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Letter of the Law: Independent Contractor Designation Not a Matter of Choice

Legal Update 2016, Vol 2

Jean Smith and Sue Jones shook hands at the end of the interview. “We’re so glad you’re coming aboard,” said Jean, the HR manager for a mid-sized professional services firm. “We’ve been looking for someone with your skills.”

“I’m really excited,” said Sue. “It’s great that we were able to work out the pay issue. I don’t need insurance because I have it through my husband’s work, and I just prefer to get the 1099 and pay the taxes myself. I’m glad that independent contractor status works well for both you and me.”

Jean and Sue are in agreement with each other, but are they in agreement with the law?

What is an independent contractor?

Employers frequently misunderstand and misapply independent contractor status to workers who should be employees. Many employers believe that they can simply choose to hire a worker and classify him or her as an independent contractor rather than as an employee based on the preference of either the employer or the worker.

The benefits to this arrangement for the employer are many – the employer is not required to pay federal payroll taxes, unemployment insurance premiums, or overtime compensation, or to provide family or medical leave or any benefits. In addition, the employer is not subject to discrimination or harassment claims brought by the worker. The worker may benefit from higher take-home pay, due to the lack of tax withholdings, or perceived flexibility.

However, the status of a worker as an independent contractor or an employee is not based on the parties’ preferences. Instead, various laws set standards establishing a worker’s status. These laws look closely at the relationship between the worker, the employer, and the worker’s business outside of the relationship. Misclassification penalties are stiff, and various agencies have agreements through which they share information on employers who have misclassified workers. Thus, an employer who is determined to have misclassified a worker for unemployment purposes also could be subject to an IRS investigation. Accordingly, employers would be wise to analyze each of their independent contractor arrangements under the applicable laws. Below are the tests used by three employment laws that most frequently
result in misclassification penalties for employers.

Federal Tax Law: Right to Control Test

The IRS test for determining whether an employer is required to withhold and pay payroll taxes for and issue a W-2 instead of a 1099 to a worker is known as the “right to control test.” Under this test, the IRS examines the employer’s behavioral and financial control over a worker, as well as the relationship between the worker and the employer using specified factors that include whether the: 

  • Employer specifies the means or methods of doing the work.
  • Employee works exclusively for the employer or makes his or her services available to the market.
  • Service being performed by the worker is a key aspect of the employer’s business.

The IRS looks at all of these factors together to make a determination – no single factor controls.

Federal Minimum Wage and Overtime Law: Economic Realities Test

The U.S. Department of Labor (DOL) uses a different test to determine whether a worker is owed minimum wage and overtime for work performed for an employer under the federal Fair Labor Standards Act (FLSA). DOL believes that a broad standard should be applied because the definition of “employ” under the FLSA is expansively defined as “to uffer or permit to work.” Thus, DOL and the federal courts have adopted this six-factor “economic realities” test that examines the:

  • Degree of control that the employer has over the manner in which the work is performed.
  • Worker’s opportunities for profit or loss dependent on his managerial skill.
  • Worker’s investment in equipment or material, or his employment of other workers.
  • Degree of skill required for the work.
  • Permanence of the working relationship.
  • Degree to which the services rendered are an integral part of the employer’s business.

Like the IRS’s test, no one factor controls, and the factors differ slightly depending on the court interpreting them.

State Unemployment Laws

State unemployment compensation laws can be even more complicated, as most have different tests for determining whether a worker is eligible to receive unemployment compensation. Maryland, for example, uses this stringent 3-factor test, evaluating whether the:

  • Worker is free from control or direction in the performance of the work.
  • Work is done outside the usual course of business or is off the premises of the business.
  • Worker is customarily engaged in an independent trade, occupation, profession, or business of the same nature as that involved in the work.

Unless the worker meets all of these three factors, he or she is deemed to be an employee.

State and federal agencies, as well as plaintiffs’ attorneys representing employees, have increasingly focused on the misclassification of workers as independent contractors when bringing claims against employers. This is because – in addition to the government recovering unpaid payroll taxes – workers themselves may recover back wages due to the employer’s failure to pay the minimum wage for hours worked or the failure to pay overtime.

Where an employer has misclassified several workers, claims for back wages can be brought by the workers as a group through a class or collective action. Because of this, employers should consult employment counsel regarding any existing or prospective contracting arrangements to see whether the worker qualifies as a contractor or an employee under applicable law.

Julie Reddig is an employment attorney who counsels management on issues involving employment and the workplace, including defending against wage and hour investigations by state and federal officials, and claims made by current and former employees. For more information on independent contractor designation issues, contact Julie at (301) 961-6099 or jareddig@lerchearly.com.

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This content is for your information only and is not intended to constitute legal advice. Please consult your attorney before acting on any information contained here.

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