When Is An Independent Contractor Really An Employee? The Perils of Misclassification

Most employers have a basic understanding of the differences between independent contractors and employees. Most fundamentally, you pay wages to employees and must withhold taxes and Social Security, pay unemployment taxes, pay worker’s compensation insurance premiums and provide various benefits. None of this is required for independent contractors, who are responsible for paying their own taxes and insurance.
Naturally, the additional obligations that exist with respect to employees create a strong incentive for many businesses to classify their workers as independent contractors rather than employees. However, misclassifying a worker as an independent contractor when in reality they function as an employee can carry severe penalties. In this blog, I will discuss the factors the courts and regulatory agencies will examine to classify workers as employees or independent contractors.

Why the Distinction Matters

A business that misclassifies an employee as an independent contractor runs the risk of having their classification challenged by the Internal Revenue Service or state tax department, federal or state labor agencies, or by the worker themselves. If a challenge results in a reclassification of an independent contractor as an employee, the business may be required to pay a host of taxes and other obligations, along with penalties and interest. This may include federal and state income tax withholding, Social Security tax, federal and state unemployment taxes, workers compensation insurance premiums and health and other benefits that the business made available to employees. Depending on the number of workers reclassified as employees, these sums may be substantial.
Moreover, the U.S. Department of Labor has recently entered into information-sharing agreements with the Internal Revenue Service and the relevant agencies of several states (including New York) to crack down on employers that misclassify employees as independent contractors. As a result, employers should expect greater scrutiny of their employee classifications.

Hallmarks of the Employer-Employee Relationship

No single factor conclusively establishes the existence of an employer-employee relationship. Instead, the courts and the various regulatory agencies will look at the totality of the relationship to determine if the putative employer exercises (or has the right to exercise) supervision, direction or control over the person performing the services. Significantly, an employer’s characterization of of an individual as an independent contractor, even if agreed to in writing by the individual, is not dispositive.
The courts have held the following to be some of the more significant indicia of an employer-employee relationship, where the employer:

• Requires full-time work
• Stipulates the hours of work
• Requires attendance at meetings or training
• Requires prior permission for absence from work
• Tells the individual when, where and how to do the job
• Provides facilities, equipment, tools or supplies
• Sets the rate of pay
• Provides compensation in the form of salary, an hourly rate, or draw against future commissions with no requirement to repay if unearned
• Provides reimbursement or allowance for travel expenses
• Requires services to be rendered personally
• Provides fringe benefits
• Sets time, money or territorial limits
• The services performed are an integral part of the business, particularly when done on continuing basis
• Provides business cards or other identification of the individual as a representative of the employer
• Does not allow the individual to perform services for competing businesses
• Reserves the right to terminate on short notice
• The services provided are unskilled labor that is usually supervised

Indicia of True Independent Contractor Status

In contrast, some factors the courts have found significant in finding independent contractor status include the following:

• The individual has established an independent business offering services to the public. An independent business is usually marked by elements such as media advertising, a commercial telephone listing, business cards, stationery and billheads, carrying its own business insurance and maintaining its own establishment
• The individual has a significant investment in facilities
• The individual assumes the risk of profit or loss in providing services
• Freedom to set work hours and to schedule activities
• Not required to attend meetings or training sessions
• Freedom to provide services to other businesses, both competitive and non-competitive

In conclusion, if you are a business that uses independent contractors, expect more scrutiny from federal and state agencies. Be sure to review with counsel whether your classification of certain workers as independent contractors is defensible and examine the risk reclassification presents to your business.