The use of independent contractors has skyrocketed in the past decade. With the rise of the “gig economy” the trend has accelerated. But do you understand what factors make one worker an employee and another one an independent contractor? If not, you should.
In 2015, a California regulatory agency posed a similar question to Uber, and they were not satisfied with the answer. They went on to conclude that Uber’s drivers were employees. Subsequently, nearly 400,000 Uber drivers in CA and MA reached a $100 million settlement with the company in 2016 (later thrown out by a federal court as insufficient compensation).
While Uber may serve as a poster child in this vexing area of employment law, no business, however large or small, is exempt from the requirements and the penalties for failure to comply. In this essential guide, we’ll look at some practical tips to help you understand the differences.
Setting the stage
The debate over worker misclassification pervades the modern workforce and economy. In the United States, a multitude of employment arrangements exist. For instance, some workers are part-time while others are full-time. Some are salaried employees, while others work on an hourly basis. One of the more complicated, and important, classifications is between employees and independent contractors.
These differences may seem like academic labels used merely to categorize the American workforce. However, in practice, they have far-reaching implications for employers (and employees too) on everything from worker rights to taxation, to compensation.
An important initial step in onboarding any employee is determining whether he or she is an employee or an independent contractor. Employers that misclassify their workers—whether by accident, negligence, or wilfully —face financial penalties and other legal ramifications. Thus, as an employer, you must understand the difference between an employee and an independent contractor.
But why does it matter?
It’s really quite simple: Taxes. Sure, other reasons exist, but none more paramount than taxes. If an employer classifies a worker as an employee, it needs to withhold, deposit, report, and pay employment taxes, withhold and pay Social security and Medicare taxes, and pay unemployment tax on wages paid. The IRS also has filing requirements for employees.
On the other hand, for “independent contractors”, the employer is subjected to a much lower compliance standard. Independent contractors arrange and pay their own income tax quarterly, they receive no benefits and are not eligible for unemployment insurance.
Not withholding taxes and benefits (or incorrectly withholding them) does not just put an undue burden on employees and contractors. If you misclassify a worker and fail to correctly withhold or pay the required amounts, the IRS may flag your business and pursue you for the money, penalties, and interest (which can be excessive).
For the employee, the impacts of misclassification are almost always the same: below-market wages, no benefits, and increased exposure to risks. And when misclassification is adopted as a business strategy by some companies, it disadvantages competitors who bear the costs of compliance with labor standards and responsibilities.
How to get it right
In certain situations, the line between employee and contractor can get incredibly pale. But the difficulty is no excuse, as the employer is responsible to make an accurate and consistent classification for each new hire. Thankfully, the IRS has provided some guidance to help (at least at the federal level). Four key gating questions to ask are:
- Does the company control what the worker does?
- Does the company administer the financial and business aspects of the worker’s job (how the worker is paid, reimbursement of expenses)?
- Does the company provide common benefits to the worker (ie. personal time-off, 401k plans, pensions, health or dental insurance)?
- Does the company provide the equipment and/or tools needed to complete the worker’s job?
While each factor is considered, the IRS cautions that no single factor is dispositive. Control is of particular importance. State and federal agencies, such as the IRS, normally rely on the right of control test to determine whether a worker is an employee or independent contractor. If an employer controls when and how a worker performs the job, that militates in favor of employee status. On the other hand, if the company’s input is limited to accepting or rejecting the final results (much like you would with a painter at your house), then independent contractor classification seems correct.
While a survey of 50 state laws around classification is well beyond the scope of this article, it is worth noting that the home state of the company and the worker will also have an interest in the classification, as it has implications for workers’ compensation and unemployment insurance laws. Most tend to rely heavily on control, but also focus on other factors. Most good small business lawyers will be able to help you with the classification, and with multiple employees on the books, you will likely need a good accountant.
What happens if I am wrong?
The legal consequences of misclassification will include, at minimum, payment of back taxes. The financial exposure increases if misclassification was intentional, and repeat-offenders will incur substantial financial penalties (in some cases even jail-time). In addition to back taxes payable at the federal level, the business will also owe state unemployment taxes and unpaid workers’ compensation premiums and may owe unpaid overtime or minimum wages, medical expenses, and unpaid vacation and sick pay.
Also, as noted, each state has an interest in the employee/contractor classification, so applicable penalties will likely be two-fold, once at the federal level and again at the state level.
Remember that state and federal tests as to proper classification will apply irrespective of the parties’ intent and contract language. Any business currently using independent contractors on a regular basis should review those relationships based upon the tests described in this article.
If a company is not certain about the proper classification of its workers, a business attorney with employment expertise can assist with the analysis. The IRS, Department of Labor and state regulatory bodies are all paying attention even if you are not.
Jason Gabbard is the founder and CEO of JUSTLAW. Most recently he founded and led Counselytics, an AI-powered legal technology company that was acquired by Conga (Insight Ventures). Jason is also an attorney admitted to the New York bar association. Jason began his career with Cravath, Swaine & Moore in New York, as a corporate and M&A attorney. After Cravath, Jason worked at Morgan Stanley’s MSREF private equity fund in London.
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