Worker Status Is No Way to Pad Your Bottom Line

Too often, employers attempt to reduce payroll costs (by avoiding payroll withholdings and contributions required for employees) by converting existing employees to independent contractor status or by having contractors perform work traditionally performed by employees.  Such cost-reduction efforts can be costly in the long run, because erroneously characterizing a worker as an independent contractor can have serious economic consequences for employers. 

Are Your Workers Employees or Independent Contractors?

Although all definitions agree an “employee” is someone who performs services for wages, it is difficult to distinguish an employee from other workers who provide services for money.  One way is to look at the relationship between the worker and the organization.

An employer-employee relationship exists when the employer has the right to control and direct the worker as to the results to be accomplished and in the details and means by which the results are to be achieved.  It is not necessary that the employer actually direct or control the manner in which the work is performed; it is sufficient if the employer has the right to exert such control. 

In contrast, a typical independent contractor is a consultant who provides specified services for agreed-upon compensation for a limited period of time.  While the company may specify the number, type and quality of services to be performed, and the results to be obtained, it has neither the right to control the manner in which the services are performed nor how the results are achieved.  Commonly, independent contractors are service providers engaged in the pursuit of an independent trade or business (e.g., a plumber).

A test often used to decide a worker’s status is the Internal Revenue Service (IRS) “twenty-factors” test.  Among other things, it involves determining whether

• the worker must comply with company instructions
• the worker’s services are integrated into company business (i.e., whether it is a  routine, regular, necessary part of the operation)
• the worker’s services must be performed personally or he can hire substitutes or assistants to do the work
• there is a continuing (not simply short-term) relationship between the parties
• the worker must work required hours or a set schedule
• the worker must work exclusively or full-time for the company or can offer his services to the general public
• the worker works at the company’s offices using its tools and materials 
• the worker risks profit or loss

Companies can seek IRS advice about whether a worker is an employee by filing Form SS‑8; however, the IRS ruling on that filing is not a final decision and there is some evidence that the agency uses such filings as invitations to audit the filer to determine if it has been properly classifying workers.)

A worker and a company can agree on the worker’s status but, sadly, the agreement may not be decisive.  The courts and agencies almost always respect the parties’ characterization of their relationship as employer-employee, but the characterization of the relationship as company-independent contractor is always subject to scrutiny. 

Regardless what test is applied, the actual treatment of the worker is determinative and any agreements inconsistent with actual practice will be ignored.  Further, the courts and agencies using multifactor tests have said that no single factor or sum of factors is decisive; for example, even if 14 of the IRS factors suggest independent contractor status, the agency may conclude from the other six factors that the worker is an employee.

Legal Obligations to Employees and Contractors

A company owes significantly different legal obligations to employees than it owes to independent contractors.  The differences are economically significant.

Employees are owed numerous and substantial legal obligations.  For example, a company must withhold and pay over federal, state, local, FICA and other payroll taxes from wages paid employees and, in addition, the company must match the FICA amount; payroll taxes often are quite sizeable and, more importantly, failure to withhold and pay over those sums can subject the employer to civil and criminal liability.  Employees participate in the employer’s frequently expensive fringe benefit plans.  A number of laws regulate the treatment of employees, including the employment discrimination laws, the minimum wage/overtime laws, and the National Labor Relations Act.  Further, companies generally must provide workers’ compensation insurance for employees. 

In contrast, a company’s legal obligations to contractors are dictated by an agreement and governed by the general law of contracts.  Other than providing a safe workplace, and ensuring that they are not sexually harassed, a company has essentially no statutory obligations to its independent contractors. 

Legal Consequences of Misclassifying Workers

The costs and legal responsibilities associated with employees make it tempting to classify a worker as an independent contractor.  Be warned that there are serious consequences if such a decision is challenged successfully: the company will be liable to the workers for all wages, benefits and protections to which employees are entitled and, possibly, damages and penalties for the improper classification.

A federal appeals court ruling against Microsoft illustrates the consequences of misclassifying workers as independent contractors. In Vizcaino v. Microsoft Corp, the court held that free-lance workers had been misclassified as independent contractors and, thus, were entitled to retroactive fringe benefits equal to those paid to regular employees.  Microsoft took steps to ensure that the free-lancers were independent contractors: they were paid through the company’s accounts receivable department (and were not on the payroll), they had signed contracts stating they were independent contractors, and they had accepted higher-than-normal compensation in exchange for expressly waiving fringe benefits given to employees.  Nonetheless, the court was persuaded to find that the workers were employees by the facts that the free-lancers worked alongside Microsoft’s regular employees, often took direction from the same supervisors, and had very few contacts with their temporary agencies (i.e., only to receive their paychecks and W-2 forms).  The court noted that “Microsoft fully integrated the [free-lancers] into its workforce: they often worked on teams along with regular employees, sharing the same supervisors, performing identical functions, and working the same core hours.  Because Microsoft required that they work on-site, they received admittance card keys, office equipment and supplies from the company.”

Proper classification of workers is of continuing active interest to various government agencies.  For example, during one recent seven-year period, the IRS conducted nearly 13,000 audits to determine whether employers had properly classified workers; the audits concluded with recommended assessments of more than $830 million in employment taxes and the reclassification of 527,000 workers as employees.  (There is real financial incentive for the IRS: one study suggested that, over a seven-year period, the agency could raise $334.8 billion by ensuring that employers properly classify their workers.)

Minimizing Future Controversies

If you have decided that your workers are independent contractors, there are various ways to minimize future controversies over the decision. 

First, require your independent contractors to be incorporated and employed by  their corporation, with its own federal employer tax identification number.  Your payments to that company for their services, and your issuance of an IRS Form 1099 for those monies, will be circumstantial evidence of independent contractor status. 

Second, ensure that all workers performing similar tasks be similarly classified, i.e., all persons doing the same job should either be all “employees” or all “independent contractors.”  Further, avoid unnecessarily switching an employee’s status to “independent contractor”: the change may lead to government inquiries about the validity of the change.

Finally, consider having contractors sign agreements.  An effective, enforceable independent contractor agreement should have various provisions, including statements that

• the parties agree their relationship will be company-independent contractor
• the workers must achieve certain results, but the methods used are outside the company’s control
• the workers are paid a fixed fee from the project (i.e., not on an hourly or daily basis)
• the company will not provide fringe benefits (including insurance, vacation/sick time, expense reimbursement, training, payment of licenses or permits, etc.)
• the workers are entitled to delegate or subcontract the work and need not personally perform the tasks and, if assistants are used, their supervision must be provided by the independent contractor
• the workers will provide all necessary tools, equipment and insurance (including workers’ compensation coverage)
• the workers will set their daily schedules (even though the company may impose project deadlines and insist that work on company premises occur only during certain hours), and all risks of profit and loss are on the workers (i.e., the company has no responsibility for any financial losses to the workers)