Legal Update - January - 2005
Employee or Independent Contractor? The Consequences of Misclassification

Introduction

Engaging the services of a so-called "independent contractor" is attractive to many businesses as a cost-reduction technique to save employment taxes and benefits and payroll expenses. Simply calling a worker an independent contractor, however, does not mean that the individual is one, even if a written independent contractor agreement exists. In the eyes of a number of government agencies, whether or not an individual is an independent contractor depends on the nature of the relationship between the business and the worker.

Different federal and state agencies use different legal tests for determining a worker’s status. There is no single determinative factor, although one common thread runs throughout: the more the hiring company has the right to control when, where and how assigned tasks are accomplished, then the greater the chance that the worker will be considered an employee. There is no clear definition of just how much control is sufficient to cause a worker to be classified as an employee as opposed to an independent contractor. Rather, each case depends on an analysis of its own particular set of facts.

Internal Revenue Service

To determine whether a worker is an employee or an independent contractor, the IRS applies its "Common-Law Rules" (formerly known as the "Twenty Common Law Factors") to analyze the degree of control an employer has over a worker’s activities. Factors considered include:

• The degree to which the employer gives the worker instructions about when, where and how to do the work. Independent contractors generally work their own schedule and do the job their own way.
• The training the employer gives the worker. An employee may be trained, while an independent contractor usually uses his or her own methods.
• The extent to which the worker has unreimbursed business expenses. Independent contractors are more likely to have unreimbursed expenses than employees.
• 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.
• The extent to which the worker makes services available to the relevant market. The independent contractor is generally free to seek out business opportunities. The independent contractor often advertises, maintains a visible business location, and is available to work in the relevant market.
• How the business pays the worker. An employee is generally guaranteed a regular wage amount over a set period of time (hourly, weekly, etc.). The independent contractor usually is paid a flat fee (though in some professions it is common to pay independent contractors hourly).
• The extent to which independent contractors can realize profit or loss.
• Type of relationship. A number of factors are considered, including written contracts describing the relationship; whether the business provides employee-style benefits such as insurance, vacation pay, sick pay, etc; the permanency of the relationship (indefinite or a specific project period); and the extent to which the services performed are a key aspect of the regular business of the enterprise.

The Safe Harbor Provision

Notably, even if a worker "looks" like an employee under the Common-Law Rules, under Section 530 of the Revenue Act of 1978 (known as the Safe Harbor provision), such worker may nonetheless be considered an independent contractor if all three of the following conditions are met:

• A "reasonable" basis exists for not treating the worker as an employee. A "reasonable basis" includes reasonable reliance on judicial precedent, a past audit, or a "long-standing," recognized practice of a "significant segment" of the industry in question treating the type of worker as an independent contractor.
• The business has not treated the worker or others performing substantially similar work as employees during any period after December 31, 1977.
• Amounts paid to the worker have been reported and filed on Form 1099 on a timely basis.

Penalties for Misclassification

If the IRS determines that a worker has been misclassified as an independent contractor rather than an employee, the hiring company may be required to pay all back withholding taxes, plus interest, even if the misclassified independent contractor has already paid his or her taxes. In addition, the hiring company may also face substantial penalties and, in some cases, criminal charges.

Other Agencies

The Department of Labor, state taxing authorities, and state unemployment and workers compensation agencies each have their own guidelines for determining independent contractor status. While most of these guidelines mirror the IRS Common-Law Rules in many ways, they are not identical, and they vary from state to state. Penalties for misclassification also vary and may include backpayment of taxes, providing retroactive benefits, including vacation pay and 401(k) contributions, and stiff financial penalties.

Conclusion

There are major differences between employees and independent contractors, and the consequences of misclassification can be very serious. Just because an employer labels a worker an "independent contractor" does not mean that the IRS, other agencies, or the courts will agree.

Funkhouser Vegosen Liebman & Dunn Ltd. publishes updates on legal issues and summaries of legal topics for its clients and friends solely for general informational purposes. They do not constitute legal advice, nor are they intended as a substitute for obtaining legal or other professional advice based upon specific factual circumstances or issues. If we can be of assistance, please call or write Jon Vegosen, 312.701.6860, , Sharon Beth-Halachmy, 312.701.6875, , or consult with your regular FVLD contact.

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