In any relationship where an individual is hired to complete work for another, it is important to determine whether or not that person is being hired as an employee or as an independent contractor. This classification matters greatly to both the employer and the individual hired, and there are advantages and disadvantages to both classifications.
Generally, someone is an employee if they perform services for the employer and the employer controls what is being done and how it is being done. The employer’s right to control the details of how a service is performed is the key element of an employer-employee relationship.
An independent contractor is an individual who is in an independent trade, business, or profession in which they can offer services to the general public. Independent contractors can include doctors, dentists, veterinarians, lawyers, accountants, contractors, and subcontractors. They are not considered employees when hired to perform a service by an employer, rather they are self-employed and enter into contractual agreements with employers to perform a designated service in exchange for payment. Oftentimes independent contractors are called upon in a consulting capacity, to contribute their expertise on a certain project that the employer alone may not have.
It is essential for an employer to correctly classify whether or not someone he is hiring is an employee or an independent contractor. If an employer incorrectly classifies an individual as an independent contractor rather than an employee, the employer can be held liable for violations of laws that apply to employees. These laws include general employee protections including wage and hour laws, worker’s compensation, unemployment compensation, disability insurance, social security, and Medicare.
In general, it is the employer’s preference to hire an individual as an independent contractor rather than as an employee. With an employee, the employer must pay taxes to cover employees under workers’ compensation insurance and unemployment insurance. Both of these taxes come from the employer’s own funds, instead of employees paying from their wages or employers withholding some wages to pay for the insurance. Additionally, an employer must pay payroll taxes. An employer must withhold the federal income tax from employee’s wages, as well as part of Social Security and Medicare taxes. The employer is then responsible for paying the taxes on the employee’s wages from the employer’s own funds. Additionally, because employees are so well-protected by the employment laws of the state, they have the ability to raise employment dispute claims with the company.
These general protections that an employee enjoys do not apply to independent contractors. An employer does not pay any of the taxes of the independent contractor that has been employed for a project. The independent contractor must file his own income tax He must also file for his own self-employment tax to cover Social Security and Medicare costs. The one perk awarded to the independent contractor is that he or she can deduct business expenses on their own personal income tax return. Because the independent contractor does not have the same protections as an employee, he likewise cannot raise a dispute claim against an employer.
In this way, an employer would much rather hire an independent contractor, because none of the employer’s own funds go towards the taxes of the independent contractor, unlike the employee, and the independent contractor cannot bring an employment action against the employer.
Being Classified as an Independent Contractor
Although an independent contractor does not receive the same employment benefits as an employee, it is worth mentioning that being an independent contractor has its perks as well.
As an independent contractor, a worker gets to be his own boss. The contractor does not have to answer to someone on a regular basis and is not subject to supervision or other superior authority. Additionally, a contractor contracts for jobs in which most times his specialized skills and resources in that area are valued by the business. The business hires the contractor because it cannot do the work without his expertise. In this way, the contractor gains respect for his skill and gains value in an industry for being able to complete a specific task. Furthermore, an independent contractor works on his own terms, picking his own hours. There is also a tax benefit for independent contractors because no state and federal taxes are withheld from payroll like an employee is subject to. Last, the independent contractor is economically independent from the company he is providing a service for; he is in control of his own economic fate because his payment depends on the quality and quantity of his individual work.
There are also some downsides to being an independent contractor. Most prominently, there is a lack of job security in being a contractor. One’s work depends on how much business he can find, and if no business is in need of the contractor’s services there is a high risk of not being paid. Although there is great flexibility in being an independent contractor, there is a lot more risk involved in payment and staying in business than an employee experiences.
Determining Employee or Independent Contractor
There are guidelines available when a question arises regarding whether or not a relationship is employer-employee or when two entities are contracting independently. The Minnesota Department of Labor and Industry has a five-factor test available for solving this question. On a federal level, the Internal Revenue Service (IRS) has also set out a test to help determine whether or not an individual is an employee or an independent contractor.
Minnesota Department of Labor and Industry Test
The Minnesota Department of Labor and Industry has established a five-factor test to help determine the classification of a worker as either an employee or an independent contractor. The five factors are:
- Does the employer have the right to control the means and manner of the performance of the worker?
- What is the mode of payment?
- Who furnishes the tools and materials?
- Who has control over the premises and where the work was done?
- Does the employer have the right of discharge?
In this test, the right of control is the most prominent factor. If the employer has a high degree of control over the project and the means by which the individual accomplishes the project, it is most likely that the worker is going to be classified as an employee. In analyzing this factor, it is important to look at whether or not the employer has the right to control the project, not necessarily that he or she does so. The worker can still be an employee if the employer is not directly controlling the project, however, what is essential is whether or not the employer has the right at any time during the project to exercise control and get involved.
The IRS has also established a test in order to help employers determine whether or not they should be withholding taxes from the workers’ salaries and making unemployment and workers’ compensation payments on the employees’ behalf. The test has three main factors:
- Behavior Control: whether there is a right to control how the worker performs the task. Within this analysis, two further factors are taken into consideration:
- Instructions: receiving detailed instructions about how the work is to be done suggests that the worker is an employee. Instructions may include how, when, and where to do the work, what tools to use, who helps with the work, and where to purchase materials for the job.
- Training: if the business provides training for the project, this suggests that the business wants the project done a certain way and that the worker is an employee.
- Financial Control: whether there is a right to control the business part of the work. Within this analysis it is important to consider three additional factors:
- Significant Investment: if the worker has a significant investment in the work, it is most likely that the worker is an independent contractor.
- Expenses: if the worker is not reimbursed for expenses incurred while working on the project, it is most likely that the worker is an independent contractor.
- Opportunity for Profit or Loss: if the worker can gain a profit or experience a loss based on this project, it suggests that the worker is in business individually and is an independent contractor.
- Relationship of the Parties: looks at how the business and the worker perceive their relationship to one another. Within this analysis it is important to look at:
- Employee Benefits: if the worker receives benefits such as workers’ compensation insurance, unemployment insurance, pension, or paid leave, it is most likely that the worker is an employee.
- Written Contracts: having a written contract can show exactly what the worker and the business intended at the time of hiring.
Besides these tests as set out by the Minnesota Department of Labor and Industry and the IRS, there are several other factors that someone can look at to aid in the classification of a worker as an employee or independent contractor. Some of these additional factors include whether or not the worker makes himself available to the public for services, if he files his own tax returns, how dependent the worker is on the income from one or more projects, and the duration of the relationship between the business and the worker.
Due to the occurrence of employer’s failing to correctly classify workers as employees or independent contractors, legislation has been proposed in order to help clarify such classification to all of the parties involved. Two such recent legislative acts include the Fair Playing Field Act and the Employee Misclassification Prevention Act (EMPA).
The Fair Playing Field Act
The Fair Playing Field Act was introduced to Congress in March 2012 and is in the process of being reviewed, and has not yet been passed.
The Act seeks to amend the Internal Revenue Code (IRC) regarding the classification of workers for employment tax purposes. The amendments would do a number of things. First, the Secretary of Treasury would be allowed to issue regulations and guidance in order to clarify the proper employment status of workers for employment tax purposes. The IRC, in its current form, does not allow this sort of guidance. Second, there would be a requirement that all taxpayers who hire independent contractors on a regular and ongoing basis must give contractors notice of the contractor’s federal tax obligations, the labor and employment law protections that do not apply to them, and the contractor’s right to seek a status determination (employee or independent contractor) from the IRS. This is meant to clear the air and make it well understood between both parties what their responsibilities are in the working relationship and what they should and should not expect from working together. Last, it is federal tax law that an employer must withhold the income taxes for his employees. The IRC currently states that there is a reduced penalty for an employer who fails to withhold income taxes and does not have a reasonable basis for treating the worker as an independent contractor (essentially, that there is no reasonable reason why the employer considered this worker an independent contractor and not an employee and therefore did not withhold the appropriate income taxes). The amendment proposed in this Act is to eliminate the reduced penalty. The removal of a reduced penalty would ideally make an employer more careful about who he considers an independent contractor and to discourage an employer from rashly classifying a worker as an independent contractor to avoid tax responsibilities.
In general, the Fair Playing Field Act is an attempt to make the classification process much more clear and to help avoid misclassifications. Such misclassifications can detrimentally harm an employee who was deprived of benefits he should have been receiving and can improperly benefit the employer if he pays less taxes than he was supposed to by classifying a worker as an independent contractor.
The Employee Misclassification Prevention Act
The Employment Misclassification Prevention Act (EMPA) was introduced to Congress in 2011 but has still yet to be enacted. This bill seeks to amend the Fair Labor Standards Act (FLSA) in order to impose new obligations on employers who hire independent contractors for projects and also imposes penalties on employers who wrongly classify employees as independent contractors.
There are several propositions included in this bill. First, it would require employers to document wages and hours worked by an independent contractor, with a failure to do so resulting in categorizing the worker as an employee. Second, it would require employers to provide a written statement to all workers of their classifications. Third, it would make misclassification of an employee under the FLSA prohibited and would impose double damages for violations of the wage and hour provisions of the FLSA. An employee has certain protections under the FLSA that an independent contractor does not (including wage and hour protections), and a misclassification where a worker should have been an employee results in violations of protections and benefits that the employee was supposed to have. Fourth, the bill would allow the Department of Labor to conduct audits of certain employers in industries where misclassifications have been abundant.
These are just a few of the more important provisions of the suggested legislation. Similar to the Fair Playing Field Act, the EMPA seeks to reduce the occurrence of misclassifications. While the Fair Playing Field Act seeks to promote giving notice to the parties involved of their rights and responsibilities, the EMPA seeks to impose more stringent penalties on those who fail to properly classify employees and independent contractors.
In conclusion, what might seem like a simple decision between calling someone an employee or an independent contractor is actually a contentious issue. There can oftentimes be a fine line between an employee and independent contractor, and unfortunately, making the mistake and classifying an employee as an independent contractor can be a big mistake for a business to make. It is important to know the difference and the consequences of doing so incorrectly. It is in a business’s best interest to contact the Department of Labor or the IRS for further information regarding making the classification in order to make sure that who it is considering an employee truly should be an employee, or if the employee should actually be considered an independent contractor.