From time to the Human Resources Department here at A Plus Benefits receives an inquiry concerning how a client might classify one of their employees as an independent contractor in order to avoid paying overtime wages. Generally this happens when the client wants to have the employee perform some kind of work that is different from the employees regular job on an after hours basis.

The short answer is….it is all but impossible to accomplish. A more “smart alec” answer is - you can indeed call a duck a horse – but the duck is still a duck no matter what you do. So, you can call an employee an independent contractor but the employee is in fact just an employee and would have to jump through a lot of hoops in order to qualify as an independent contractor. It is all but impossible to accomplish.

Below are some important factors to know about Independent Contractors.

Legal Exemptions
Independent contractors relieve employers of a variety of legal compliance issues, as the following examples illustrate:

• Independent contractors do not count toward the employee thresholds used for determining employer coverage under most federal employment statutes.

• Employers have no obligation to pay federal and state unemployment insurance, Social Security, and Medicare taxes on behalf of independent contractors.

• Employee protections under the Fair Labor Standards Act, ERISA, the Family and Medical Leave Act, the National Labor Relations Act, and federal nondiscrimination statutes do not apply to independent contractors.

• Employers often do not have to pay state workers’ compensation premiums on behalf of independent contractors.

As a result, using independent contractors can save employers substantial money. However, improperly classifying employees as independent contractors carries substantial penalties. As a result, employers need to make sure that a worker meets the requisite tests for independent contractor status. These tests and exceptions to the tests are discussed below.

Common-Law Test
IRS examines 20 factors—derived from court rulings or common law—to determine whether someone qualifies as an independent contractor or an employee for purposes of federal income, Social Security, Medicare, and unemployment taxes.

Similar factors for determining employee or independent contractor status apply under:

• the National Labor Relations Act, which specifically exempts independent contractors from its employee protections (29 U.S.C. § 152(3));

• the Occupational Safety and Health Act (OSHA Standard Interpretation Letter “Information on Temporary Workers, Particularly Those in the Electronic Assembly Industry,” 4/30/96); and

• most federal discrimination laws, including Title VII of the Civil Rights Act of 1964, the Americans with Disabilities Act, and the Age Discrimination in Employment Act.

The IRS test often is termed the “right-to-control test” because each factor is designed to evaluate who controls how work is performed. Under IRS rules and common-law doctrine, independent contractors control the manner and means by which contracted services, products, or results are achieved. The more control a company exercises over how, when, where, and by whom work is performed, the more likely the workers are employees, not independent contractors.

A worker does not have to meet all 20 criteria to qualify as an employee or independent contractor, and no single factor is decisive in determining a worker’s status. The individual circumstances of each case determine the weight IRS assigns different factors.

NOTE: Employers uncertain about how to classify a worker can request an IRS determination by filing Form SS-8, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding.” However, some tax specialists caution that IRS usually classifies workers as employees whenever their status is not clear-cut. In addition, employers that request an IRS determination lose certain protections against liability for misclassification.

20 Factors
The 20 factors used to evaluate right to control and the validity of independent contractor classifications include:

• Level of instruction. If the company directs when, where, and how work is done, this control indicates a possible employment relationship.

• Amount of training. Requesting workers to undergo company-provided training suggests an employment relationship since the company is directing the methods by which work is accomplished.

• Degree of business integration. Workers whose services are integrated into business operations or significantly affect business success are likely to be considered employees.

• Extent of personal services. Companies that insist on a particular person performing the work assert a degree of control that suggests an employment relationship. In contrast, independent contractors typically are free to assign work to anyone.

• Control of assistants. If a company hires, supervises, and pays a worker’s assistants, this control indicates a possible employment relationship. If the worker retains control over hiring, supervising, and paying helpers, this arrangement suggests an independent contractor relationship.

• Continuity of relationship. A continuous relationship between a company and a worker indicates a possible employment relationship. However, an independent contractor arrangement can involve an ongoing relationship for multiple, sequential projects.

• Flexibility of schedule. People whose hours or days of work are dictated by a company are apt to qualify as its employees.

• Demands for full-time work. Full-time work gives a company control over most of a person’s time, which supports a finding of an employment relationship.

• Need for on-site services. Requiring someone to work on company premises—particularly if the work can be performed elsewhere—indicates a possible employment relationship.

• Sequence of work. If a company requires work to be performed in specific order or sequence, this control suggests an employment relationship.

• Requirements for reports. If a worker regularly must provide written or oral reports on the status of a project, this arrangement indicates a possible employment relationship.

• Method of payment. Hourly, weekly, or monthly pay schedules are characteristic of employment relationships, unless the payments simply are a convenient way of distributing a lump-sum fee. Payment on commission or project completion is more characteristic of independent contractor relationships.

• Payment of business or travel expenses. Independent contractors typically bear the cost of travel or business expenses, and most contractors set their fees high enough to cover these costs. Direct reimbursement of travel and other business costs by a company suggests an employment relationship.

• Provision of tools and materials. Workers who perform most of their work using company-provided equipment, tools, and materials are more likely to be considered employees. Work largely done using independently obtained supplies or tools supports an independent contractor finding.

• Investment in facilities. Independent contractors typically invest in and maintain their own work facilities. In contrast, most employees rely on their employer to provide work facilities.

• Realization of profit or loss. Workers who receive predetermined earnings and have little chance to realize significant profit or loss through their work generally are employees.

• Work for multiple companies. People who simultaneously provide services for several unrelated companies are likely to qualify as independent contractors.

• Availability to public. If a worker regularly makes services available to the general public, this supports an independent contractor determination.

• Control over discharge. A company’s unilateral right to discharge a worker suggests an employment relationship. In contrast, a company’s ability to terminate independent contractor relationships generally depends on contract terms.

• Right of termination. Most employees unilaterally can terminate their work for a company without liability. Independent contractors cannot terminate services without liability, except as allowed under their contracts.

Economic Reality Test
Independent contractors are not covered by FLSA’s minimum wage and overtime protections for employees. Court interpretations have established an “economic reality test” for determining whether someone is an employee or independent contractor under FLSA.

Rather than examine who controls how work is performed, the economic reality test evaluates whether a worker is economically dependent on a company’s business. The greater the economic dependence, the more likely the worker qualifies as an employee protected by FLSA.

Similar to the common law test, the economic reality test focuses on the degree of control exercised by the employer as an essential factor in determining whether an employer-employee relationship exists. While no single factor is controlling or decisive in determining whether an employment relationship exists, the facts and circumstances that courts and federal enforcement officials examine in deciding whether an individual is an employee or an independent contractor are:

• the degree to which the employer controls or directs the manner in which work is performed,

• whether the worker’s opportunity for profit or loss depends on his or her managerial skills,

• whether the worker’s duties are performed for the employer on an ongoing or permanent basis,

• whether the service performed by the worker is an integral part of the employer’s business,

• the extent of the worker’s investment in equipment or materials needed to perform the job, and

• the degree to which the worker is engaged primarily for the benefit of the employer.

Worker’s Compensation
In many states the Worker’s Compensation Insurance Laws have been written to make a business that has hired an independent contractor responsible for work place injuries if the business has not verified that the independent contractor has his own worker’s compensation policy.

This is another was to ascertain if a person is in fact an independent contractor. If upon being quizzed about worker’s compensation, the employee who is acting like an independent contractor seems to know nothing about worker’s compensation insurance and his need to have a policy as an independent contractor – any government investigator or auditor is going to see through the smoke and mirrors that the business has attempted to use to qualify someone who is in fact not an independent contractor as an independent contractor.

Are there penalties for misclassifying employees as independent contractors?
There are penalties for misclassifying employees. If the IRS finds your independent contractor was really an employee, it may assess you:

An amount equal to 1.5% of wages (3% if no information return was filed) if you erroneously treated a worker as an independent for income tax withholding purposes. (The worker is still liable for 100% of his/her income tax bill) [IRC Sec. 3509 (a)(1), (b)].

20% of the worker’s share of Federal Insurance Contribution Act (FICA) tax that you should have withheld (40% if you failed to file an information return) if you erroneously treated a worker as an independent for FICA tax purposes [IRC Sec. 3509(a)(2), (b)].

A civil penalty equal to 100% of the total amount of tax evaded or not collected, if the IRS finds your misclassification was an attempt to evade or defeat employment taxes. The responsible person must receive written notice by mail or in person [IRC Sec. 6672]. There may also be a criminal penalty of a $100,000 fine ($500,000 in the case of a corporation) and/or five years in prison [IRC Sec. 7201].

Up to $50 per Form W-2 you should have filed but didn’t (maximum penalty, $250,000 per calendar year) because you treated the worker as independent.

A civil penalty of $50 per W-2, if the IRS finds you willfully failed to furnish correct W-2s to employees [IRC Sec. 6674]; there’s also a criminal penalty consisting of a $1,000 fine and/or one year in prison for willful failure to furnish W-2s as required [IRC Sec. 7204].

Interest on past-due tax payments (although IRS’s Proposed Regulations would allow an interest-free adjustment if you failed to file Form 941 for a given quarter solely because you improperly failed to treat any individuals as employees for that quarter (and therefore failed to pay over any withheld income tax or employer-employee FICA tax) [26 CFR 31.6205-1].

When in doubt
We encourage any client of A Plus Benefits who has a question about independent contractors and employees to call us for direction. We are committed to keeping you far from the danger line that can be crossed when an employee is improperly allowed to work as an independent contractor.

Randall Barker is the VP of Human Resources for A Plus Benefits, Inc.Read Randall’s previous HR Update.

Read Randall’s previous .

This entry was posted on Friday, October 19th, 2007 at 11:46 am and is filed under Compensation, Hiring, Human Resources, Legal. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.