By Susan Prince, JD, Legal Editor

    Whether a worker is an employee or an independent contractor is critical when it comes to important issues such as pension eligibility, workers’ compensation coverage, wage and hour law, and many other matters. Employers frequently retain the services of independent contractors (also referred to as consultants or freelancers) to assist them during peak business periods, to work on special assignments, and to perform services that are not part of the employer’s regular business.

    Employers do not pay employment taxes for independent contractors and do not withhold federal, state, and local taxes from payments made to independent contractors. Also, independent contractors are not included in an employer’s benefits programs, and they are not eligible for unemployment insurance benefits.

    Freelancer-vs-employeeNotably, independent contractors are exempt from wage and hour and employment discrimination laws. However, problems arise when individuals who are truly employees are treated by employers as independent contractors.

    DOL’s Misclassification Initiative

    The economic and tax advantages associated with the independent contractor relationship are significant. Therefore, the temptation to pursue and establish such agreements instead of permanent employment arrangements is a practical reality.

    The federal Department of Labor’s (DOL) Misclassification Initiative is currently “combating this pervasive issue and … restoring [employee] rights to those denied them.” With the signing of a Memorandum of Understanding (MOU) between the Department and the Internal Revenue Service (IRS), agencies are now working together and sharing information to reduce the amount of employee misclassification.

    Various tests applied by the courts

    In order to ensure the DOL does not come knocking on your door, employers should audit their employee classifications to ensure employees are not being labeled independent contractors. Independent contractors are not covered under numerous federal laws. Depending on the particular law, courts have applied different tests for determining whether an individual is an employee or an independent contractor.

    Common-law test. The IRS/common-law test has been used for the following laws:

    • Federal Insurance Contributions Act
    • Federal Unemployment Tax Act
    • Income tax withholding
    • Employee Retirement and Income Security Act
    • National Labor Relations Act
    • Immigration Reform and Control Act

    Economic realities test. Under the economic realities test, an employment relationship exists if an individual is economically dependent on a business for continued employment. The economic realities test has been used for the following laws:

    • Title VII of the Civil Rights Act
    • Age Discrimination in Employment Act
    • Americans with Disabilities Act
    • Fair Labor Standards Act
    • Family and Medical Leave Act (likely to apply)

    Hybrid test. A hybrid test under which an employment relationship is evaluated under both common-law and economic reality test factors, with a focus on who has the right to control the means and manner of a worker’s performance, has been applied by courts to the following laws:

    • Title VII of the Civil Rights Act
    • Age Discrimination in Employment Act
    • Americans with Disabilities Act

    In order to minimize intentional or inadvertent abuse that can result in substantial penalties, the IRS has developed guidelines to assist the employer in correctly identifying and classifying employment relationships.

    IRS Reasonable Basis Test

    The “reasonable basis” test provides a “safe harbor” to employers based on existing government or court classifications of workers in a particular business or industry and was mandated by the Revenue Act of 1978 (P.L. 95-600, Sec. 530), which provides that a worker may be appropriately classified as an independent contractor exempt from federal employment taxes if one or more of the following conditions are met:

    • Judicial precedent treating workers in similar circumstances as nonemployees
    • A Revenue Ruling issued by the IRS indicating that similar workers are exempt
    • An IRS Technical Advice Memorandum stating that the worker in question is not an employee
    • A long-standing and recognized practice in the industry of treating similar workers as nonemployees
    • A prior IRS audit finding that individuals in substantially similar positions were not employees

    IRS Common-Law Test

    The common-law test may be used as an alternative to the “reasonable basis” test to classify workers. 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 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: behavioral control, financial control, and 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 performs his job functions include the type and degree of:

    • Instructions that the business gives to the worker. An employee is generally subject to the business’s instructions about 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, and 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.
    • Training that the business gives to the worker.An employee may be trained to perform services in a particular manner. Independent contractors normally 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:

    • The extent to which the worker has unreimbursed business expenses.Independent contractors are more likely to have unreimbursed expenses than are 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. However, a significant investment is not necessary for independent contractor status.
    • The extent to which the worker makes his or her services available to the relevant market. An independent contractor is generally free to seek out business opportunities. They often advertise, maintain a visible business location, and are available to work in the relevant market.
    • 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 a flat fee for the job. However, it is common in some professions, such as law, to pay independent contractors hourly.
    • 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 or not 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 employers engage the worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the employer’s intent was to create an employer-employee 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 the employer’s regular business activity, it is more likely that the employer will have the right to direct and control his or her activities.

    Not sure?

    When in doubt about the status of a particular worker or class of workers, an employer or a worker may request an IRS determination preapproval by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. A Form SS-8 determination may be requested only to resolve federal tax matters. The party requesting a determination must file an income tax return for the years in question before a determination can be issued.

    A determination will not be issued for a tax year for which the statute of limitations on the tax return has expired. The statute of limitations expires 3 years from the due date of the tax return or the date filed, whichever is later. Although it can take at least 6 months to get a determination, a business that continually hires the same types of workers to perform particular services may want to file the Form SS-8.

    Independent Contractor resources

    Susan PrinceSusan E. Prince, J.D., is a Legal Editor for BLR’s human resources and employment law publications. Ms. Prince has over 10 years of experience as an attorney and writer in the field of human resources and has published numerous articles on a variety of human resources and employment topics, including compensation, benefits, workers’ compensation, discrimination, work/life issues, termination, and military leave. Ms. Prince also served as an expert on several audio conferences discussing the 2004 changes to the federal regulations under the Fair Labor Standards Act. Before starting her career in publishing, Ms. Prince practiced law for several years in the insurance industry and served as president of a retail sales business. Ms. Prince received her law degree from Vermont Law School.

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