Misclassified Workers (Part I)

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As employer obligations, costs, and federal and state mandated regulations continue to increase, many companies are tempted to avoid the burden and expense of hiring workers as their employees.

To escape employment related costs, companies sometimes establish independent contractor relationships with individuals who perform work for them. Some of those relationships are legitimate; many are not.

This two-part article looks at the comparative costs of employees versus independent contractors, helps you to classify workers as either independent contractors or employees, and (in the second part) will examine the consequences of misclassification as it affects clients, independent contractors, and third party payers (such as a consulting firm or a contract agency).

Cost Differences

There can be a significant cost difference when a business hires an independent contractor instead of an employee at the same rate of pay. The company does not pay matching employer FICA (Social Security and Medicare taxes), federal or state unemployment taxes, jury duty pay, bonding costs or state disability insurance in connection with an independent contractor. Independent contractors do not receive employee benefits such as holidays, vacations, sick pay, medical insurance or pensions. Companies often also avoid payment of workers' compensation premiums.

In addition, the business saves on indirect costs, such as the cost of filing tax reports, EEO reporting, processing of INS-9 Forms and liability insurance in connection with the worker.

In a strong economy, however, an independent contractor will often demand a higher level of compensation than an employee would be paid to perform the same task. This makes sense, since the higher rate compensates for the higher level of self-employment tax paid by the independent contractor and allows the independent contractor to make up for other missing benefits. The contractor, for example, must pay herself between projects in lieu of unemployment compensation, must makeup for lost billing when searching for new clients and will have other business-related expenses.

Employee vs. Independent Contractor

Certain people such as lawyers, physicians, auctioneers, licensed real estate agents, public stenographers, construction contractors, etc. are clearly identified in the tax code as either independent contractors or statutory non-employees, providing they make their services available to the general public. They may be paid without withholding taxes.

Other individuals are considered statutory employees, such as full-time life insurance sales agents who work for one company, certain driver / delivery agents and many full-time traveling sales agents. Income tax is not withheld from statutory employees, but the employer must withhold and pay social security taxes. Unless they are full-time life insurance sales agents or work at home, the employer must also pay federal and state unemployment taxes.

For other workers, the IRS uses a list of 20 factors (which can be found on IRS Form SS-8) to determine under common law whether a worker should be classified as an employee or as an independent contractor for tax withholding purposes. Either the worker or company can complete and submit a Form SS-8 to the IRS in order to determine employee or independent contractor status for that worker or a group of workers performing the same work.

Common Law Factors

The 20 common law factors that the IRS will look at are also outlined in IRS Publication 937, "Business Reporting," which is available free of charge. All of the factors must be considered, and no one factor outweighs the others. Different occupations might lead to different responses to the questions, yet result in the same classification for tax purposes.

Here are some of the factors the IRS looks at to determine whether a worker should be classified as an employee or as an independent contractor:

1. Instructions: If the worker can be given instructions regarding when, where and for whom the work is done, she is an employee.
2. Training: Providing training to a worker or requiring the worker to use specific work methods indicates employee status.
3. Integration: if the work performed is important to the success or continuation of the company's business, the person is an employee.
4. Services rendered personally: This indicates employee status, since the person for whom services are performed is interested in the methods as well as the results. An independent contractor is responsible only for the results.
5. Hiring, supervising and paying assistants: If an employer hires, supervises and pays others to assist a worker in his efforts, that worker is an employee. An independent contractor would hire, supervise and pay his own assistants and is responsible for the results of their work.
6. Continuing relationship: A continuing relationship, even if work is performed infrequently or at irregular intervals, indicates employee status.
7. Set hours of work: An employer can establish hours of work for an employee. An independent contractor should not have set hours of work that are established by the entity for which the work is performed.
8. Full-time work: A full-time work schedule would indicate employee status.
9. Place of work: If the place of work is designated by the person or persons for whom the work is performed, employee status is implied, especially if the work could be done elsewhere.
10. Setting the order or sequence: An employer can set the order or sequence in which work will be performed by an employee. An independent contractor is not subject to such direction and control.
11. Reporting: An employer can require regular oral or written reports from an employee. An independent contractor does not have to account for his or her actions to the person for whom services are performed.
12. Payment intervals: Payment on an hourly, weekly or monthly basis would point to employee status. An independent contractor would be paid by the job or on straight commission.
13. Payment of expenses: Employees' business and travel expenses may be paid by the employer; an independent contractor's are not.
14. Tools and materials: An employee relationship tends to exist if the person for whom work is performed furnishes significant tools, materials or other equipment to the worker.
15. Significant investment: An independent contractor has significant investment in facilities and resources used to perform services for another. Employees tend not to maintain such facilities and are dependent upon the employer's resources.
16. Profit or loss: An employee must be paid for work performed, regardless of profit or loss. Independent contractor status requires that the worker can realize a profit or suffer a loss.
17. Working for more than one person or firm at a time: An independent contractor performs services for two or more unrelated persons or firms at the same time.
18. Services made available to the general public: The services of independent contractors are made available to the general public on a regular basis.
19. Right to fire: An employee can be discharged by the employer. An independent contractor cannot be fired unless the results produced do not meet the agreed specifications.
20. Right to quit: An employee can terminate his job at any time with no liability. An independent contractor is generally responsible for satisfactory completion of a specific, finite job.

In general, employees are subject to the direction and control of employers, while independent contractors are not. Independent contractors are hired to complete specific tasks that are of limited duration. An employee relationship may be ongoing.

The IRS also looks for consistency. For example, it would be difficult to explain a scenario where two technical writers worked together, both did the same work, and one was treated as an employee and the other as an independent contractor.

Misclassification of workers as independent contractors who should classified as employees can be a costly mistake. The second part of this article will appear in the next issue of the Broadside and will examine the consequences of invalid independent contractor arrangements.

Brett Randolph, who has been marketing contract services since 1973, is a partner in Randolph Associates, Inc. in Boston, Mass.