It’s a problem that faces small and large agencies alike. A principal wants to control every move the rep makes. Your regional manager starts telling you how many people to hire and sometimes whom to hire. He wants onerous frequent reports about how you spend your time, and he wants more of that time. In short, the company wants to treat you as an employee.

In the United States, most workers are either 1099 independent contractors or W-2 employees. But there is no such thing as a “1099 employee” or a “W-2 contractor.” Misclassification of a sales representative as a 1099 independent contractor instead of a W-2 employee may be especially problematic for smaller rep agencies that do not represent multiple product lines. We hear complaints from agencies where the manufacturer tries to control every aspect of how the agency conducts its business, yet the manufacturer insists that the agency is an independent contractor because it says so in the contract. This control sometimes means that the manufacturer wants to control what other lines your agency can represent, or even refuses to allow an agency to represent other product lines.

The determination of whether a sales representative is legally an independent contractor or an employee involves a detailed analysis of each representative’s unique situation. Each state has its own standards regarding such an analysis. Additionally, the IRS has identified many factors (which may well be different from a particular state’s standards) to answer the same question, independent contractor or employee? Because each state has its own factors surrounding the analysis, this article will focus on the IRS factors.

The IRS analysis focuses on three major categories of facts: behavioral, financial, and type of relationship. The main point of all of these factors is to determine how much control the manufacturer exerts over how the agency conducts its business.

Behavioral Factors

The behavioral factors are concerned with whether the manufacturer controls or has the right to control what the agency does and how the agency does its job. They include:

Type of Instruction Given. An independent contractor is not generally instructed when, where, and how to work. Accordingly, the IRS will examine factors including:

• Whether the manufacturer controls which workers the agency hires to assist with the work.
• Whether the manufacturer controls where the agency purchases supplies and services.
• Whether the manufacturer dictates that work must be performed by a specified individual.
• Whether the manufacturer controls the order or sequence to follow when the agency is performing the work.

Degree of Instruction. The more detailed the instructions, the more likely it is that the worker is an employee.

Evaluation System. If an evaluation system measures the details of how the agency performs, then these factors would point to an employee. But if the evaluation system measures just the end result, e.g., annual sales, then this would more likely point to an independent contractor.

Training. If the manufacturer provides the worker with training on how to do the job, this indicates that the manufacturer wants the job done in a particular way. The IRS believes that extensive training can be strong evidence that the worker is an employee and that periodic or on-going training about procedures and methods is even stronger evidence of an employer-employee relationship.

Financial Factors

These factors are concerned with how much an agency controls the financial aspects of its business:

Significant Investment. Independent contractors often make a significant investment in the equipment used in working for someone else. However, “significant investment” may simply not be necessary for independent contractors in certain industries that do not require large expenditures.

Unreimbursed Expenses. According to the IRS, independent contractors are more likely to have unreimbursed expenses than employees and have fixed ongoing costs.

Opportunity for Profit and Loss. An independent contractor is more likely to have the possibility of incurring loss (and profit) than an employee.

Services Available to the Market. Independent contractors are generally free to seek out business opportunities and will usually do their own marketing and maintain a visible business location.

Method of Payment. Employees are generally guaranteed a certain wage or salary. According to the IRS, a guaranteed wage/salary is generally indicative of an employee, even if the wage/salary is supplemented by a commission.

Type of Relationship

These factors concern whether a written contract governs the relationship, whether there is a benefits plan, and whether the work is performed by a key individual.

Written Contracts. Although a contract may state that a worker is an independent contractor or an employee, the IRS is adamant that this is not the end of the analysis and that it is not required to follow such a contract. The relevant inquiry is how the parties work together.

Employee Benefits. Businesses generally do not grant benefits like insurance, pension plans, paid vacation, sick days, and disability insurance to independent contractors.

Permanency of the Relationship. If the business relationship is for a specific period of time, then the agency/worker is more likely to be considered an independent contractor. If the business relationship is to continue indefinitely, then the IRS will consider this to be evidence of an employer-employee relationship.

Services Provided as Key Activity of the Business. If a worker provides services that are a key aspect of the business, the IRS is more likely to conclude that the business will have the right to direct and control the worker’s activities, which indicates an employer-employee relationship.

Manufacturers benefit by mischaracterizing agencies as independent contractors because they do not have to pay any portion of an independent contractor’s taxes, provide benefits, or comply with the many laws that deal with the employee-employer relationship. However, misclassification can subject a manufacturer to tax liability and penalties, as well as various legal claims.

Avoiding the Employee Trap

As an independent business owner, the hairs on the back of your neck should rise if a principal tries to exercise too much control over your business. The best way to avoid this occurring is to do the following:

• Take the time to negotiate fair, long-term contracts that tie keeping the line to performance: if you meet reasonable performance standards, you are entitled to continue representing the principal.
• Keeping a line should also be premised on performance, not meeting arbitrary requirements of a manufacturer because most manufactures are very good at identifying the best way to manufacture a part, but very bad at marketing. You need to ensure that your ability to make decisions about how to sell product is not hamstrung by a principal who probably knows very little about your territory.
• You are especially vulnerable to the whims of a principal who provides most of your revenue, and effectively pays your mortgage. Sales representative agencies that grow over many decades almost always have numerous lines, and no single line that accounts for more than 30 percent of gross revenue. Having a balance of lines, even if you own a small agency focused on a particular product niche, protects you from being too reliant on any one manufacturer. In addition, being diverse in terms of products sold and industries served helps protect revenue during economic and business cycles.