Editor’s note: Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees and investors. Jeremy Sayre’s practice focuses on employment counseling and employment litigation.
RALEIGH — The financial advantages of using independent contractors (as opposed to traditional employees) are unmistakable. Under the federal wage and hour laws, many employees are subject to overtime and minimum wage requirements, while independent contractors are eligible for neither. Further, unlike employees, independent contractors generally are not eligible for employee benefits such as vacation, health insurance, and retirement plans. Businesses also do not have to make FICA contributions, withhold income taxes, worry about workers’ compensation, or pay unemployment insurance, social security, or Medicare taxes. Finally, independent contractors generally are not covered by employment discrimination statutes and are not eligible for leave under the Family and Medical Leave Act.
An Employee by Any Other Name Is Still an Employee
For the above and other reasons, using independent contractors can have significant benefits for the bottom line. It is important, however, to understand the guidelines used by the federal government when it determines which persons providing services to your business actually qualify as independent contractors. The guiding principle to remember is: Control, and who has it, is the key. Independent contractors are in business for themselves and therefore have the right to control how they will accomplish the task they have been retained to perform. The principal (the one who retains the contractor) has rights only to the ultimate result of the independent contractor’s work, not to the means and methods used to accomplish the result.
U.S. Department of Labor
Unfortunately, beyond the basic "control" test, there is no single, uniform test to determine who qualifies as an independent contractor. The U.S. Department of Labor uses the "Economic Realities" test. The crux of this test is whether the worker is economically dependent upon the business for which he or she works, based on six factors:
- The nature and degree of the control the business has over the way in which the worker is to perform the work (the greater the actual or permitted control, the more likely the worker is an employee);
- The opportunity the worker has to make a profit or the risk of experiencing a loss (the profit/loss risk signifies independent contractor status);
- The investment (or lack thereof) in the materials, equipment, and job supplies necessary to perform the work (investment weighs in favor of independent contractor status);
- The ability of the worker to hire, directly, others to assist him in the job (such ability weighs in favor of independent contractor):
- The degree of skill and independent initiative required (these qualities are indicative of independent contractors);
- The expected duration of the working relationship (workers engaged for an indefinite or long period of time are more likely to be classified as employees); and,
- The extent to which the work is an integral part of the business’s practices (workers retained to perform a function traditionally performed by regular employees are more likely to be classified as employees).
U.S. Internal Revenue Service
Until recently, the IRS used the so-called "Twenty Factor" test to evaluate independent contractor status. Following many pleas from labor and business groups (and a little pressure from Congress), the IRS attempted to simplify and refine this test, consolidating the 20 factors into three categories: behavioral control, financial control, and the type of relationship. "Behavioral control" focuses on whether the business has a right to direct and control how the worker performs the task for which he or she is retained. The IRS will look at the type and degree of instructions and training that the business gives to the worker. Evaluation of "financial control" considers whether the business has a right to control the business aspects of the worker’s job. Here the IRS will consider how the worker is paid (e.g., a guaranteed salary versus a flat fee), and whether the worker has made any significant investment in the work. In addition, the IRS will evaluate the extent to which:
- The worker has unreimbursed business expenses;
- The worker’s services are available to other businesses; and
- The worker can realize a profit or loss.
Finally, the IRS will explore the "type of relationship" between the business and the worker, looking to whether the parties have entered into a written contract describing the relationship, whether the business provides the worker with employee-type benefits (for example, insurance, vacation, and retirement benefits), and whether the services performed by the worker are a key aspect of the regular business of the company. In evaluating the type of relationship, the IRS also will consider the permanency of the relationship, recognizing that employees generally are employed indefinitely and independent contractors more likely are to be retained for a specific project or time period.
What Happens if the Business Gets It Wrong?
Unfortunately, many businesses operate under the faulty assumption that it is sufficient if the business and the contractor mutually desire and agree to classify the worker as an independent contractor. The Internal Revenue Service and the U.S. Department of Labor, however, do not operate under this assumption, and courts regularly ignore or reject so-called independent contractor agreements that expressly designate workers as independent contractors. Misclassifying employees as independent contractors can prove to be very expensive. Potential liabilities include:
- Payment of back pay and overtime compensation going back for a period of at least two years, and an equal amount of what the law refers to as "liquidated" damages;
- Payment of the full amount of the employee’s income tax which should have been withheld, both the employer and the employee’s portions of the FICA tax, plus a substantial penalty; and
- Liability for attorneys’ fees, criminal sanctions, and other penalties against the employer and, if the employer is an entity, against its corporate officers personally.
Even more frightening is what a misclassification can mean for your employee benefit plans. The most publicized example of this risk involved Microsoft Corporation, which settled a class action lawsuit for $96.9 million. Microsoft hired "freelancers" to work on specific projects. The workers entered into written agreements labeling them independent contractors and disavowing any employee benefits. However, the freelancers worked alongside regular Microsoft employees, shared the same supervisors, worked the same hours, and performed identical functions. Following a tax audit, the IRS found that the workers qualified as common-law employees and not independent contractors. Subsequently, a federal court ruled that Microsoft should have offered the same benefits to the freelancers as it provided to its employees, including participation in Microsoft’s 401(k) and employee stock purchase plans.
Strategies for Successful Independent Contractor Agreements
While the IRS test acknowledges that a written "independent contractor" agreement designating a worker as an independent contractor is a step in the right direction, it is not, alone, enough. If properly prepared, however, this written agreement will require the parties to consider and address the appropriate factors. For example, the written agreement should include provisions which:
- Require the worker to certify that he or she has the requisite skill, experience, and training necessary to perform the services without need for training by the hiring organization;
- Explain that the manner of performing the work (including the work location and schedule) is the exclusive province of the worker;
- Establish a clear payment schedule based on results, and classify all amounts paid as fees (not a salary or wage);
- Confirm that the worker is responsible for ensuring compliance with IRS requirements, and that the hiring organization will not withhold or pay any income or employment taxes;
- Confirm that the worker is to provide his or her own supplies and will be responsible for his or her costs;
- Confirm that the worker is entitled to none of the traditional benefits afforded to regular employees, and that the business will not be maintaining workers’ compensation insurance or any other similar type of insurance; and,
- Clearly define the term of the relationship, which should coincide with the conclusion of the work or, where more appropriate, an absolute length of time (the shorter, the better); and
- Require the transfer or ownership of all intellectual property created during the work.
Using independent contractors can be an effective way to minimize costs and increase the efficiency of your business. Because of the severe consequences of incorrectly classifying an employee as an independent contractor, however, you must be careful to consider the various tests and limitations in reaching an agreement with the worker. Although helpful, a written agreement to work as an "independent contractor" is less important than the actual working relationship. What matters most is whether the worker satisfies the appropriate test.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees and investors. Jeremy Sayre’s practice focuses on employment counseling and employment litigation. Comments or questions can be sent to firstname.lastname@example.org.