Employers take a risk when they classify someone performing services for them as an independent contractor instead of an employee. Because employers owe contractors far fewer obligations than employees, employers risk each of the following if a court determines that a misclassification occurred:
– Unpaid overtime.
– Unpaid taxes.
– Un-provided benefits.
– A discrimination claim, or claims under other laws that protect employees but not contractors (i.e., the FMLA).
In determining whether a worker is an employee or an independent contractor, the IRS compares the degree of control exerted by the company to the degree of independence retained by the individual. Generally, the IRS examines this relationship in three ways:
- 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 worker’s job controlled by the payer? (these include things like how the worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.)
- Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue and is the work performed a key aspect of the business?
If you are considering classifying someone performing services for you as an independent contractor, your answers to these three questions will determine whether that individual is a bona fide contractor, or instead, is an employee. When in doubt, err on the side of caution. The government applies these tests aggressively to find employee-status whenever it can. You should too, and the risks are too high to make a mistake.
Hire a Contractor or an Employee?
Independent contractors and employees are not the same, and it’s important to understand the difference. Knowing this distinction will help you determine what your first hiring move will be and affect how you withhold a variety of taxes and avoid costly legal consequences.
What’s the Difference?
An Independent Contractor:
- Operates under a business name
- Has his/her own employees
- Maintains a separate business checking account
- Advertises his/her business’ services
- Invoices for work completed
- Has more than one client
- Has own tools and sets own hours
- Keeps business records
- Performs duties dictated or controlled by others
- Is given training for work to be done
- Works for only one employer
Many small businesses rely on independent contractors for their staffing needs. There are many benefits to using contractors over hiring employees:
- Savings in labor costs
- Reduced liability
- Flexibility in hiring and firing
Why Does It Matter?
Misclassification of an individual as an independent contractor may have a number of costly legal consequences. If your independent contractor is discovered to meet the legal definition of an employee, you may be required to:
- Reimburse them for wages you should’ve paid them under the Fair Labor Standards Act, including overtime and minimum wage
- Pay back taxes and penalties for federal and state income taxes, Social Security, Medicare and unemployment
- Pay any misclassified injured employees workers’ compensation benefits
- Provide employee benefits, including health insurance, retirement, etc.
Visit the IRS Independent Contractor or Employee Guide to learn about the tax implications of either scenario, download and fill out a form to have the IRS officially determine your workers’ status, and find other related resources. NOTE: For tax consequences for limited liability entities in California see: http://www.edd.ca.gov/pdf_pub_ctr/de231llc.pdf
There is no single test for determining if an individual is an independent contractor or an employee under the Fair Labor Standards Act. However, the following guidelines should be taken into account:
- The extent to which the services rendered are an integral part of the principal’s business
- The permanency of the relationship
- The amount of the alleged contractor’s investment in facilities and equipment
- The nature and degree of control by the principal
- The alleged contractor’s opportunities for profit and loss
- The amount of initiative, judgment, or foresight in open market competition with others that is required for the success of the claimed independent contractor
- The degree of independent business organization and operation
Whether a person is an independent contractor or an employee generally depends on the amount of control exercised by the employer over the work being done. Read Equal Employment Opportunity Laws – Who’s Covered? for more information on how to determine whether a person is an independent contractor or an employee, and which are covered under federal laws. If there is a serious concern as to whether you should classify an individual as an employee or independent contractor you may use Form SS-8 to ask the IRS to give their opinion.
The IRS, Department of Labor and many state agencies are taking aim at businesses using independent contractors. Why? Paying an independent contractor means no wage withholding, no employment taxes, no unemployment insurance, no workers’ compensation, and no liability for pensions and fringe benefits. Even the red tape of nondiscrimination rules go out the window.
When you look at the advantages of using independent contractors and at the amorphous question of who qualifies, it is clear why some businesses push the envelope. With tax revenues everywhere suffering, enforcement takes a front seat. Besides enforcing existing laws, new laws have been implemented to further punish wrong-doers.
California passed legislation to increase the stakes:
- California’s Labor and Workforce Development Agency can fine you for “willfully misclassifying” an employee from $5,000 to $15,000 per violation.
- The penalty goes up to $25,000 per violation if you commit a “pattern and practice” of “willfully misclassifying” workers.
- There’s joint and several liability for consultants (but excluding practicing lawyers) who advise employers on such independent contractor engagements.
- It’s unlawful to charge misclassified independent contractors any fee or take deductions from the compensation paid to them. Companies cannot deduct fees for goods, materials, space rental, services, government licenses, repairs, etc. provided to contractors who are reclassified.
These penalties are in addition to existing penalties for misclassifying contractors. California’s Labor Commissioner can enforce the law, but Private Attorney General Act lawsuits also seem allowed. Also, if a business has willfully misclassified an independent contractor, a prominent public notice must be posted for one year on a website or worksite reciting the misclassification.
What’s Willful Misclassification?
It can be hard to tell whether someone is an independent contractor or an employee. So how do you know you won’t be labeled “willful” if it turns out you misclassified someone? ”Willful misclassification” means avoiding employee status for an individual “by voluntarily and knowingly misclassifying that individual as an independent contractor.” Does a good faith dispute over the individual’s classification mean you can’t be “willful?” It’s not clear.
WHO IS AN EMPLOYER?
Under Section 675 of the California Unemployment Insurance Code (CUIC), a business becomes an employer when it employs one or more employees and pays wages in excess of $100 during any calendar quarter. Wages are compensation for personal services performed, including, but not limited to, cash payments, commissions, bonuses, and the reasonable cash value of nonmonetary payments for services, such as meals and lodging. Once a business becomes an employer, a registration form from the DE 1 series must be completed and submitted within 15 days to the Employment Development Department (EDD). Employers are responsible for reporting wages paid to their employees and paying Unemployment Insurance (UI) and Employment Training Tax (ETT) on those wages, as well as withholding and remitting State Disability Insurance (SDI) and Personal Income Tax (PIT) due on wages paid.
WHO IS AN EMPLOYEE?
An “employee” includes all of the following:
- Any officer of a corporation.
- Any worker who is an employee under the usual common law rules.
- Any worker whose services are specifically covered by law.
An employee may perform services on a less than full-time or permanent basis. The law does not exclude services from employment that are commonly referred to as day labor, part-time help, casual labor, temporary help, probationary, or outside labor.
Who Is a Common Law Employee?
Whether an individual is an employee for the purpose of Section 621(b) of the CUIC will be determined by the usual common law rules applicable in determining an employer/employee relationship. To determine whether one performs services for another as an employee, the most important factor is the right of the principal to control the manner and means of accomplishing a desired result. The right to control, whether or not exercised, is the most important factor in determining the relationship. The right to discharge a worker at will and without cause is strong evidence of the right to control. Other factors to take into consideration are:
- Whether or not the one performing the services is engaged in a separately established occupation or business.
- The kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of a principal without supervision.
- The skill required in performing the services and accomplishing the desired result.
- Whether the principal or the person providing the services supplies the instrumentalities, tools, and the place of work for the person doing the work.
- The length of time for which the services are performed to determine whether the performance is an isolated event or continuous in nature.
- The method of payment, whether by the time, a piece rate, or by the job.
- Whether or not the work is part of the regular business of the principal, or whether the work is not within the regular business of the principal.
- Whether or not the parties believe they are creating the relationship of employer and employee.
- The extent of actual control exercised by the principal over the manner and means of performing the services.
- Whether the principal is or is not engaged in a business enterprise or whether the services being performed are for the benefit or convenience of the principal as an individual.
Another consideration relative to employment is whether or not the worker can make business decisions that would enable him or her to earn a profit or incur a financial loss. Investment of the worker’s time is not sufficient to show a risk of loss. The numbered factors above are evidence of the right to control. These factors are described more fully in Section 4304-1 of Title 22, California Code of Regulations.
A determination of whether an individual is an employee will depend upon a grouping of factors that are significant in relationship to the service being performed, rather than depending on a single controlling factor. The courts and the California Unemployment Insurance Appeals Board have held that the existence of a written contract is not, by itself, a determining factor. The actual practices of the parties in a relationship are more important than the wording of a contract in determining whether a worker is an employee or independent contractor.
Not all workers are employees as they may be volunteers or independent contractors. Employers oftentimes improperly classify their employees as independent contractors so that they, the employer, do not have to pay payroll taxes, the minimum wage or overtime, comply with other wage and hour law requirements such as providing meal periods and rest breaks, or reimburse their workers for business expenses incurred in performing their jobs. Additionally, employers do not have to cover independent contractors under workers’ compensation insurance, and are not liable for payments under unemployment insurance, disability insurance, or social security.
The state agencies most involved with the determination of independent contractor status are the Employment Development Department (EDD), which is concerned with employment-related taxes, and the Division of Labor Standards Enforcement (DLSE), which is concerned with whether the wage, hour and workers’ compensation insurance laws apply. There are other agencies, such as the Franchise Tax Board (FTB), Division of Workers’ Compensation (DWC), and the Contractors State Licensing Board (CSLB), that also have regulations or requirements concerning independent contractors. Since different laws may be involved in a particular situation such as a termination of employment, it is possible that the same individual may be considered an employee for purposes of one law and an independent contractor under another law. Because the potential liabilities and penalties are significant if an individual is treated as an independent contractor and later found to be an employee, each working relationship should be thoroughly researched and analyzed before it is established.