The Benefits of Retaining Independent Contractors

In addition to basic monetary benefits, the ability to hire independent contractors allows employers to swiftly react to changes in business needs and the demands of the marketplace. In addition, independent contractors usually possess some type of specialized knowledge and expertise.

With all of these benefits, it is easy to see why many employers go out of their way to classify individuals as independent contractors. It is important to note, however, that what matters is not so much whether the parties believe an independent contractor relationship exists, but whether the individual is considered an independent contractor under the various tests defined under state/federal law and government enforcement agencies.

Determining Independent Contractor Status

While the number of factors change depending upon the test applied, all tests used by federal and state authorities focus on the alleged employer’s right to control the individual in the performance of the task(s) or job(s) for which he/she is retained. The federal Fair Labor Standards Act (FLSA) establishes minimum wage, overtime pay, recordkeeping, and child labor standards affecting full- time and part-time workers in the private sector and in Federal, State, and local governments. Many of the standards established by the FLSA apply only to employees (as opposed to independent contractors). The U.S. Department of Labor (citing the view of the U.S. Supreme Court) has stated that there is no single rule or test for determining whether an individual is an independent contractor or an employee for purposes of the FLSA. Instead, it is the “total activity or situation” which controls.

Among the factors considered significant are:

• 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 required for the success of the claimed independent contractor, and
• The degree of independent business organization and operation.

The IRS is the government agency responsible for determining whether an individual is an employee or independent contractor for the purposes of federal employment taxes. The IRS formerly utilized a “20 Factor Test,” but simplified the rules in 2006 and now focuses on three specific areas:

• Behavioral Control, which focuses on whether the contracting company has retained the right to direct and control how the individual performs the task for which he or she is engaged
• Financial Control, which focuses on facts that show whether the contracting company has the right to control various different business aspects of the individual’s job, and
• Type of Relationship, which looks at other indicia that tend to demonstrate the type of relationship (i.e., whether a written contract/agreement describes the relationship they intended to create, whether the individual receives employee-type benefits, the permanency of the relationship, and the extent to which services performed by the individual are a key aspect of the regular business of the company).

The Importance of a Well Drafted Independent Contractor Agreement

Although government agencies (such as the IRS and U.S. Department of Labor) and courts look beyond the agreements in determining whether an individual is an employee or an independent contractor, a well drafted agreement is vital to defending your independent contractor classifications.

A well drafted independent contractor agreement defines the relationship between the alleged employer and consultant as that of a “business to business” relationship, as opposed to that of an “employee and employer.” This agreement should set forth the specific services to be performed (including fee and term) and reinforce the independent relationship between you and the individual.

The Risks of Misclassifying Employees

The main risk associated with misclassifying individuals is that a governmental agency will take action and determine that your independent contractor is really an employee.

The IRS frequently audits companies which retain large numbers of independent contractors. In addition, an “individual non-employee taxpayer” who reports more than $10,000 in earned income from a single source or who earns the majority of his/her income from a single source may attract the attention of the IRS. An individual’s claim against a denial of benefits often triggers investigations and audits by state workers’ compensation and unemployment authorities. Likewise, an individual’s claim for wages and/or overtime under the FLSA could result in the federal Department of Labor uncovering misclassifications. Misclassifying employees as independent contractors can result in investigations and audits by these governmental agencies, which may subject your business to:

• income tax liability and penalties for amounts that should have been withheld from the wages of the individual
• social security and unemployment taxes
• overtime pay and other wage claim liability
• unemployment insurance payments
• workers’ compensation insurance premium, as well as potential legal liability for workplace injuries, and
• other civil and criminal liabilities.

Employers must be very careful when retaining independent contractors. While there are numerous advantages to using independent contractors, the risks associated with misclassification are substantial and should be taken seriously.