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Employee or Independent Contractor?Posted 10/7/1997By Brian T. Farrington, JD and William F. Yancey, Ph.D., CPA
When you have employees, you have to withhold federal income tax, and pay Social Security, Medicare, FUTA and state unemployment taxes. Most employers are also subject to all the federal and state anti-discrimination laws (Civil Rights Act, ADA, ADEA), as well as wage and hour laws like the federal Fair Labor Standards Act and its state analogues. Then there's the question of unions and the National Labor Relations Act, not to mention all the intricacies of workers' compensation. Add to this such issues as wrongful discharge, employment contract theories, and the ever-popular employment tort actions like defamation, emotional distress, privacy, false imprisonment, whistle blowing and "public policy," and even the most devoted entrepreneur may wonder if he wouldn't be better off punching a time clock for someone else. To avoid the hassles of having employees, therefore, many companies designate individuals who perform services for them as "independent contractors" or "contract labor." Unfortunately, it's not that easy. Shakespeare said a rose by any other name would smell as sweet. Similarly, a worker is an employee or independent contractor based on the facts and the law, not on whether there is a written contract, or what you call them, or what they want to be. The purpose of this article is to provide a brief look at the legal framework within which businesses must operate when determining whether someone is an employee or not, and an idea of the consequences of the wrong decision. The subject is too complex, and the space allotted is too small to provide a detailed analysis, and we're certainly not giving legal advice. The reader should consult with experienced professionals such as attorneys and accountants before classifying anyone as an independent contractor. Historically, the common law classified a worker as an employee if the alleged employer had the right to control not only the results of the worker's work, but the details and means by which the result is accomplished. The Internal Revenue Service (IRS) has essentially adopted the common law definition, but to apply it, they have come up with the infamous "20 factor" test (available by calling ASA at 800-272-7467, ext. 238). No particular factor is supposed to be determinative - the IRS is supposed to look at the totality of the circumstances. In practice, the most important factors seem to be whether the worker holds himself out to the general public and does work for others, and whether the worker can make a profit or suffer a loss. What will the IRS do to you if they determine your "independent contractors" are actually employees? First, of course, there are back taxes. They will require you to pay the 7.65 percent employer's share of Social Security and Medicare. Often they will assess you the employee's share as well. Worse, they can and often do assess you the income tax you should have withheld, even if the employee has paid tax on the income! Then there is interest, which will always be assessed on any back taxes. Finally, there are penalties, which amount to 100 percent for willful failure to withhold; 0.5 percent per month up to 25 percent for failure to pay tax due; 2 percent to 15 percent for failure to deposit employment tax timely; and 20 percent for an underpayment due to negligence or disregard. Another tax problem with "independent contractors" concerns fringe benefits. Some kinds of fringe benefits, such as life and health insurance, lose their tax deductibility if they are not offered to all eligible employees, and employees can be eligible if they work an average of 20 hours per week. As long as we're talking about fringe benefits, we should mention ERISA, the Employee Retirement and Income Security Act of 1974. Fringe benefit plans that qualify under ERISA (usually pension plans) must include all employees who average 30 hours per week. In a recent ERISA case in the 9th Circuit, Microsoft Corporation was found to have violated the law when they classified people as independent contractors who worked for the company for years, and who worked right alongside acknowledged employees who did the same thing the independent contractors did. One more word on taxes - state taxing agencies often share information with the IRS, and a determination by the IRS that an employer has misclassified employees as independent contractors may lead to state unemployment and other tax assessments, with subsequent penalties and interest as well. (In fact, states often define employment relationships even more broadly than the IRS.) The bottom line is that the economic consequences of a mistake in this area can be catastrophic. You can lose your business. All these problems begin with the IRS's version of the old common law definition of "employee." Amazingly, other laws enforced by other agencies actually define employment more broadly than the IRS. In other words, under other laws, even workers that the IRS would accept as independent contractors can be employees. The basic federal wage and hour law is the Fair Labor Standards Act (FLSA). The FLSA goes beyond the common law test and relies on what the Supreme Court refers to as the "economic reality" test - as a matter of economic reality, does the worker "follow the usual path of an employee" and is he "economically dependent on the business which he serves?" Economic reality means that the worker is a separate business entity; an entity that exists separately from its relationship with the business to which it provides service. So unless a worker has a business of his own, with an investment in facilities and equipment, and an opportunity for profit and loss, and unless this business competes with other businesses in the open market, the FLSA (and the other major labor laws) will consider the worker an employee. The effect of employee classification under labor laws can be as damaging as under tax law. The most basic impact is usually overtime. Workers paid as contract labor typically aren't paid time and a half. If the Department of Labor concludes the worker is an employee, the employer owes back overtime for two, and sometimes three years. In addition, if the employer is big enough to be covered by anti-discrimination laws (usually 15 employees for Federal law, often fewer for state law), the alleged independent contractor can file claims for discrimination based on race, color, national origin, sex, religion, age or disability (some states add more categories, such as marital status, sexual preference and even off-duty smoking). The worker may be delighted to be an independent contractor until the owner fires him. Suddenly, the worker decides he was an employee, and files any of a myriad of complaints and lawsuits for discrimination, wrongful discharge, breach of contract, tort, etc. Discrimination can be punished by equitable relief, such as reinstatement and lost wages, and in many cases, by compensatory and punitive damages. Some wrongful discharge and other cases, especially involving torts, can involve punitive damages in the millions. Employees, unlike contract laborers, are covered by workers' compensation, mandatory in almost every state. The employer who doesn't have his contract laborers on their workers' compensation policy will have major problems if the contract laborer is an employee, and gets hurt. So far we've looked in general terms at who should be an employee under various laws, what the standards are for determining employee status, and what some of the consequences of error could be. Let's tie this analysis to a typical ASA shop. As a blanket statement, it's fair to say that anyone who does body or mechanical work on your premises for your customers is an employee. The fact that technicians traditionally furnish some or all of their tools does not change this fact. A technician who also drives a tow truck for you is an employee in both capacities, and hours and wages in both jobs must be combined to determine overtime. Further, employees who might do work for you at home are your employees even while working at home. The IRS will allow an employee also to be an independent contractor for tax purposes, but under the wage and hour and other labor laws, the work at home would count as working hours of employment. Whether workers' compensation would apply to an injury doing shop work at home would depend on the fact, and the law in the particular state, but in general, it would apply. A short, dirty, and generally accurate rule is this: unless the alleged independent contractor has a business of his own, with his own place of business, tools, equipment and other overhead, his own employees, and an ad in the Yellow Pages; unless he competes with other independent firms for your business and the business of others; and unless he has the opportunity to make a true profit and suffer a real loss ... he's an employee.
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Copyright (c) 1996-2009. Automotive Service Association®. All rights reserved.
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One of the most basic issues faced by any entrepreneur is the employment relationship. An entrepreneur is someone who has made a decision that he is not going to be an employee, but is going to work for himself, with all the risks and potential rewards that go along with running his own business. In most cases, however, running your own business means you must hire employees of your own, and if there's one thing tougher than being an employee, it's being an employer.
