GUIDELINES ON EMPLOYMENT AND INDEPENDENT CONTRACTOR CLASSIFICATION This memo first summarizes the legal distinctions between an independent contractor and an employee. It then discusses the distinctions between certain types of employees. Finally, it addresses the financial consequences to consider when deciding whether to treat a particular individual as an employee or an independent contractor. This document is intended to provide general guidelines, and every situation requires individual attention to the particular facts and circumstances involved. For further information about these guidelines, please contact Michael Lasky, Partner and Chair of the Public Relations Law Practice at Davis & Gilbert LLP (mlasky@dglaw.com; 212-468-4849) I. DISTINGUISHING BETWEEN AN INDEPENDENT CONTRACTOR AND AN EMPLOYEE The tests for distinguishing between an independent contractor and an employee vary according to different laws. A. Common Law Factors Typically, an individual is an employee, and not an independent contractor, where the employer controls what will be done and how it will be done (i.e. the manner, means and results). Indicators of control may include: determining when, where and how services will be performed providing facilities, equipment, tools and supplies directly supervising the services stipulating the hours of work requiring exclusive services setting the rate of pay requiring attendance at meetings and/or training sessions requiring oral or written reports reserving the right to review and approve the work product evaluating job performance requiring prior permission for absences reserving the right to terminate the services Moreover, the nature of the individual s compensation and services further distinguishes an independent contractor from an employee. For example, employees typically are paid a salary, an hourly rate of pay or a draw against future commissions with no requirement for repayment of unearned commissions. Employees may also receive certain fringe benefits, including an allowance or reimbursement for business or travel expenses. Furthermore, unskilled or casual labor is usually employment because such services are typically subject to supervision. However, even professionals such as doctors
and lawyers who have considerable freedom in the performance of their duties may be employees if they are subject to significant control. Independent contractors, on the other hand, are free from supervision, direction and control in the performance of their duties. They are in business for themselves, offering their services to the general public. Indicators of independent contractor status may include: having an established business advertising in the electronic and/or print media maintaining a listing in the commercial pages of the telephone directory using business cards, business stationery, and billheads carrying insurance maintaining a place of business and making a significant investment in facilities, equipment and supplies paying one s own expenses assuming risk for profit or loss in providing services determining one s own schedule setting or negotiating own pay rate providing services concurrently for other businesses, competitive or non-competitive being free to refuse work offers being free to hire help If an employer-employee relationship exists, it does not matter how the relationship is described by the person engaging the services. For example, merely because an employer issues 1099 forms rather than W-2 forms, does not mean that the individuals in question are not employees. Even independent contractor agreements confirming an individual s status and waiving any rights as an employee do not insulate an employer from a finding that the individual is an employee. The Unemployment Insurance Law provides that no agreement by employees to waive their rights under the law is valid. B. The IRS s Test According to the IRS, for purposes of the tax laws, the general rule is that an individual is an independent contractor if the company has the right to control or direct only the result of the work and not the means and methods of accomplishing the result. According to the IRS, to determine whether an individual is an employee or an independent contractor under the common law, the relationship of the worker and the business must be examined. In any employee-independent contractor determination, all 2
information that provides evidence of the degree of control and the degree of independence must be considered. Facts that provide evidence of the degree of control and independence fall into three categories: (1) behavioral control, (2) financial control, and (3) the type of relationship of the parties. 1. Behavioral control. Facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired include the type and degree of instructions the business gives the worker. An employee is generally subject to the business' instructions about when, where, and how to work. All of the following are examples of types of instructions about how to do work: 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. Another indicator is the training the business gives the worker. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods. 2. Financial control Facts that show whether the business has a right to control the business aspects of the worker's job include: (a) the extent to which the worker gets unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than are employees. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. (b) the extent of the worker's investment. An independent contractor often has a significant investment in the facilities he or she uses in performing services for someone else. 3
(c) 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. (d) how the business pays the worker. An employee is generally guaranteed a regular wage amount 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 by a flat fee for the job. (e) the extent to which the worker can realize a profit or loss. An independent contractor can make a profit or loss. 3. Type of relationship Facts that show the parties' type of relationship include: Written contracts describing the relationship the parties intended to create. 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. If you engage 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 your intent was to create an employeremployee 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 of your regular business activity, it is more likely that you will have the right to direct and control his or her activities. In addition to the above factors, which are taken from an official IRS publication, in our experience, investigators have often looked favorably (when companies treat an individual as an independent contractor) upon situations where the person in question has established a separate business entity and files a Schedule C tax return as a business. 4
II. TYPES OF EMPLOYEES Employees are often classified as full-time, part-time, temporary or leased. However, with few exceptions, those distinctions are irrelevant under the law. Any such employee will be covered by unemployment insurance law (assuming they meet the necessary compensation standards discussed in Section III below) as well as by laws protecting employees from discrimination. Please note that certain laws will define an eligible employee to include only those individuals who have worked a given number of hours during a given period, and that in such instances, the employer s designation of the employee as full-time, part-time or temporary will not matter. Full-time employees typically comprise the majority of the workforce. They are usually scheduled to work thirty hours per week (or more, as defined by company policy), and are eligible under the company s group health insurance and other benefit policies. All standard tax withholdings and deductions are taken from these employees paychecks, i.e. federal, state and local taxes, unemployment and social security. Part-time employees are usually those who work less than thirty hours per week (but that number can be higher or lower, as defined by company policy). Such employees are subject to the same withholdings and deductions as full-time employees. That said, entitlements under the company s benefit plans or as outlined in the company s employee handbook may delineate coverage distinctions for full-time and part-time employees. Be aware, however, that even though part-time (and temporary) employees typically are not eligible for coverage, employees who work 1000 hours or more in a twelve-month period may be eligible for certain pension benefits i.e. 401(k) benefits under Federal law. Temporary employees typically are hired for a specific project (or to cover for another employee on leave), with the understanding that the employer expects the employment relationship to end when the project ends. Companies often misclassify these employees as independent contractors because of the short duration of their employment, but, unless they meet the criteria for independent contractors set forth in Section I above, they must be treated like full-time or part-time employees. A temporary employee s wages are subject to the same regular withholdings and deductions, and he or she is entitled to benefits in accordance with the terms of the company s plans and employee handbook. Leased employees are those individuals hired through a leasing agency and leased for short-term or long-term assignments. The key distinction is that, typically, the company signs an agreement with the leasing agency whereby the leasing agency remains the employer of the employee, despite the employee s performance of services for the company. The leasing agency should be responsible for compensating the employee, providing benefits and terminating the employee. The leasing agency should also be responsible for all tax consequences associated with the employee, and such responsibilities 5
should be outlined in a contract between the leasing agency and the company. Moreover, in order to prevent the company from becoming a joint employer of the employee, the leasing agency should be involved as quickly as practicable in any issue concerning the employee s terms and conditions of work for the company. Finally, as a further safeguard, companies should specifically address the consequences of legal action by the employee in the agency-company contract. III. THE COSTS ASSOCIATED WITH THE CLASSIFICATION OF EMPLOYEES AND INDEPENDENT CONTRACTORS On occasion, employer records are audited to determine whether the employer has been improperly categorizing its employees as independent contractors. This usually happens when someone has applied for unemployment and the company responds that the person is not an employee but an independent contractor. A company that incorrectly categorizes workers as independent contractors when they should be considered employees opens itself up to significant financial penalties. An employer that has failed to withhold employer taxes from a worker that should have been classified as an employee will be liable for back income, social security, unemployment insurance and Medicare taxes, including interest, and may face penalties. In addition, if an employer s benefit plans provide that they apply to all employees, but that employer denied participation to a worker that should have been classified as an employee, the IRS may disqualify the plan and the employee may be able to sue the employer for its failure to let that individual participate, which could result in a significant financial liability. While these back-end costs may result from an audit, there are also certain up-front costs associated with treating an individual as an employee. Those costs include: Social security and Medicare taxes Workers compensation Disability insurance Unemployment Insurance Federal Unemployment Insurance Based on our discussions with certified public accountants, such costs typically equal an additional 10%-12% on top of the employee s actual compensation though your accounting department should be able to provide a more precise estimate. All of the foregoing must be factored in when deciding whether to classify workers as independent contractors or employees. If the individuals in question meet the independent contractor tests outlined in Section I, then this is the least costly situation for an employer. However, assuming that these individuals are sufficiently controlled by the 6
company - such that an investigator would conclude that the individuals are employees then there is some risk to calling the person an independent contractor. If you classify an individual as an employee, it will cost about 10%-12% of their compensation on an ongoing basis for the above listed costs (and more if benefits are included) but it will avoid the potential liability that could result from an audit. Or, you can take the risk, save the money up front, and hope that no audit occurs. If you choose the second option, the damages likely will exceed that initial investment due to the imposition of penalties, liquidated damages and costs. An additional cost is that an employee previously characterized as an independent contractor may file a lawsuit for unpaid overtime or other violations of state and Federal wage and hour laws (or other employment laws), which would result not only in further damages, but also the payment of attorneys fees. 7