Determing
the Classification of Workers
February
4, 2011
Last month we discussed several ways to increase the profitability
of your business by reducing operational costs. One of the cost
cutting methods I suggested was to trim from your payroll any
employee who did not either make or save money for your business.
Based upon this advice, I received several inquiries asking about
the use of independent contractors in place of employees. I even
got a question regarding the utilization of unpaid interns as
a labor source.
Why
use independent contractors?
When
legal, it is almost always advantageous for a business to classify
its workers as independent contractors. Independent contractors
are liable for 100% of the employment taxes owed on their income
and they are not eligible to receive paid time off, healthcare
benefits, or retirement benefits. In addition, the tortious actions
of independent contractors are not the vicarious liability of
the business for which they work.
Sign me up, I want all my employees to be independent contractors!
Establishing
that a worker is an independent contractor is rarely simple, and
not always possible. By default, every worker is an employee unless
the business can show a principal/contractor relationship rather
than an employer/employee relationship. Misclassifying an employee
as an independent contractor also carries stiff penalties from
the IRS and state taxing authorities, not to mention civil liability
to the employee.
The IRS formerly used what was known as the “Twenty Factor”
test to determine if a worker could be properly classified as
an independent contractor. Under pressure from Congress and business
and labor representatives, the IRS recently attempted to refine
and simplify the test by condensing the twenty factors into three
groups of eleven factors. As you might imagine, the test did not
really become more simple, as each of the eleven factors must
be examined and weighed, and there is no clear way for an average
employer to decide which factors will weigh more heavily than
others.
The
independent contractor test.
The
three groups into which the eleven factors used to determine if
a worker may legally be classified as an independent contractor
are (1) behavioral control, (2) financial control, and (3) relationship
type. While a detailed analysis of each factor is beyond the scope
of this discussion, the general idea of each group is as follows:
Behavioral
Control
The
idea behind behavior control is to examine how a worker completes
his or her tasks. Independent contractors must not be subject
to the direction and control of their principals. If the business
has the right to direct how the worker completes tasks, the worker
is likely an employee. Even if the business does not actually
control the way work is done, having the unexercised right to
direct and control is sufficient to establish behavioral control.
Another form of behavioral control is training. Independent contractors
are not permitted to receive training from their principals. If
a business gives training to a worker, it establishes that the
business wants the worker to complete tasks in a specific manner,
which is indicative of the behavioral control an employer exerts
over an employee. If periodic or continuing training is provided
by a business, this provides an even stronger indication of an
employer/employee relationship.
Financial
Control
Independent
contractors frequently make significant investments in the tools
and instrumentalities used to perform tasks. Employees, to the
contrary, are usually supplied with everything needed to complete
their work by the employer. There are no set investment figures
by which to judge the significance of a worker’s investment,
and this factor alone is never dispositive, but independent contractors
generally have their own computers, their own software, and other
similar tools. A worker using the tools of a business is likely
to be considered an employee.
The opportunity for profit or loss is another consideration of
financial control. Independent contractors are usually paid by
a flat fee for a job, while employees are guaranteed a regular
wage amount for an hour, week, or other period of time. Most expenses
are reimbursed to employees, while independent contractors generally
pay their own expenses. If costs increase, an independent contractor
may be paid less than the cost of completing a task and lose money,
shifting the loss to the employer. Showing an opportunity for
profit or loss is a great way to support an assertion that a worker
is an independent contractor.
Type
of Relationship
A
worker might contractually agree to independent contractor status
in writing, but the IRS is not required to follow a contract stating
that a worker is an independent contractor. Instead, the IRS will
look at how the business and the worker interact.
Independent contractors usually work on a specific project or
for a specific period of time, whereas an ongoing relationship
is indicative of an employer/employee relationship.
The importance of the worker’s role in the business is also
examined. If a worker provides services key to the success of
a business, these services are more likely to be performed under
the direction and control of the business, meaning the worker
is an employee and not an independent contractor.
Interns.
Did someone say free labor?
I
gained a tremendous amount of legal experience as a law student
toiling away in windowless rooms with five other unpaid interns
just to have the honor of doing “real work” for an
actual attorney. You probably have your own internship horror
stories. Unfortunately, federal labor laws were drastically changed
in January 2010, and the internships we all remember with such
fondness are much more heavily regulated.
The current state of the Fair Labor Standards Act (FLSA) defines
the term “employ” very broadly. Covered and non-exempt
individuals who are “suffered or permitted” to work
must be compensated under the law for the services they perform
for an employer. However, there are some circumstances under which
individuals who participate in “for-profit” private
sector internships or training programs may do so without compensation.
The Supreme Court of the United States has held that a person
whose work serves only his or her own interest need not be compensated.
This may apply to interns who receive training for their own educational
benefit if the training meets certain criteria. The determination
of whether an internship or training program meets this exclusion
depends upon all of the facts and circumstances of each such program,
but the following six criteria must be applied when making this
determination:
- The
internship, even though it includes actual operation of the
facilities of the employer, is similar to training which would
be given in an educational environment;
- The
internship experience is for the benefit of the intern;
- The
intern does not displace regular employees, but works under
close supervision of existing staff;
- The
employer that provides the training derives no immediate advantage
from the activities of the intern; and on occasion its operations
may actually be impeded;
- The
intern is not necessarily entitled to a job at the conclusion
of the internship; and
- The
employer and the intern understand that the intern is not entitled
to wages for the time spent in the internship.
Unlike the test for determination of employee versus independent
contractor status, which is a balancing test, ALL THE
CRITERIA listed above must be met for an employment relationship
to not exist under the FLSA’s minimum wage and overtime
provisions. If even one of the six criteria are not met, the intern
must be a paid employee.
Conclusion.
It
is possible for a business to replace certain employees with independent
contractors in order to reduce costs. However, a business needs
to be very careful in selecting which positions might be good
candidates for the use of independent contractors, and which positions
should continue to be filled by employees.
Furthermore, while I always felt that trading my time for experience
and a few extra lines on my resumé was a worthwhile exchange,
it seems the federal government now disagrees.
Before classifying workers as independent contractors or bringing
unpaid interns into your business, always speak with a trusted
advisor who is knowledgeable in federal and state labor and employment
laws.
Warm
Regards,
Michael J. Leonard, Esq.
Attorney at Law
San Diego Corporate Law
Find me on Facebook: http://www.facebook.com/SanDiegoCorporateLaw
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