Misclassifying Employees as Independent Contractors ... One of
the Most Expensive Mistakes of Them A
DETERMINING WHETHER JOE IS EMPLOYEE OR INDEPENDENT CONTRACTOR
Unfortunately, as far as the various government agencies are
concerned, there is not one single test that determines whether
Joe is your employee or an independent contractor. Even more
difficult, it is quite possible that for the purposes of one
government agency Joe is considered to be an independent
contractor while for another he is treated as an employee.
=> The IRS/Common Law "Control" Test
The IRS follows the common law "control" test for determining
whether someone is an employee or independent contractor. This
test looks at 20 factors as being indicative (and only
indicative) of whether the person is an employee or independent
contractor. The test basically involves a balancing of these
factors -- which way does the scale tip?
Here are the IRS factors:
1. Whether the worker can earn a profit or suffer a loss from
the activity (if so, the more likely it is that the worker is an
independent contractor). 2. Whether the worker is told where to
work (indicative of employee status). 3. Whether the worker
offers his or her services to the general public (indicative of
independent contractor status). 4. Whether the worker can be
fired by the hiring firm. 5. Whether the worker furnishes the
tools and materials needed to do the work (indicative of
independent contractor status). 6. Whether the worker is paid by
the job or by the hour (independent contractors are more likely
to be paid by the job; employees by the hour). 7. Whether the
worker works for more than one firm at a time (indicative of
independent contractor status). 8. Whether the worker has a
continuing relationship with the hiring firm (indicative of
employee status). 9. Whether the worker invests in equipment and
facilities (indicative of independent contractor status). 10.
Whether the worker pays his or her own business and traveling
expenses (indicative of independent contractor status). 11.
Whether the worker has the right to quit without incurring
liability (indicative of employee status). 12. Whether the
worker receives instructions from the hiring firm (indicative of
employee status). 13. Whether the worker is told how to perform
the work (indicative of employee status). 14. Whether the worker
receives training from the hiring firm (indicative of employee
status). 15. Whether the worker performs the services
personally. 16. Whether the worker hires and pays assistants
(indicative of independent contractor status). 17. Whether the
worker sets his or her own working hours (indicative of
independent contractor status). 18. Whether the worker provides
regular progress reports to the hiring firm. 19. Whether the
worker works full-time for the hiring firm (indicative of
employee status). 20. Whether the worker provides services that
are an integral part of the hiring firm's day-to-day operations
(indicative of employee status).
It is important to note that none of the above factors are, of
themselves, determinative. The IRS will balance all of the
factors to determine which side of the equation is favored.
=> Other Agencies
The other government agencies with which you need to be
concerned are:
1. Your state Unemployment Compensation Board. 2. Your state
Workers' Compensation Insurance Agency. 3. Your state Tax
Department. 4. Your state/federal Department of Labor.
Unfortunately each state agency varies in its approach to
determining whether a worker is an employee or independent
contractor. Many states' agencies use a statutory test focusing
on just a few of the "control" test factors. You should
therefore find out the factors that your state's agencies take
into account before hiring any independent contractors. Most of
this information will be available on the agency's website. If
not, call them and get them to send you information about their
policies.
PROTECTING YOURSELF
OK, so you know the difference between an independent contractor
and an employee, you know the advantages and disadvantages of
hiring independent contractors and you know the dangers of
misclassification. How do you protect yourself?
=> Independent Contractor Agreement
First and foremost, arm yourself with the IRS' control test
factors and the tests used by the various government agencies in
your state. Once you have that information, you can structure
your arrangements with your independent contractors accordingly.
These arrangements should be reduced to writing, in the form of
an independent contractor agreement.
An independent contractor agreement should contain a description
of the services the independent contractor is to perform, by
when they are to be performed and the amount the independent
contractor is to receive in return for satisfactory service.
This agreement can be very helpful evidence in proving that the
worker's status was independent contractor rather than employee.
Although such an agreement is insufficient by itself (if you
nonetheless treat the independent contractor as an employee the
agreement will be worthless for this purpose), if the factors
weighed by the IRS under the control test are evenly balanced,
an independent contractor agreement may well tip the scales in
your favor.
=> Screening
Before hiring an independent contractor, put him or her through
a few hoops first. It's a good idea to prepare some form of
questionnaire to extract the sort of information you would need
to be able to prove in support of your argument that the worker
is, in fact, an independent contractor and not an employee.
Examples of such information (courtesy of the NOLO website -
http://www.nolo.com) include:
1. Whether the worker has formed a legal entity for his or her
business. 2. Whether the worker has filed a fictitious business
name (also known as a "DBA" or "doing business as"). 3. The
worker's business address and telephone numbers. 4. The number
of employees employed by the business. 5. Whether the worker has
any professional or business licenses. 6. References from other
business for whom the worker has performed services as an
independent contractor. 7. How the worker markets his or her
business. 8. Whether the worker maintains an office separate
from his or her home. 9. A description of the equipment and
facilities the worker owns and will use in the project. 10.
Whether the worker has business cards and stationery etc.. 11. A
listing of the types of insurance coverage the worker has for
his or her business.
Request documents that evidence the responses to the above
questions. For example, get copies of fictitious business name
statements, professional and business licenses; references;
business cards and stationery and insurance policies.
At the end of the day, whether you hire an employee or an
independent contractor is a decision for you and your business.
If you feel you can adequately protect yourself against an
allegation of misclassification then, by all means, follow the
independent contractor route if that makes most sense to you.
But if you don't feel confident in managing the relationship to
protect yourself from such a charge, for your own peace of mind,
you may be well advised to hire an employee even if that is more
expensive up-front. After all, if you get it wrong, you'll be
paying those additional costs anyway in the form of back-taxes
(and interest and penalties to boot).