INDEPENDENT CONTRACTORS Traditionally, the IRS had used a 20-factor test to classify workers, but the cumbersome test often provided little guidance to businesses. In the late 1990s, Congress, labor and business interests pressured the IRS to produce a new test. In 2009, the IRS issued a simpler test listing 10 factors grouped into three categories: behavioral control, financial control and the type of relationship between the parties. Behavioral control Facts that show whether the business has a right to direct and control how the worker does the task for which he or she is hired include the type and degree of: Instructions the business gives the worker. An employee is generally subject to the business s instructions about when, where and how to work. The following are examples of those types of instructions: When and where to do the work What tools or equipment to use What workers to hire or to assist with the work Where to purchase supplies and services What work must be performed by a specified individual What order or sequence to follow The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker s performance or instead has given up that right. Training that the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods. Financial control Facts that show whether the business has a right to control the business aspects of the worker s job include: The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services they perform for their business. The extent of the worker s investment. An employee usually has no investment in the work other than his or her own time. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. However, a significant investment is not necessary for independentcontractor status. The extent to which the worker makes services available to the relevant market. An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location and are available to work in the relevant market.
How the business pays the worker. An employee is generally guaranteed a regular wage for an hourly, weekly or other period of time. This usually indicates that a worker is an employee, even when the wage or salary is supplemented by a commission. An independent contractor is usually paid a flat fee for the job. However, it s common in some professions, such as law, to pay independent contractors hourly. The extent to which the worker can realize a profit or loss. Since an employer usually provides employees a workplace, tools, materials, equipment and supplies needed for the work, and generally pays the costs of doing business, employees do not have an opportunity to make a profit or loss. An independent contractor can make a profit or loss. Type of relationship Facts that show the type of relationship the parties have include: Written contracts describing the relationship the parties intended to create. This is probably the least important of the criteria, since what really matters is the nature of the underlying work relationship, not what the parties choose to call it. However, in close cases, the written contract can make a difference. Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay or sick pay. The power to grant benefits carries with it the power to take them away, which is generally exercised by employers over employees. A true independent contractor will finance his or her own benefits out of the overall profits of the enterprise. The permanency of the relationship. If the business engages a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship. The extent to which services performed by the worker are a key aspect of the regular business of the company. If a worker provides services that are a key aspect, it s more likely that the business will have the right to direct and control his or her activities. For example, if a law firm hires an attorney, it will likely present the attorney s work as its own and have the right to control or direct that work. This would indicate an employer-employee relationship. WATCH STATE LAWS Don t overlook state laws, which may provide more protection for independent contractors. While the IRS is largely concerned with the issue of who collects and who pays taxes on earnings, states have different interests to protect. Thus, some states may prefer for some contractors to be considered employees under the IRS rule. For example, workers compensation insurance covers employees injured on the job. If an independent contractor is injured, it may be the state that ends up picking up the tab for medical treatment and rehabilitation. Therefore, it s in the state s interest to consider the independent contractor as an employee. The same is true for unemployment compensation. Check with your state s labor department to see if stricter rules apply. If so, be sure to structure your independentcontractor relationship to comply. Generally, those states that set higher standards concentrate on three factors: whether the contractors are free from control over their work, have an off-site place of business and have an independently established business and customers. Although these criteria seem remarkably simple compared to the IRS common-law test, the states require that all three conditions be fully satisfied. To further complicate the issue, IRS standards for employees may differ from those of the Department of Labor. The FLSA defines employ to mean to suffer or permit to work (29 USC 201 3 (g)) and defines an employee as any individual employed by an employer. The FLSA has a lengthy list of exceptions to this rule but doesn t specifically exclude independent contractors. Nor does it specifically adopt the
IRS framework for defining employees. A reclassification of em-ployees by either the DOL or a state agency often leads to an IRS investigation. When hiring a contractor, you are less likely to be entangled in federal anti-discrimination laws, such as Title VII and the ADA. However, state laws in your area may supersede the federal statutes and extend discrimination protection to contractors. In addition, if your company is a federal contractor or subcontractor, you must comply with most of these laws. THE IRS NEW ATTITUDE Besides shifting gears on the 20-factor test discussed earlier, the IRS now has the burden of proof when it interrogates an employer about its worker classifications. Before the Small Business Job Protection Act of 1996, the onus was on the employer to prove that the individual did not qualify as an employee. But the new law does prohibit employers from relying on a prior audit to validate the classification unless the audit specifically examined the worker s status. Section 530 relief Under revised IRS training manual guidelines, IRS agents must inform you of your so-called Section 530 relief. The law provides you with immunity from back employment taxes if the IRS reclassifies your contractors as employees. However, employment law experts say many employers miss out on the tax break because IRS agents fail to explain it fully. If an agent does not provide you with a copy of IRS Publication 1976 (05-07), he or she is breaking the rules. While Section 530 does provide for back tax relief, the IRS will still require you to convert those workers to employees and begin paying payroll taxes. To be eligible for Section 530 relief, employers must prove that they: Had a reasonable basis for treating the workers as -independent contractors. Regularly filed a Form 1099 for each worker. Consistently classified all workers with similar jobs as independent contractors never as employees. New IRS initiatives have also cut the tax liability from three years to one year for employers who misclassify workers. And in an effort to convince offenders to confess their misclassification of workers, the IRS launched a clemency program in 1996 whereby employers may be able to escape liability for back taxes if they agree to reclassify their workers. This applies only if firms notify the IRS before they are audited. Form SS-8: Inviting a ruling Despite these steps to simplify the process, many employers still find it daunting to classify their workers. The IRS attempts to streamline the classification test have not eliminated the complexity. Case in point: Form SS-8, Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding. Employers who submit this completed four-page form receive a written ruling from the IRS on whether an individual qualifies as an independent contractor. Revised in 2014, it remains a long, detailed and somewhat ambiguous document. Form SS-8 is designed as a checklist so that employers (or workers) can answer a series of questions based on the 20-point test, but the form leaves room for different interpretations. In some cases, angry workers who think their employers misclassified them as independent contractors will file Form SS-8 to clarify their status. Although the individuals will receive an IRS ruling, they will also probably irritate their employer for attracting the IRS attention.
CONTRACTS: YOUR MOST IMPORTANT PROTECTION Your contract with an independent contractor establishes payment rates and methods, the nature of the work to be completed, the deadline for completing the job and performance standards. No matter how casual the relationship or how well you know the contractor, you should always have a signed contract describing the work to be done. Why? It helps establish that your intent was to hire the individual as a contractor, not an employee. The contract won t prove a bona fide contractor relationship existed, but the lack of a contract makes it extremely difficult to prove such a relationship existed. It offers you protection should the contractor s work be unacceptable in some way. If a disgruntled contractor sues you and there s nothing in writing, it s up to the court to decide whether the terms of the contract were met. Most reliable contractors will insist on a contract. After all, the contract represents the freelancer s best protection as well. Remember: Although the contract affirms your intent to hire the individual as a contractor and not as an employee, an IRS inquiry would focus on how the contractor performed his work. Thus, the safest course is to ensure that your company s supervisors understand that they must produce a quality end product with only minimum involvement with contractors. Courts may overlook the contract Even if you draft a contract that classifies workers as independent contractors and they sign it, you re not home free. If the workers challenge their status, a court may care less about the contract they signed and more about the actual terms of the work relationship. FedEx found this out the hard way. In 2005, a California trial court ruled that FedEx s delivery drivers were employees because the company exercised close to absolute actual control over the drivers. In fact, the court described FedEx s operating agreement the basis of the company s defense, as a brilliantly drafted contract creating the constraints of an employment relationship with [the drivers] in the guise of an independent contractor model. The court awarded $5 million in damages. A Superior Court affirmed, ruling, The drivers look like FedEx employees, act like FedEx employees, are paid like FedEx employees and receive many employee benefits. The judge added: If it looks like a duck, walks like a duck, swims like a duck, and quacks like a duck, it is a duck. To date, the courts have awarded more than $14 million in damages in that case. More than 27,000 drivers in 19 states eventually joined class action lawsuits over the company s driver classification. FedEx eventually agreed to settle those cases for $228 million in 2015. The IRS originally hit FedEx with a $319 million tax assessment for improperly classifying 12,000 of its drivers as independent contractors. But in 2009, the IRS backed off the assessment and allowed the workers to be classified as employees. In a high-profile case, hundreds of Microsoft Corp. programmers who had signed a document saying they were independent contractors later sued the company for inclusion in its 401(k) plan and claimed they were really employees. The programmers had worked full time for 18 months in Microsoft s offices, side by side with fulltimers doing similar work, so it was hard to tell the difference. The 9th Circuit judges ruled that because the difference between these workers and Microsoft s regular employees was not very clear, the independent contractors qualified as common-law employees eligible for benefits. The software giant s argument that its freelancers signed contracts agreeing to independent-contractor status was ruled invalid. Vizcaino v. Microsoft Corp., 97 F.3d 1187 (9th Cir. 1996), cert. denied, 522 U.S. 1098 (1998). Note that in the Microsoft case the contractors won the right to participate in the company s 401(k) plan because the benefit was made available to all employees. But in a later, similar case, the DuPont Co. was able to
escape a similar fate because DuPont s benefits plan explicitly excluded contractors. Clark v. E.I. DuPont, 105 F.3d 646 (4th Cir. 1997) Recommendation: You can avoid similar problems with contingent workers by carefully wording the language in your benefits plans to exclude contract workers. CONTRACTORS CAN SUE FOR DISCRIMINATION In an important ruling in 2000, the U.S. Supreme Court let stand a lower court s $300,000 award under Section 1981 of the Civil Rights Act of 1866, which bars racial discrimination in making and enforcing contracts. Congress had broadened the racial bias law in 1991, and some courts say the new language protects independent contractors. Here are the specifics of the case: A Mexican-American owner of a company hired to clean parking lots at Wal-Mart claimed that several racially tinged incidents such as the words white supremacy being painted on the lot created a hostile work environment. Wal-Mart had argued the ruling would make a company responsible for protecting all its contractors, but the 1st Circuit said only on-site workers would likely be affected. The 1st Circuit s decision applies to Maine, Massachusetts, New Hampshire, Rhode Island and Puerto Rico. Danco Inc. v. Wal-Mart Stores Inc., 178 F.3d 8 (1st Cir. 1999), cert. denied, 528 U.S. 1105 (2000) Nonetheless, there are limits to suing under Section 1981, as the U.S. Supreme Court ruled a few years ago. The case involved John McDonald, a black male who was president of his own incorporated business. He contracted with Domino s Pizza to build restaurants in Las Vegas. Their relationship became strained, and eventually Domino s refused to deal with McDonald s company. A Domino s rep allegedly told him, I don t like dealing with you people anyway. McDonald sued, alleging Domino s violated the contract-bias law. In a unanimous decision, the Supreme Court threw out the case. It concluded that because McDonald did business as a corporation, Section 1981 didn t protect him. Only individuals can sue, the court said. Domino s Pizza v. McDonald, No. 04-593 (2006) LIABILITY FOR CONTRACTOR S ACTIONS In 2003, the U.S. Supreme Court ruled that when independent contractors are acting as a company s agents, the company is liable for their actions. While this is a long-held common-law principle, the court s decision actually protects individual owners of the company from liability arising from the actions of an independent contractor. The case involved a charge of racial discrimination by a real estate agent in violation of the Fair Housing Act. The Supreme Court ruled that the agent and company could be sued, but not the officers or owners of a company in cases when the law specifically forbids individual suits against the owners. Meyer v. Holley et al., 537 U.S. 280 (2003) The Fair Housing Act doesn t allow individual lawsuits or authorize personal liability for employees who violate the law. Be aware, however, that supervisors and managers can be sued individually under both the Family and Medical Leave Act and the Fair Labor Standards Act.