear cut examples. With only a small amount of effort, one can imagine all sorts of permutations and combinations of facts, not all of which will point in the same direction. Moreover, the correct classification depends on the totality of the facts, with no one fact being dispositive. Now you can begin to understand why that training manual is 160 pages long.
When determining whether a person providing services is an employee or independent contractor, all information that provides evidence of the degree of control and independence of the worker must be considered. Under the common law, facts that provide evidence of the degree of control and independence of the worker fall into three categories:
• Behavioral. Does the company control or have the right to control what the worker does and how the worker does his or her job?
• Financial. Are the business aspects of the workers’ job controlled by the employer, including matters like how the worker is paid, whether expenses are reimbursed, who provides the tools/supplies, etc?
• Are there written contracts for employee benefits such as a pension plan, insurance, vacation pay, etc? Will the relationship continue after the specific job is completed and is the work performed a key aspect of the business?
The correct classification depends on the totality of the facts, with no one fact being dispositive. Now you can begin to understand why that training manual is 160 pages long.
One solution is to make use of a checklist. Ask yourself the following questions. If the answer to most of them is yes, the worker is likely an employee.
• Does the worker use your facilities and equipment to perform the work?
• Do you set the hours of work?
• Do you have the right to control how the work is performed?
• Do you train the worker in how to do the work?
• Is the worker required to perform the work personally?
• Does the worker work primarily or exclusively for you?
• Are you required to pay the worker for time spent working, regardless of the results?
• Do you pay the expenses incurred by the worker in performing the work?
Other factors to consider when determining whether workers are independent contractors or employees include the degree of control by the employer over the worker, whether the worker is “at risk” with respect to his or her capital when performing the work, the method of compensation and whether the worker possesses the qualifications to successfully perform the job without help.
Applying these standards to manufacturers’ representatives, if an individual serves as a rep only for you and your company throughout the year, has no other lines, is entirely controlled by you and has no other income or business activities, the likelihood is that the individual is an employee and not an independent contractor.
Businesses must weigh these and other factors when determining whether a worker is an employee or independent contractor. Some factors may indicate that the worker is an employee, while other factors may indicate that the worker is an independent contractor. There is no magic or set number of factors that classifies the worker an employee or an independent contractor and no one factor stands alone in making this determination. Factors that are relevant in one situation may not be relevant in another. It is important to look at the entire relationship, consider the degree or extent of the right to direct and control the worker, and finally, to document each of the factors used in coming up with the determination.
If, after reviewing the three categories of evidence, it is still unclear whether a worker is an employee or independent contractor, IRS Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) can be filed with the IRS. The form may be completed and filed by either the employer or the worker. The IRS will review the facts and circumstances and officially determine the worker’s status. It should be noted that it could take at least six months to get a determination, but a business that continually hires the same types of workers to perform particular services may want to consider filing Form SS-8.
Employers often misclassify workers as independent contractors in order to save 30% of the cost of compensating the worker, including such items as Federal Social Security Taxes, workers compensation premiums, overtime compensation, state unemployment insurance, Federal unemployment tax, avoid state wage-hour laws and similar reasons.
However, employers need to understand that there is a significant risk when workers are misclassified and that risk is increasing with time because of the loss of income at both the Federal and State level and the need for all governmental agencies to maximize their revenues. Many state unemployment and workers compensation funds are broke and require substantial relief in the form of tax dollars. Based upon these factors it is understandable that the Internal Revenue Service has launched an initiative with over 100 additional agents to audit employers in the coming years to insure compliance. Many states have recently enacted legislation to prevent misclassification of employees and are particularly targeting high-tech engineers and salespersons. It is important to note that just because you pay a commission to a salesperson doesn’t mean that he or she is an independent contractor. The ramifications to both the employer and the worker of misclassifying the worker as an independent contractor may be significant. For example, the failure to withhold taxes can result in the collection by the IRS or the State Department of Revenue of back taxes, interest and penalties. Workers who are injured on the job and have been misclassified as independent contractors can subject an employer to the entire cost of the claim being passed directly through to the employer in addition to the retroactive payment of insurance premiums.
If you are utilizing independent contractors and want to make sure they are properly classified as such, it is important to have a separate written agreement with each worker. Form book model Independent Contractor Agreements from an on-line or other generic source should be avoided. The objective is to make the worker a real independent contractor by giving him or her as many indicias of independence as possible, and most important, don’t forget to provide the worker and the IRS the 1099 Form at the end of the year.
By following these rules and treating the independent contractor as truly “independent” you will avoid the pitfalls and unnecessary expenses of misclassification.
