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Correctly Classifying a Worker as an Independent Contractor

by Tracey A. Cullen

It’s no news flash that companies must proceed with caution when classifying someone who provides them with services as an independent contractor. Independent contractors are paid flat fees without tax deductions or employment taxes. Employees are paid salaries subject to withholding, FICA, FUTA, and other employment taxes and are protected under myriad employment laws. It’s vital to understand the factors for determining how to classify a worker as an employee or an independent contractor and what to do if you suspect a worker has been misclassified ― before any lawsuits begin.

HR Guide to Employment Law: A practical compliance reference manual covering 14 topics, including overtime and FLSA requirements

Pitfalls of misclassification
Classifying a worker as an independent contractor rather than an employee allows businesses to compensate their workers without withholding federal, state, and social security taxes and to avoid paying workers’ compensation insurance, unemployment insurance, and employment taxes. Independent contractors aren’t entitled to benefits a company may provide to its employees, including health insurance, paid vacation time, life insurance, disability insurance, stock options, and 401(k) retirement plans.

Why does it matter what your company chooses to call a worker? A number of recent cases have held that employers that classified their workers as independent contractors were wrong. The courts found that the workers were really employees, and the employers were required to pay back taxes, overtime, and various fines and penalties.

How to classify workers
Business owners may genuinely believe that someone is an independent contractor rather than an employee. Proper classification depends on the degree of supervision, direction, and control exercised over the worker, not only in regard to the results but also to the means, manner, and methods of the services provided. Courts in New York have found that no single factor or group of factors will conclusively define whether a worker should be classified as an employee or an independent contractor, and specific definitions vary under federal and state statutes and regulations.

It may help your company if a worker has signed a contract indicating that he’s an independent contractor and agreeing that’s his status. Although a written agreement is helpful in determining whether a classification was appropriate, a contract alone will not save the day or transform an employer-employee relationship into something else.

It’s crucial to conduct a self-audit to determine if independent contractor classification is appropriate. Employers that are found to have violated the state labor laws will be required to pay back taxes, back wages, and unpaid workers’ comp and unemployment premiums. And depending on which law was violated as well as whether the violation was willful, there’s a potential for additional liability.

Evaluate your polices and practices with the Employment Practices Self-Audit Workbook

Federal government steps in
Like some states, the federal government also is bearing down on misclassification. In May 2007, the IRS announced that worker classification cases will be a “major area of emphasis” in 2008. The Government Accountability Office estimates that misclassification cost the federal government $4.7 billion in income taxes in 2006. Testimony presented before a House education and labor subcommittee on March 27, 2008, indicated that employer misclassification costs the federal government more than $3.3 billion annually.

Similar to what some states have done with interagency communications, the IRS is sharing information with several federal agencies, including the U.S. Department of Labor (DOL), as well as workforce agencies that administer state employment and unemployment taxes in California, Michigan, New Jersey, and North Carolina. The agencies send each other leads about businesses that have misclassified workers.

In December 2007, the IRS announced that it has developed a new form for employees who were misclassified as independent contractors by their employer. Form 8819 is used to calculate and report an employee’s share of uncollected social security and Medicare taxes when the employer didn’t withhold those taxes. Using Form 8819 ensures that an employee’s social security and Medicare taxes are credited to her social security record.

DOL investigations into misclassification appear to be on the rise, as well. On March 25, the department announced that a Texas company that provides water transfer services for the natural gas industry had agreed to pay nearly $600,000 in back wages to 237 employees. The DOL investigation revealed that workers had been improperly classified as independent contractors for a two-year period and therefore weren’t properly paid for overtime hours they worked.

Learn more about classifying workers and other wage and hour issues with the Wage and Hour Compliance Manual

What to do if you’re concerned about misclassification
What can your business do if you determine any of your workers should have been classified as employees rather than independent contractors? You have several options: You can do nothing, you can reclassify the workers as employees, or you can retain their status as independent contractors but restructure their relationship within your business.

A company that elects to bury its head in the sand and do nothing faces a litany of legal issues, including the potential for punitive damages under certain statutes (if it was aware of the violation but did nothing). That is not a recommended course of action. The longer you wait to change workers’ status, the more likely the violation will be found “willful,” which is what triggers punitive damages. A wiser course is to make corrections as soon as possible.

If you want a worker to legitimately maintain independent contractor status, you can restructure his relationship with your company. The job can be restructured to ensure the factors for determining whether an individual is an independent contractor are actually met. For instance, you can make sure the worker determines when, where, and how his services will be performed, negotiates his own rate of pay, and reports his own salary.

If you don’t already have one, you should create an independent contractor agreement. Styled in the form of a contract, your agreement should describe the services to be provided, confirm independent contractor status, delineate the worker’s fee and invoicing procedure, and set forth the procedure for terminating his services. The agreement should also state that your arrangement isn’t exclusive, and the worker is free to perform services for other businesses.

Consult with an attorney or law firm with a substantial labor and employment practice if you’re concerned about whether you’ve properly classified your workers.

Audio Conference: Misclassification Myths: Are Your Workers Really Independent Contractors?

Bottom line
To ensure proper classification, familiarize yourself with the indicators of employer control and independent contractor status, and conduct a self-audit of your workforce to ensure you’re operating in full compliance with applicable law. The most important factor in determining whether you have an employment relationship with someone generally is who has the right to control the manner and means by which the tasks are completed. A business seeking to legitimately classify a worker as an independent contractor should leave as much control as possible in the worker’s hands.

Did you know…
Whether it’s done deliberately or inadvertently, employers that improperly classify workers as independent contractors evade:

  • federal and state labor and employment laws;
  • federal and state tax laws;
  • minimum wage laws;
  • overtime laws;
  • prevailing wage laws;
  • unemployment insurance taxes;
  • workers’ comp premiums;
  • temporary disability insurance laws;
  • wage payment laws;
  • income tax laws; and
  • contribution to social security and Medicare taxes.