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An independent contractor is a worker who individually contracts with an employer to provide specialized or requested services on a project or as-needed basis. There is really no absolute definition of an independent contractor. The important distinction, from the point of view of an employer, is that an independent contractor is an individual who is performing services for the employer but who is not an employee. Courts and government agencies generally examine the nature of the relationship between workers and employers to determine a particular individual's status. Independent contractor status is generally characterized by an “arm's length” relationship between the worker and employer.
Consequences of treating an employee as an independent contractor. 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 Internal Revenue Service (IRS)/common-law test has been used for the following laws:
• Federal Insurance Contributions Act (FICA)
• 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
The U.S. Department of Labor (DOL) has said that the economic realities test should also be applied to the Family and Medical Leave Act, as well as the Migrant and Seasonal Agricultural Worker Protection Act.
The economic realities test was widely perceived to narrow the definition of “independent contractor” and encourage a finding of employee status. On June 7, 2017, U.S. Secretary of Labor Alexander Acosta announced the withdrawal of DOL’s 2015 informal guidance on independent contractors, which was the source of the economic realities test. Accordingly, it should no longer be used to evaluate a worker’s status.
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
As noted above, the economic realities test was withdrawn by the DOL on June 7, 2017.
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. 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.
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
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. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.
• 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. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform with their business.
• 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 workers 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.
Note: Be careful of the lure of past practice. Even though similar positions or the same position may have been classified as an employee or independent contractor in the past, working arrangements typically change over time. Therefore, be certain to evaluate the current status of the position in light of these factors.
Statutes. Some workers who do not meet the reasonable basis or common-law tests for independent contractor status may still be classified as such by operation of law (i.e., statute). For example, licensed real estate agents who work under a written contract stating that they will be treated as nonemployees for federal tax purposes and who receive all of their income from real estate sales or related output (IRC Sec. 3508(b)(1)) will be considered nonemployees. Similarly, direct sellers meeting these same two conditions and who sell consumer products from a private home or as resale door-to-door will also be considered nonemployees (IRC Sec. 3508(b)(2)).
Contracts. Although in some cases the existence of a contract will lend support to an independent contractor classification, a contract may not, in and of itself, “cure” an otherwise inappropriately classified employer-employee relationship. Therefore, employers should be careful to avoid falling prey to such “quick fixes.”
Employers and workers may be subject to stiff criminal and civil penalties and fines if the IRS determines that the employment relationship has been misclassified. Therefore, employers should be extremely cautious when classifying individuals as independent contractors. For example, the IRS audited Microsoft and found that the company had misclassified certain employees as independent contractors, despite the existence of signed agreements in which the workers agreed that they were independent contractors and were ineligible for benefits (Vizcaino v. Microsoft, 120 F.3d 1006, U.S. Court of Appeals for the 9th Circuit (7/24/97)). Microsoft was ordered to pay back taxes. In addition, these individuals filed claims and sued for benefits they contended they would have received had they been properly classified as employees, and the court ultimately ruled that many misclassified employees were entitled to participate in the company's 401(k) and stock option plans, which compounded the cost of Microsoft's error.
Note: Once an individual is determined to be an employee and not an independent contractor, the terms of the benefit plan in question determine eligibility for coverage. However, a properly drafted plan can often preemptively exclude employees who were improperly classified as independent contractors.
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.
Information regarding the IRS approach to worker classifications may be obtained by reviewing IRS Publication 15-A, Employer's Supplemental Tax Guide. Both Publication 15-A and Form SS-8 may be ordered by telephoning 800-TAX-FORM or on the Internet at http://www.irs.gov/formspubs.
The DOL’s Misclassification Initiative includes a Memorandum of Understanding (MOU) with the IRS. Under this agreement, the agencies work together and share information to reduce misclassification of employees, to help reduce the tax gap, and to improve compliance with federal labor laws. According to the DOL, employers that misclassify their employees may not be paying the proper overtime compensation, FICA and unemployment insurance taxes, or workers' compensation premiums. Several states have also joined the Misclassification Initiative. Additional information is available here: www.dol.gov/whd/workers/misclassification.
Last updated on June 8, 2017.
Related Topics:
National
An independent contractor is a worker who individually contracts with an employer to provide specialized or requested services on a project or as-needed basis. There is really no absolute definition of an independent contractor. The important distinction, from the point of view of an employer, is that an independent contractor is an individual who is performing services for the employer but who is not an employee. Courts and government agencies generally examine the nature of the relationship between workers and employers to determine a particular individual's status. Independent contractor status is generally characterized by an “arm's length” relationship between the worker and employer.
Consequences of treating an employee as an independent contractor. 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 Internal Revenue Service (IRS)/common-law test has been used for the following laws:
• Federal Insurance Contributions Act (FICA)
• 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
The U.S. Department of Labor (DOL) has said that the economic realities test should also be applied to the Family and Medical Leave Act, as well as the Migrant and Seasonal Agricultural Worker Protection Act.
The economic realities test was widely perceived to narrow the definition of “independent contractor” and encourage a finding of employee status. On June 7, 2017, U.S. Secretary of Labor Alexander Acosta announced the withdrawal of DOL’s 2015 informal guidance on independent contractors, which was the source of the economic realities test. Accordingly, it should no longer be used to evaluate a worker’s status.
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
As noted above, the economic realities test was withdrawn by the DOL on June 7, 2017.
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. 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.
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
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. A business may lack the knowledge to instruct some highly specialized professionals; in other cases, the task may require little or no instruction. The key consideration is whether the business has retained the right to control the details of a worker's performance or instead has given up that right.
• 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. Fixed ongoing costs that are incurred regardless of whether work is currently being performed are especially important. However, employees may also incur unreimbursed expenses in connection with the services that they perform with their business.
• 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 workers 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.
Note: Be careful of the lure of past practice. Even though similar positions or the same position may have been classified as an employee or independent contractor in the past, working arrangements typically change over time. Therefore, be certain to evaluate the current status of the position in light of these factors.
Statutes. Some workers who do not meet the reasonable basis or common-law tests for independent contractor status may still be classified as such by operation of law (i.e., statute). For example, licensed real estate agents who work under a written contract stating that they will be treated as nonemployees for federal tax purposes and who receive all of their income from real estate sales or related output (IRC Sec. 3508(b)(1)) will be considered nonemployees. Similarly, direct sellers meeting these same two conditions and who sell consumer products from a private home or as resale door-to-door will also be considered nonemployees (IRC Sec. 3508(b)(2)).
Contracts. Although in some cases the existence of a contract will lend support to an independent contractor classification, a contract may not, in and of itself, “cure” an otherwise inappropriately classified employer-employee relationship. Therefore, employers should be careful to avoid falling prey to such “quick fixes.”
Employers and workers may be subject to stiff criminal and civil penalties and fines if the IRS determines that the employment relationship has been misclassified. Therefore, employers should be extremely cautious when classifying individuals as independent contractors. For example, the IRS audited Microsoft and found that the company had misclassified certain employees as independent contractors, despite the existence of signed agreements in which the workers agreed that they were independent contractors and were ineligible for benefits (Vizcaino v. Microsoft, 120 F.3d 1006, U.S. Court of Appeals for the 9th Circuit (7/24/97)). Microsoft was ordered to pay back taxes. In addition, these individuals filed claims and sued for benefits they contended they would have received had they been properly classified as employees, and the court ultimately ruled that many misclassified employees were entitled to participate in the company's 401(k) and stock option plans, which compounded the cost of Microsoft's error.
Note: Once an individual is determined to be an employee and not an independent contractor, the terms of the benefit plan in question determine eligibility for coverage. However, a properly drafted plan can often preemptively exclude employees who were improperly classified as independent contractors.
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.
Information regarding the IRS approach to worker classifications may be obtained by reviewing IRS Publication 15-A, Employer's Supplemental Tax Guide. Both Publication 15-A and Form SS-8 may be ordered by telephoning 800-TAX-FORM or on the Internet at http://www.irs.gov/formspubs.
The DOL’s Misclassification Initiative includes a Memorandum of Understanding (MOU) with the IRS. Under this agreement, the agencies work together and share information to reduce misclassification of employees, to help reduce the tax gap, and to improve compliance with federal labor laws. According to the DOL, employers that misclassify their employees may not be paying the proper overtime compensation, FICA and unemployment insurance taxes, or workers' compensation premiums. Several states have also joined the Misclassification Initiative. Additional information is available here: www.dol.gov/whd/workers/misclassification.
Last updated on June 8, 2017.
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