Are Your Independent Contractors Truly Independent?

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• In Wisconsin, Most Workers Are "Employees"
• Tips to Protect an Employer

By Jordan W. Siev & Kirsten M. Eriksson

sing independent contractors to perform work once done by traditional employees is widely recognized as an effective cost-cutting measure. Independent contractors, or "temporary" workers, need not be included in benefit plans, and they carry a lesser tax liability than regular employees. Also, their numbers can be easily expanded and contracted to meet changing needs. While this relationship can be mutually advantageous, it also can subject the hiring company to significant liability if the independent contractors should have been classified as employees and awarded traditional benefits.

Does this seem like an unlikely scenario? Just look at Time Warner and Microsoft, two of the best-known companies involved in recent lawsuits challenging their treatment of certain workers as independent contractors. Time Warner has been sued by the U.S. Department of Labor, which is seeking to remove plan fiduciaries and to require payments to workers excluded from benefit plans. Microsoft was subjected to an IRS audit and forced to pay back taxes for improperly classifying workers as independent contractors. The IRS also could have required interest payments and imposed penalties on Microsoft. Indeed, between 1988 and 1995, the IRS reclassified 500,000 "free-lancers" as employees, and levied $830 million in back taxes and penalties against various entities.

The danger does not end with the government. After the IRS audit, Microsoft was faced with an ERISA-based class action lawsuit by workers who were not treated as employees and who successfully sought to obtain employee benefits from which they were excluded. Such claims can result in large payments of back benefits and steep statutory penalties.

Thus, to avoid the perils faced by Time Warner, Microsoft, and others, lawyers should ensure that their own business entities and those they counsel correctly classify workers as independent contractors. This article examines the factors considered in determining whether a worker is an independent contractor or an employee, and provides some practical tips to help protect businesses from the dangers of misclassification.

Employee or Independent Contractor: The Test

Many state and federal laws that require a determination of whether a worker is an "employee" use the common law definition of employee.

The fundamental characteristic of employees under the common law is that their employer has the right to control the manner and means by which their work is performed. Obviously, a certain amount of control by a company is inevitable in all employee and independent contractor relationships. However, the determinative factor is whether, under all the circumstances, the company has the right to control not only what work is to be done, but how it is to be done. That the company does not actually exercise this right is irrelevant; all that matters is that the right exists.

The question of control, while simple in theory, is difficult to assess in practice. One of the most complete analyses of the common law test is contained in the IRS training materials, which are used as a guide in this article. These materials focus on three categories of evidence - behavioral control, financial control, and the relationship of the parties. No one category or factor is determinative and, in many cases, some factors pointing in both directions will exist. Ultimately, whether a worker is an employee or an independent contractor will be determined by balancing all of the factors in light of the relationship as a whole.

Behavioral Control

Behavioral control - the extent to which a company directs or controls how the specific tasks are performed by the worker - focuses on the instruction and training provided by the company.

Instructions. Two types of instructions are important - instructions as to what the final work product will be, and instructions as to how to achieve the desired product. Generally, the fewer details a company provides as to the completion of the work, the less control appears to be exerted, and the less likely that the worker is an employee. Thus, it is likely that an employer-employee relationship exists if a company provides instructions as to the details of the work, such as: when to do the work, where to do the work, what tools or equipment to use, what workers to hire to assist with the work, where to purchase supplies or services, what routines or patterns must be used, or what order or sequence to follow. By contrast, because businesses often require a uniform end product and a specific delivery date of that product, instructions concerning matters such as these are less indicative of control.

Training. Independent contractors should be workers who neither need nor receive periodic or ongoing training from a particular company. Such training, if provided, indicates an employer-employee relationship. Moreover, if a company pays to train a worker through a third party, such as paying for professional development courses, an employer-employee relationship generally will be found. However, companies commonly provide some limited training to independent contractors, such as general orientation information or information on new product lines. Again, as with the instruction provided, the more detailed and comprehensive the training provided, the more likely it is that control exists.

Financial Control

Financial control refers to whether a company has the ability to direct or control the economic or business aspects of the worker's activities. Factors to determine whether financial control exists are: significant investment, unreimbursed expenses, services available to others, opportunity for profit or loss, and method of payment.

Significant Investment. Workers who purchase, rent, or lease their own equipment or office space to perform a particular job are more likely to be independent contractors, whereas employees generally have equipment and office space provided to them by their employers.

Unreimbursed Expenses. Workers who pay for their own supplies generally are independent contractors. Workers who receive such materials from the company, or who have such costs reimbursed, are likely to be employees.

Services Available to Others. Workers marketing their services to the public are likely to be independent contractors. Although employees who "moonlight" may have more than one employer, workers with a regular practice of working for different companies generally will be labeled independent contractors. This is particularly true if a worker provides services to competing companies in the same field, and even more so if a company has a policy prohibiting its employees from providing services to competitors.

Opportunity for Profit or Loss. If the worker makes decisions affecting his or her bottom line, the worker likely has the opportunity for a profit or loss, and will be considered an independent contractor. Examples of decisions that may affect a worker's bottom line include the type and quantity of inventory to purchase, the amount of capital investment, and where and whether to purchase supplies or equipment.

Method of Payment. Generally, compensation by the hour, day, or week is evidence of an employer-employee relationship, while payment of a flat fee is evidence of independent contractor status.

Relationship of the Parties

The final category of evidence examines what the parties intend their relationship to be. It must be emphasized that the parties' intent, while persuasive, is not controlling. Even if both parties agree in writing that an independent contractor relationship exists, a court or the government could find otherwise.

A written agreement setting forth the terms of the independent contractor relationship is one of the clearest indicators of the parties' intent. Similarly, the worker's incorporation of his or her business, even if the worker is a sole proprietor, demonstrates an intent to be independent. Moreover, the exclusion of a worker from employee benefit plans and the provision of a Form 1099 rather than a Form W-2 demonstrate the parties' intent to create an independent contractor relationship.

In addition, the terms and length of the relationship may be important factors. A company's absolute right to terminate the worker without penalty, and a worker's right to quit, are generally evidence of an at-will employer-employee relationship. Conversely, an independent contractor relationship generally can be terminated only subject to certain limitations, sometimes including payment of a penalty. Moreover, independent contractor relationships generally exist for a definite term. The longer and more indefinite the term of the relationship, the more likely that an employer-employee relationship will be found.

Finally, if the work performed by the worker is part of a company's integral business activity, it is likely that the worker is an employee. "Integral" in this context means that the work or project is part of the business's regularly conducted activity. For example, a store may retain workers to install electricity and plumbing in its building. This work, while necessary to the functioning of the store, is not the store's regular business activity. These workers are independent contractors.

Jordan W. Siev and Kirsten M. Eriksson are members of the New York office of Anderson Kill & Olick P.C., whose practice includes representing companies and fiduciaries in matters involving the employee/independent contractor distinction.

Some companies believe they can eliminate the problems created by this issue by hiring their independent contractors through a temporary help agency. This is only partly true. If the temporary agency is no more than a shell with which the worker has little or no contact, and the trappings of an employee-employer relationship exist between the worker and the company, the relationship with the temporary agency may be disregarded.¹ To prevent this result, the company should not recruit specific workers, but should use whatever workers are provided by the agency. The company should not train the workers extensively, and should not use the same workers for an extended period. Finally, the workers should not be given additional tasks or projects that go beyond their original assignments.

Conclusion

The use of independent contractors can be a valuable way for companies to decrease costs. However, the use of independent contractors is not without its dangers. Companies must be careful to ensure they do not run afoul of the law and misclassify employees as independent contractors. Companies should scrutinize their practices following the above guidelines, periodically audit their independent contractor relationships, and consult with a professional about any concerns of misclassifying independent contractors.

Endnotes

¹ See, e.g., Vizcaino v. U.S. District Court for the Western District of Washington, 1999 U.S. App. Lexis 9057 (9th Cir. May 12, 1999) (later proceeding in Microsoft holding that Microsoft can still be employer of workers from temporary agency).

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