Legal Insight: Independent Contractor or Employee?

June 1, 2012
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At the heart of the classification is how work is performed.



Organizations need personnel to perform services or produce goods. Depending on the nature of the relationship and the degree of control the company exercises over the worker, a worker can be classified as an employee or independent contractor. Most employment relationships are “at will,” which means that the employer can discharge an employee at any time for many reasons. Similarly, the employee may quit at any time. Independent contractor relationships are governed by contracts, which may be terminated only according to their terms.

In the past few decades, organizations have frequently used contractors. They tend to earn a substantial premium over employees’ wages for similar work. Many organizations use contractors because they do not have to pay for their fringe benefits or remit employment taxes to the authorities with respect to those workers. Among other things, contractors bear the cost of their own insurance and pay their own taxes (e.g., quarterly estimated taxes). Whether a worker is an employee or a contractor is a matter of law, not contract. Thus, even if a company and worker agree that the worker is a contractor, and they explicitly state that in a written contract, government agencies are not bound to accept the classification if circumstances indicate otherwise.

At the heart of the classification is whether the company controls the worker and how the person’s work is performed. It is not a simple conclusion because different government agencies (the IRS, U.S. Department of Labor, state workers’ compensation agencies, and state unemployment agencies) examine working relationships under different, albeit similar, sets of factors. While no one factor is conclusive, if a company has control over a worker, the relationship is more likely to be deemed employment.

Next month, we will explore many of the factors in depth. Some important factors include where the person works; who pays for supplies; whether the relationship is exclusive; the form of compensation; the duration of work; the scope of instructions and training; and supervision. Due to the vague standards, it is possible to unintentionally misclassify a working relationship.

Tax authorities tend to receive less tax revenue with respect to contractors’ wages as compared to receipts on employees’ wages. During a recession, governments want to collect as much tax revenue as quickly as possible. Rather than raising taxes, which is politically unpopular, politicians prefer to increase enforcement of existing laws. A small increase in the auditing budgets of tax and labor authorities can substantially increase tax receipts and provide a large return relative to the modest expenditure.

The current presidential administration has focused on auditing contractor relationships. Now, departments within the IRS share information with one another about investigations, and the IRS entered information-sharing agreements with dozens of state agencies. Thus, due to increased governmental coordination, one investigation and reclassification may lead to others.

Investigations are triggered in a variety of ways. A contractor may file an unemployment or workers’ compensation claim. A disgruntled contractor or employee may call the authorities. An agency may seek information on its own volition. An agency may begin an investigation by sending a request for documentation. Also, it may perform a “sweep,” and agents may show up unannounced.

Regardless of the reason or process, the company bears the burden of justifying contractor classifications. When an agency requests information and performs an investigation, company representatives should act respectfully. They should immediately contact legal counsel to interact with the agency. Hostility or providing too much information can harm one’s case. If an agency concludes that the worker is actually an employee, the company may have to pay back wages, damages, back taxes, unemployment penalties, and workers’ compensation fines. When applied to a large work force, the costs can be substantial.

Regardless of the type of relationship parties decide to enter, they should memorialize the agreement in a written contract. By clearly outlining their respective rights and responsibilities, they can avoid confusion and disagreements. Contractor relationships should be structured to withstand scrutiny. Early on, companies should think about how to prove classifications. While a written contract cannot guarantee that a government agency will respect the classification, it provides a reasonable basis for the company’s position and appeal if necessary.



Editor’s note: This column does not constitute legal advice.



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