Businesses often find it advantageous to hire independent contractors to perform a variety of duties in place of employees. Using independent contractors can reduce expenses for payroll taxes and benefits, avoid the impact of laws like the Fair Labor Standards Act (FLSA) and the Family and Medical Leave Act (FMLA), and arguably make it easier and less risky to terminate the relationship. However, in their quest to gain those advantages, employers sometimes misclassify employees as independent contractors, which creates significant potential liability.
For example, businesses that misclassify employees can face tax liability for failing to withhold payroll taxes. The IRS has become much more aggressive in questioning workers’ independent contractor status for tax purposes in recent years, especially in the building and construction industry. If the IRS questions the status of a particular individual, the employer will likely be asked to complete an SS-8 form, which requests information that the agency uses to make its determination. You must timely submit the completed form with your supporting information or risk an adverse finding.
The IRS generally uses the following factors in determining whether a worker is an independent contractor:
Behavioral control involves facts that show whether the business has a right to direct or control how the work is done, through instructions, training, or other means. The IRS looks at:
- the type of instructions given to workers, including when and where work is to be performed, the tools/equipment that must be used, whether the worker purchases his own supplies, and instructions on the order in which tasks are performed;
- the detail and degree of the instructions, as a means of determining how much control is exercised over the worker;
- evaluations, including whether the employer measures the worker’s performance or just the end result; and
- training, including whether the worker is trained to do the job, whether the training is periodic or ongoing, and whether the training is mandatory.
Financial control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker’s job. This includes:
- the extent to which the worker has unreimbursed business expenses;
- the extent of the worker’s investment in the facilities used in performing the services;
- the extent to which the worker makes his services available to the relevant market (e.g., does he also perform work for unrelated businesses?);
- how the business pays the worker; and
- the extent to which the worker can realize a profit or incur a loss.
Type of relationship covers facts that show how the parties perceive their relationship. This includes:
- written contracts describing the relationship the parties intended to create;
- the extent to which the worker is available to perform services for similar businesses;
- whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay;
- the permanency of the relationship; and
- the extent to which services performed by the worker are a key aspect of the regular business of the company.
Statutes such as the FLSA and the FMLA have slightly different procedures for determining independent contractor status. One thing the various laws’ tests have in common is that they all look at a number of factors, none of which are dispositive, or conclusive. Also, the fact that a worker agrees to be hired as an independent contractor and even signs a contract isn’t dispositive. The worker’s day-to-day duties and relationship with the business will determine whether she is truly an independent contractor.
Using independent contractors to perform certain tasks may make good business sense in some situations, but employers should carefully examine the nature of the work and the relationship with the worker before treating him as an independent contractor. You will face substantial liability if the worker is misclassified.