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If you use independent contractors, be sure you classify these
workers correctly. If you don’t, you may owe the IRS, DOL, and even
state agencies lots of money in back taxes and penalties.
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Independent contractors can provide an efficient and cost-effective
way to get work done. For example, you might hire a consultant to
install the new upgrade to your computer system or a benefits expert
to work on a new insurance proposal. Typically, these workers aren’t
on your payroll; they are self-employed. As a result, you don’t have
to pay taxes, benefits, or cover them for unemployment or workers’
compensation. But if you classify these workers incorrectly, you may
find that your organization owes thousands of dollars in back taxes,
overtime, and penalties.
Advantages of
Independent Contractors
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Clearly, there are many advantages to using independent contractors.
First, if you have a special project that requires a level of
expertise none of your employees have, hiring a consultant to do the
work can jump-start the project and ensure it is completed
correctly. In addition, using independent contractors gives
employers more flexibility to "staff up" or cut back, without
incurring the costs of hiring or layoffs. Because independent
contractors are not considered your employees, the organization does
not have to pay taxes on their behalf or allow them to participate
in any benefits plans. Also, they typically are not covered under
state workers’ compensation or unemployment compensation statutes;
they are not entitled to overtime under wage and hour laws; they
cannot sue under discrimination statutes; and they cannot take leave
under the Family and Medical Leave Act.
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Misclassification Costs
Big Money
There is a downside to using independent contractors, however. If
you miscategorize an employee as an independent contractor, you may
face claims under the many laws that protect employees. The agencies
that enforce these laws aggressively pursue claims against employers
that misclassify employees as independent contractors. Both the
Department of Labor (DOL) and the
Internal Revenue Service (IRS) have collected millions in back taxes
and penalties from employers that incorrectly categorized employees
as independent contractors.
Classify Correctly;
Know the Standards
So, how do you prevent misclassification? Answering that question is
particularly tricky since three different standards commonly are
used by the courts and agencies to determine independent contractor
status: (1) the IRS 20-factor analysis, for coverage under federal
withholding requirements; (2) the "economic reality" test, used to
determine compliance with requirements of the Fair Labor Standards
Act (FLSA); and (3) the common law "right to control" test, used by
many courts to administer discrimination and benefits statutes.
These three tests, discussed below, share several common factors,
the most important of which is the amount of control the employer
exercises over the work relationship.
The IRS 20-Factor Test
The IRS considers the existence of an employer-employee relationship
to depend on whether the worker is subject to the will and control
of the employer, based on the following factors:
1.
Instructions. Employees typically must follow instructions as to
when, where, and how to perform the job.
2.
Training. Requiring training supports employee status.
3.
Integration. Integration of the worker’s services into the business
operations suggests that the hirer directs and controls the worker.
4.
Services rendered personally. If services must be rendered
personally by a specific worker, the hirer controls the methods used
to complete the work.
5.
Control of assistants. Control by the hirer over the hiring,
supervision, and pay of assistants implies employee status.
6.
Ongoing relationship. A continuing relationship suggests that an
employer-employee relationship exists.
7. Set
hours of work. The establishment of set hours by the hirer implies
control over the worker.
8. Full
time work. A worker who must devote full working time to the hirer
is being controlled.
9. Work
on hirer’s premises. On-premises work indicates employer control,
especially when the work could be done elsewhere.
10.
Order or sequence. Work that must be performed in an order or
sequence established by the hirer suggests control.
11.
Reports to hirer. A requirement that the worker submit regular oral
or written reports to the hirer implies control.
12.
Payment method. Payment by the hour, week, or month generally
indicates an employer-employee relationship. Payment by the job or
commission indicates independent contractor status.
13.
Payment of expenses. Payment of the worker’s business or travel
expenses suggests an employer-employee relationship; the hirer is
regulating and directing the worker’s activities.
14.
Furnishing tools, materials. Provision of tools, materials, and
other equipment by the hirer shows an employer-employee
relationship.
15.
Significant investment. Independent contractor status is implied if
the worker invests in the facilities used for the work. Absence of
investment indicates an employer-employee relationship.
16.
Realization of profit or loss. A worker who can realize a profit or
suffer a loss as a result of providing services is usually an
independent contractor.
17.
Serving more than one firm. A worker who provides services to
several unrelated firms at the same time generally is an independent
contractor.
18.
Serving the public. A worker whose services are regularly available
to the general public is an independent contractor.
19.
Right to discharge. The right of the hirer to discharge the worker
at any time is a factor indicating an employer-employee
relationship. But, an independent contractor may not be fired if his
result meets contract specifications.
20.
Right to quit. A worker with the right to terminate the relationship
with the hirer at any time without liability is generally an
employee.
The
presence or absence of any one of the 20 factors is not
determinative or conclusive; rather the IRS will consider all of the
factors affecting the relationship.
The FLSA Analysis
The DOL uses the "economic realities test" to determine coverage
under, and compliance with, the minimum wage and overtime
requirements of the FLSA. The following are among the factors
considered by the DOL: (1) the degree of control exercised by the
hiring party over the manner in which the work is performed; (2) the
relative investments by the hiring party and the worker in materials
and equipment; (3) the degree to which the worker’s opportunity for
profit and loss is determined by the hiring party or the worker’s
own managerial skill; (4) the skill and initiative required in
performing the job; (5) the permanency of the relationship; and (6)
whether the service is an integral part of the hiring party’s
business.
Common Law "Right to
Control" Test
The
common law "right to control" test is used by courts to determine
employee status in various types of cases, including employment
discrimination and benefit cases, tax cases, and tort (wrongful act)
liability cases. The common law test, as applied by the courts,
includes the following ten factors: (1) the extent of control which,
by agreement, the hiring party may exercise over the hired party;
(2) whether the hired party is engaged in a distinct occupation or
business that is usually done by a specialist without supervision;
(3) how the worker’s helpers are hired and whether they are paid by
the hiring party or the worker; (4) the skill required in the
particular occupation; (5) who supplies the means, tools, and place
of work; (6) the length of time for which the person is hired; (7)
the method of payment, whether by time or the job; (8) whether the
work is part of the regular business of the hiring party; (9)
whether the parties believe they are creating an employment
relationship; and (10) whether the hired party is an actual business
entity.
Five Simple Steps Towards Compliance
A few simple steps can protect your organization against
misclassifying employees. First, make sure you understand the
various tests and apply them to each independent contractor
relationship. It is not enough to meet the standards of one of the
tests. You could face a challenge from one agency that results in an
investigation by another, so you should try to comply with all of
the factors.
Second,
enter into a contractual agreement with the worker that explains the
independent contractor relationship. The contract will help show
what both the hiring party and the worker understood and in-tended
the relationship to be. However, the contract by itself is not
determinative; the worker still must meet all independent contractor
criteria. Third, use independent contractors that are set up as
separate business entities. In addition, if you are using an
independent contractor to perform a job that is also performed by
current employees, consider carefully whether the independent
contractor really meets the criteria. Courts and administrative
agencies are less likely to accept the classification if the
independent contractor is doing the same job as employees. Finally,
be particularly careful if you have an employee who works two jobs
for you, and you classify the second position as an independent
contractor. This action may raise a red flag.
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