This Practice Note has been updated to reflect the IRS' Voluntary Classification Settlement Program, which came into existence in September 2011.
Independent Contractor Classification
A Note explaining the independent contractor classification, including the benefits of the classification and the penalties for misclassification. This note addresses federal law. For information on state law requirements, see the State Q&A Tools under Related Content.
Numerous companies and other organizations avoid significant tax and other liabilities every year by classifying certain workers as independent contractors (www.practicallaw.com/6-502-8864) instead of employees. However, a company simply referring to a worker as an independent contractor in a written agreement does not protect itself from a legal challenge. Improper classification of workers as independent contractors can result in steep penalties. Audits of independent contractor classifications and lawsuits alleging improper classification have been steadily increasing in recent years. This Note describes:
The independent contractor classification generally.
The benefits of an independent contractor arrangement over an employment arrangement.
The consequences of improper classification.
Measures companies can take to reduce liability once misclassification has been identified, including the Section 530 of the Revenue Act of 1978 safe harbor that can protect companies from tax consequences as a result of misclassification.
The Internal Revenue Service (www.practicallaw.com/0-382-3556) (IRS) independent contractor test.
How to request a determination of worker status from the IRS.
Other independent contractor tests commonly used.
Best practices for minimizing the risk of misclassification.
Enforcement issues relevant to independent contractor classification.
An assessment of workers retained through Professional Employee Organizations and joint employment relationships is beyond the scope of this Note. For more information on joint employment, see Practice Note, Join Employment: Overview (www.practicallaw.com/9-523-4928).
What is an Independent Contractor?
An independent contractor is a worker who contracts with individuals or entities to provide services. An independent contractor does not work regularly for any single company and is not an employee, but contracts with various companies and other groups to provide services when required. An independent contractor typically:
Charges fees for service.
Is contracted only for the term required to perform an identified service or task.
Pays employment taxes personally to the government.
Is not protected by most federal, state and local laws designed to protect employees.
An entity contracting with an independent contractor has the right to control only the end result of the project and not how the independent contractor accomplishes it.
Because independent contractors are self-employed, they are issued an IRS Form 1099-MISC (www.practicallaw.com/0-503-2331) by the contracting individual or entity to report their own fees earned. The contracting individual or entity has no obligation to provide benefits to the independent contractor or employment taxes to the IRS. As self-employed individuals, independent contractors can also perform work for other clients on whatever basis they choose.
An employee, by comparison, is subject to significant oversight by a company, which has the right to control the method and manner of the employee's work. An employee is:
Owed wages and company-paid benefits.
Employed for an indefinite period of time to perform whatever tasks the company requires.
Not required to pay all employment taxes directly to the government because the company pays certain taxes on her behalf and withholds certain amounts directly from the employee's compensation.
Protected by applicable federal, state and local employment laws.
General Characteristics of Independent Contractors
Generally an individual is an independent contractor if her client controls only the result of her work, and not the means and method by which she accomplishes it. Independent contractors offer their services to the general public and take on specific clients for defined projects. They own their own businesses and provide services according to their own terms. The third-party relationship to the independent contractor resembles, for example, the relationship of a client to a:
Workers operating in this kind of a capacity can usually be properly classified as independent contractors. However, companies cannot rely on generalizations to determine independent contractor status. Correct classification depends on the facts of each individual case and how those facts apply to the tests recognized for evaluating classification status (see The IRS Standard and Other Independent Contractor Tests).
Benefits of an Independent Contractor Classification
Because independent contractors are not employees, entities contracting with them can avoid many of the financial and other obligations of using employees to perform work. However, penalties for misclassification are significant (see Consequences of an Improper Classification). Whether a worker is found to be an employee or an independent contractor determines whether the company is responsible for the obligations below.
Tax and Insurance Obligations
A company must pay certain taxes, withhold certain amounts and obtain certain insurance to cover its employees. As a rule, these requirements do not extend to independent contractors. Although these considerations are heavily fact-specific, financial obligations owed with respect to employees, but generally not independent contractors, include:
Social Security and Medicare taxes (owed under the Federal Insurance Contributions Act (www.practicallaw.com/6-502-7586) (FICA)).
Federal unemployment insurance taxes (owed under the Federal Unemployment Tax Act (www.practicallaw.com/3-502-7583) (FUTA)).
State unemployment insurance taxes.
Employment Law Compliance
Companies are required to comply with certain employment laws and regulations concerning their employees (including safety and health laws, wage and hour laws, workers' compensation insurance requirements and employment discrimination laws) that may not apply to independent contractors. Laws protecting employees but generally not independent contractors include:
Immigration Law Compliance
In addition to their other obligations, all employers are required to comply with the Immigration Reform and Control Act of 1986 (www.practicallaw.com/7-504-5735) (IRCA) by completing Form I-9 (www.practicallaw.com/6-502-1061) for each employee hired after November 6, 1986. Employers are not required to complete Form I-9 for independent contractors. (See 8 C.F.R. § 274a.2(b) and the definitions of "employee," "employment" and "independent contractor" in 8 C.F.R. § 274a.1.)
Companies often provide benefits to their employees that are not provided to independent contractors. Examples of benefits typically available to employees but generally not to independent contractors include:
Retirement or pension plans (www.practicallaw.com/2-382-3683).
Consequences of an Improper Classification
Although the benefits of properly classifying a worker as an independent contractor are significant, the financial costs and penalties of improperly making that classification can be serious. Because an independent contractor avoids many of the tax and other employment law requirements of an employment relationship, the IRS, state government agencies and courts construe independent contractor status narrowly and impose large penalties for improper classification.
The IRS typically requires a company to reclassify the worker as an employee, making the company liable for any financial and litigation liability concerning that employee, including:
Back wages and overtime pay.
Tax and insurance obligations.
Employment law compliance.
Tax and Insurance Obligations
Tax and insurance obligations for reclassification are:
Social Security and Medicare taxes (owed under the FICA).
Federal unemployment insurance taxes (owed under the FUTA).
Workers' compensation insurance.
If the company does not report the amounts paid to the misclassified individual consistent with its treatment of the individual as an independent contractor and cannot cite a reasonable basis for this failure, the IRS will impose back taxes at 1.5% of the employee's wages (see IRC § 3509 and IRS Publication 15 (Circular E), Employer's Tax Guide: Treating employees as nonemployees). The IRS may also impose interest and other penalties on the company because of the misclassification. Other penalties are decided on a case-by-case basis depending on individual facts, but may fall into the range of 20% to 40% of the wages paid to the employee. (See IRC Chapter 68.)
Employment Law Compliance
A misclassified worker may also be retroactively entitled to other rights under federal employment statutes. Incorrectly classifying a worker as an independent contractor could lead to claims, including:
Reasonable accommodation and return to work benefits under the ADA and its state equivalents.
Leaves of absence under the FMLA and its state equivalents.
Plant closure and mass layoff notice under WARN (see Practice Note, Worker Adjustment and Retraining Notification (WARN) Act: Overview (www.practicallaw.com/4-501-6503)).
Right to sue for discrimination under Title VII, ADEA and other anti-discrimination laws.
Immigration Law Compliance
Employers that fail to complete a Form I-9 for a worker who is an employee are subject to a wide variety of fine and penalties under IRCA. See Practice Note, Demonstrating the Right to Work in the United States: Financial and Civil Sanctions for IRCA Violations (www.practicallaw.com/7-500-6654) and IRCA Violations: Employer Liability Assessment Chart (www.practicallaw.com/6-519-0836).
A company found to have misclassified an employee as an independent contractor can retroactively be made to pay the benefits the employee would have otherwise been owed over the course of the working relationship.
The company can also be liable for other benefits it intended to only offer to employees. For instance, in a landmark 1997 decision, Vizcaino v. Microsoft, Microsoft was required to pay benefits under its employee stock purchase plan to workers it had improperly classified as independent contractors. Microsoft paid $97 million to settle Vizcaino and a related lawsuit (see Vizcaino v. Microsoft Corp., 120 F.3d 1006 (9th Cir. 1997) and Hughes v. Microsoft, 2001 WL 34089697 (W.D. Wash. 2001)).
A year later, the Department of Labor (www.practicallaw.com/2-501-6354) (DOL) filed a well-publicized suit against Time Warner seeking health insurance, pension benefits and stock compensation for workers that had been classified as independent contractors (see Herman v. Time Warner, 56 F.Supp.2d 411 (S.D.N.Y 1999)). The case settled for $5.5 million dollars with $500,000 specifically earmarked for reimbursement of uninsured and unreimbursed medical expenses.
Mitigating Misclassification Problems
Employers have several options for mitigating consequences if they have misclassified employees as independent contractors.
Section 530 Safe Harbor
A safe harbor protecting companies from the tax consequences of misclassification is available in some instances where a company can show it meets a number of relief requirements. The safe harbor, created by Section 530 of the Revenue Act of 1978 applies where the company:
Had a reasonable basis for the misclassification.
Treated the worker and all similarly situated workers consistently as independent contractors.
Reported all federal tax returns in a manner substantially consistent with the independent contractor classification (for example, by using a Form 1099-MISC for a worker treated as an independent contractor). This criteria will not be met for a particular year if the company did not file the required returns for that year.
The IRS provides a few justifications that constitute reasonable basis for a misclassification, including, for example, that the company:
Reasonably relied on a court case or IRS ruling.
Relied on a past IRS audit that:
began before January 1, 1997; or
included an examination of whether the relevant individual (or an individual in a substantially similar position) should be treated as an employee.
Knew that a significant segment of the relevant industry practices the same misclassification.
Relied on some other reasonable basis (for example, on advice from a lawyer or an accountant who knew about the company's business).
The requirement of substantial consistency would not be met, for example, where the company withheld FICA or income tax from the worker, but treated the worker as an independent contractor for other purposes.
The Section 530 safe harbor only applies to employer-owed taxes. Qualifying workers are judged as employees for other federal tax purposes, including taxes they owe themselves. If the safe harbor rules do not apply, no presumption of employment status is made and status must be analyzed using the IRS standard (see The IRS Standard) to determine whether the worker is properly classified as an independent contractor.
Companies will not be penalized as having treated a worker as an employee (and therefore inconsistently) if either:
They file an amended or delayed tax return treating the worker as an employee because of an IRS audit.
The IRS files a return on behalf of the company treating the worker as an employee.
For more information about the Section 530 safe harbor, see the IRS: Fact Sheet Regarding the Section 530 Safe Harbor. Companies that fulfil the requirements of Section 530 safe harbor can obtain tax relief through the Classification Settlement Program.
Classification Settlement Program
The Classification Settlement Program (CSP) offers a settlement agreement to companies eligible for the Section 530 safe harbor. It gives some measure of tax relief, the amount of which depends on the strength of their safe harbor position. Generally, companies can obtain terms allowing them to avoid tax assessments over one year. If a company meets the reporting requirements, and likely can meet the remaining safe harbor requirements, their tax liability may be reduced to 25%. For more information, see IRS Manual 4.23.6 Employment Tax, Classification Settlement Program.
IRC Section 3509 Liability Reduction
For companies that do not meet the Section 530 safe harbor requirements, IRC Section 3509 Liability Reduction assistance may be available. Under IRC Section 3509, companies are eligible to pay smaller income tax withholdings along with smaller employee shares of FICA. This option does not reduce a company's employer-paid FICA costs. For more information, see 26 U.S.C. § 3509 and IRS Manual 4.23.6 Employment Tax, Classification Settlement Program.
Voluntary Classification Settlement Program
Since September 2011, the IRS has offered a Voluntary Classification Settlement Program (VCSP) authorizing companies to voluntarily reclassify independent contractors (and other nonemployees) as employees. Companies in the program pay a nominal fee to cover missed payroll taxes (10% of the company's tax liability in the most recent tax year). To qualify, employers must:
Have consistently treated in the past and currently treats the workers as nonemployees.
Have filed the required tax forms for the workers in the previous three years (a temporary expansion of the program is available until June 30, 2013 for employers that did not file all tax forms for the workers being reclassified; see Legal Update, IRS Expands Voluntary Classification Settlement Program (www.practicallaw.com/5-524-5330)).
Not be currently under an employment tax audit by the IRS or any other audit by a government agency regarding the workers' classification.
Have complied with any past audits.
Employers can reclassify workers by filing Form 8952, Application for Voluntary Classification Settlement Program, at least 60 days before the date that the worker will be treated as an employee. The IRS also offers Instructions for Form 8952 and a Frequently Asked Questions page. The IRS is not obligated to accept any applications, but does so at its own discretion. When a worker is reclassified, the employer will make a single payment, equal to one percent of the reclassified worker's wages over the past year, which will terminate the employer's previous payroll tax obligations for that employee. For more information, see IRS Manual 4.23.6 Employment Tax, Classification Settlement Program.
The IRS Standard
The federal IRS standard is the test used to determine whether a worker is an employee for federal tax purposes. Historically, the IRS Standard was the "20 Factor Test," (see The Common Law 20 Factor Test) but more recently, the IRS has grouped the 20 factors into three primary categories, explained below. It is the most commonly cited independent contractor test. However, there are different tests to determine independent contractor status for other purposes, such as exemption from the FLSA and federal employment discrimination law. Although largely beyond the scope of this Note, many states also apply their own tests to determine independent contractor status. For more information on independent contractor status for non-federal tax purposes, see Other Independent Contractor Tests and Independent Contractors: State Q&A Tool (www.practicallaw.com/2-505-9584).
The IRS test is the first and most crucial step in determining worker status for federal tax purposes: if a worker is an employee under this test, she is an employee for all federal tax purposes. However, there are distinct statutory exemptions recognized in the definition of employee under FICA, FUTA and other withholding rules. For more information about the exemptions specified under federal tax law, see IRS: Employer's Supplemental Tax Guide, Statutory Employees and Nonemployees.
The IRS standard takes a holistic approach to the independent contractor classification. It looks at three categories of facts to determine the degree of control over or independence of a given worker:
Facts concerning the type of relationship.
For more information, see IRS: Independent Contractor (Self-Employed) or Employee?
A worker is an employee when the company (or other third party) has the right to direct and control the worker. The company need not actually exercise this control, but only have the right to do so. To test whether behavioral control exists in a particular situation, a company should ask, "does the company control or have the right to control, not only what the worker does, but also how the worker does it?"
Behavioral control falls into four categories:
Type of instructions given.
Degree of instruction.
The way the work is evaluated.
The training needed or given.
If the worker is given instruction by the company about when, where and how to work, this factor favors a finding that she is an employee, not an independent contractor. If the worker is given fairly detailed instructions, the worker is more likely an employee, while less detailed instructions reflect less control, indicating that the worker is more likely an independent contractor.
An evaluation system for an independent contractor generally measures the end result only. On the other hand, if the company's evaluation system measures the details of how the work is performed, then this points to an employee relationship.
Finally, if the company provides the worker with substantial training (especially ongoing training) about how tasks should be performed, that training is evidence that the worker is an employee. An independent contractor, by contrast, is free to use her own methods of performing the work.
The following types of instructions tend to indicate a worker is an employee:
When and where to do the work.
Which tools or equipment to use.
Which workers to hire or use to assist with the work.
Where to purchase supplies and services.
What work must be performed by a particular individual.
The order or sequence to follow when performing the work.
For more information about the behavioral control category, see IRS: Behavioral Control.
Financial control refers to whether the company has the right to control the economic aspects of the worker's job. To test this factor, a company should ask, "are the business aspects of the worker's job controlled by the company or client (including, for example, how the worker is paid, whether expenses are reimbursed, who provides tools and supplies, and so on)?"
The IRS expects that independent contractors will:
Have a significant investment in tools, training, office space and the like. A significant investment in these resources indicates independent contractor status. There is no dollar amount that must be achieved for an investment to be considered significant. A significant investment is not always necessary, however, particularly for work that does not require large expenditures.
Pay their own expenses. While employees are generally reimbursed for work-related expenses, independent contractors are much more likely to have unreimbursed expenses in connection with their work. Independent contractors should have fixed ongoing costs incurred regardless of the work they are performing or for whom. For example, an independent contractor is not reimbursed for the cost of operating their equipment to perform their service.
Have the opportunity to make a profit or sustain a loss on the project. An independent contractor has an opportunity to experience a loss or a profit as a result of their investment in tools and other resources. An employee, by contrast, does not typically have an opportunity to make a profit or sustain a loss.
Offer their services to the general public. An independent contractor can generally market and offer her services to the general public as she chooses.
Receive payment based on the task and not by the hour. An employee is generally paid on an hourly or salary basis and receives regular compensation regardless of the tasks she accomplishes. An independent contractor is generally paid by the job or on a flat fee basis.
For more information, see IRS: Financial Control.
Type of Relationship
The type of relationship factor refers to how the relationship is perceived by the worker and company. It depends to a large extent on how the relationship is structured.
To test this factor, a company should ask:
Are there written contracts between the parties? A written contract is a starting point for the IRS to examine the nature of the relationship. However it is not conclusive. Even if an agreement states that the worker is an independent contractor, the IRS may still determine the worker is an employee based on the nature of the actual relationship. For a sample independent contractor agreement, see Standard Document, Independent Contractor/Consultant Agreement (Pro-client) (www.practicallaw.com/2-500-4638).
Does the worker receive employee-type benefits (for example, pension plan, insurance, vacation pay and so on)? Independent contractors should not receive employee-type benefits. Receipt of these benefits indicates an employment relationship.
Will the relationship continue indefinitely? An independent contractor should be hired for a specific project or period of time, not indefinitely. An indefinite working relationship indicates that the intent was to create an employment relationship.
Are the services provided a key activity of the business? Provision of services that are key to the business indicate that the worker providing them is an employee and not an independent contractor, as businesses are more likely to direct and control the activities of a worker providing key services.
The IRS examines written contracts in addition to other information about the working relationship to determine whether the terms clearly provide for an independent contractor relationship (although statements characterizing the worker as an independent contractor in a contract do not suffice as proof of that status). Some facts suggesting an employment-type contractual relationship rather than independent contractor status are:
Employment-like benefits are provided for by the contract.
The service that the worker provides is integral to the company's business.
The service the worker provides is similar to services that employees provide.
The contract is at-will (www.practicallaw.com/4-501-5240).
In contrast, an independent contractor contract generally contains terms specifying the following:
That the relationship is an independent contractor relationship and that the worker is not eligible to receive any employee-type benefits.
A defined service or set of services the worker is being hired to perform.
A fixed fee payable when those services are complete.
That the company may terminate the contract in the event of a material breach.
For more information, see IRS: Type of Relationship.
The Common Law 20 Factor Test
Although the IRS now uses the more holistic approach outlined above, at one time it employed a 20 Factor common law test to determine independent contractor status. Although this is no longer the test in use, it is instructive to review the 20 factors, because many of them were incorporated into the IRS's new approach. These 20 factors are cited frequently by state agencies making independent contractor determinations (for example, in California, the Employment Development Department (EDD) bases its determinations in part on these factors). For more information about state independent contractor considerations, see Independent Contractors: State Q&A Tool (www.practicallaw.com/2-505-9584)..
The 20 factors are:
Instructions: The hallmark of an independent contractor is that only the end result is measured. The independent contractor should not be given instructions or procedures regarding details or methods from the engaging entity and should not be supervised.
Training: An independent contractor should not need training and ideally should have previous expertise in performing the work.
Integration with the company's operations: If the worker provides services similar to those provided by employees or if the success of the company's operations depends on the independent contractor's successful performance, this factor indicates that the worker is subject to direction and control, suggesting an employment relationship. An independent contractor's services are usually separate from the client's business and are not integrated or merged into it.
Services rendered personally: An independent contractor usually has the right to employ others and assign them to perform the services in her place.
Hiring, supervising and paying helpers: If the company supervises or directs the work of the independent contractor's employees or assistants, this supports a finding of an employment relationship. A true independent contractor selects, hires and reimburses her own assistants.
Continuing relationship: An independent contractor tends to be hired for a finite project and the relationship ends when the project is complete. An indefinite or continuing relationship is indicative of an employment relationship.
Set hours of work: Requiring a worker to work during set hours is a clear indication of control and indicates an employment relationship.
Full time or exclusive work: An independent contractor is free to perform work for many companies simultaneously. Requiring the worker to work full time or exclusively for the company is a strong indicator that the worker is an employee.
Location where services are performed: Requiring work to be done on company premises implies a degree of control over the work, indicating an employment relationship. Independent contractors ordinarily work wherever they choose.
Specifying the order or sequence of work: Control over the worker tends to be shown if the order or sequence of work to be performed is specified either in the worker's contract or by the company's practice.
Oral or written reports: If the worker is required to submit oral or written reports about the progress of her work, this indicates an employment relationship. An independent contractor need only deliver the final result, not report on work in progress. Companies should be careful about reports from independent contractors because a report that merely identifies dates or end results is consistent with an independent contractor relationship, while a detailed time record is not.
Payments: An employee is typically paid at regular intervals, while an independent contractor is more likely to be paid a negotiated flat fee or to submit a bid and then be paid by the job. In general, lump sum, fixed fee, commission or by the job payments are consistent with independent contractor status. Hourly, weekly or monthly payments are more consistent with employee status. Further, paying the worker through payroll suggests an employment relationship while paying through accounts payable on receipt of an invoice suggests an independent contractor relationship.
Business or travel expenses: Few expenses are reimbursable to an independent contractor and those that are should be extraordinary. All normal office expenses should be paid for by the independent contractor.
Tools and materials: An independent contractor should have the tools and materials necessary to achieve the agreed on results.
Investment: This factor closely relates to the two previous factors. The focus of the evaluation is to determine whether the independent contractor has a significant investment in her own, independent business. By contrast, employees are economically dependent on their company.
Profit and loss: Payment arrangements such as lump sum payments, under which the independent contractor can profit or lose money (for example, by taking more or less time to complete the job), are consistent with independent contractor status. Independent contractors can also sustain losses relative to their investment of resources.
Number of companies with whom the independent contractor works: The best situation for a finding of independent contractor status is one where the worker can choose between competing assignments. The more dependent the worker is on a single company for income, the more the relationship tends to indicate employment.
Advertises services to the general public: Business cards, advertisements and mailers to the general public all are strong indicators of independent contractor status.
Right to fire: The contract should only allow for termination if the results do not meet the contractual requirements. On the other hand, the ability to terminate the relationship at-will, especially before the task is complete and without any liability, is a factor that points to an employment relationship.
Right to quit: An independent contractor is usually contractually bound to complete the assignment and liable for any failure to deliver the specified result.
Requesting a Determination of Worker Status from the IRS
If after considering the factors above the company is still unsure whether to classify a worker as an independent contractor or an employee, the company can request a determination from the IRS. This process involves the:
Company communicating the important facts of the work relationship to the IRS.
IRS reviewing these facts.
IRS making a decision and communicating its decision back to the company in the form of a Determination Ruling Letter.
To seek a determination, a company completes and returns a Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The form inquires into how the working relationship fits into the three primary areas of control (see The IRS Standard).
Although it can take six months or more to get a determination from the IRS, companies that hire the same type of worker over and over again can benefit from seeking a conclusive determination, which they can rely on going forward in all relationships of that category. However, if any significant element of the work relationship changes, the company should not continue to rely on an old determination. It should re-file for a new determination based on the new facts of the work relationship.
Other Independent Contractor Tests
Because there are a variety of tests used to assess independent contractor status under a variety of statutes, it is possible to be an independent contractor for some purposes and an employee for others. All tests for proper classification attempt to determine how much control the entity has over the worker, but they consider slightly different factors to reach that conclusion.
As the DOL and the IRS crack down on misclassification, courts are beginning to recognize the challenges these various tests present for companies (see Murray v. Principal Financial Group, Inc., 613 F.3d 943, 945(9th Cir. 2010), holding that tests for purposes of independent contractor status under Title VII, ERISA and ADEA were "virtually indistinguishable"). However, there is no single test for evaluating independent contractor status for all purposes. Companies should be aware of other tests recognized to evaluate classification of independent contractors.
Common Law Darden Test
The common law Darden test is generally used in the context of Title VII, the ADA, the ADEA and ERISA because those statutes share the same definition of employee. It is regularly, but not exclusively, used to determine coverage under these statutes. It focuses on the common law principles of agency law to determine the hiring party's right to control the manner and means by which the work is accomplished and, accordingly, worker status. The following factors are considered:
The skill required.
The source of the instrumentalities and tools.
The location of the work.
The duration of the relationship between the parties.
Whether the hiring party has the right to assign additional projects to the hired party.
The extent of the hired party's discretion over when and how long to work.
The method of payment.
The hired party's role in hiring and paying assistants.
Whether the work is part of the regular business of the hiring party.
Whether the hiring party is in business.
The provision of employee benefits.
The tax treatment of the hired party.
(See Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 323 (1992). For examples of courts applying the Darden test, see Weary v. Cochran, 377 F.3d 522, 525 (6th Cir. 2004), Wortham v. American Family Ins. Grp., 385 F.3d 1139, 1140-41 (8th Cir. 2004) and Barnhart v. New York Life Ins. Co., 141 F.3d 1310, 1312-13 (9th Cir. 1998).)
The US Supreme Court has rejected this test for purposes of the FLSA, and instead applies the economic realities test for evaluating independent contractor status under it (see Schwind v. EW & Assocs., Inc., 357 F. Supp. 2d 691 (S.D.N.Y. 2005), citing N.L.R.B. v. Hearst, 322 U.S. 111 (1944) and McGuiggan v. CPC Int'l, Inc., 84 F. Supp.2d 470, 479 (S.D.N.Y. 2000)). See Economic Realities Test.
Economic Realities Test
As noted above, the economic realities test is always used to assess independent contractor status under the FLSA (see Bartels v. Birmingham, 332 U.S. 126, 130 (1947) and Henderson v. Inter-Chem Coal Co., 41 F.3d 567, 570 (10th Cir. 1994)). It is also sometimes used to assess independent contractor classification under other federal employment statutes, including Title VII, the ADA and the ADEA (whether the Darden test, the economic realities test or the hybrid test below is used in a particular case depends on the jurisdiction of the court applying it).
Under the economic realities test, the hiring entity is an employer if the workers are dependent on the entity to which they provide services (see, for example, DiPilato v. 7-Eleven, Inc., 662 F. Supp. 2d 333, 346-347 (S.D.N.Y. 2009), citing Frankel v. Bally, Inc., 987 F.2d 86, 89 (2d Cir. 1993)and Bartels, at 130).
Although there are several interpretations of the factors to be considered in the economic realities test, the DOL has broken those factors down into seven elements:
The extent to which the services rendered are an integral part of the hiring entity's business.
The permanency of the relationship.
The amount of the alleged contractor's investment in facilities and equipment.
The nature and degree of control by the hiring entity.
The alleged contractor's opportunities for profit and loss.
The amount of initiative, judgment or foresight in open market competition with others required for the success of the claimed independent contractor.
The degree of independent business organization and operation.
(See DOL: Fact Sheet #13: Employment Relationship Under the Fair Labor Standards Act (FLSA) . See also Herman v. Mid-Atlantic Installation Servs., Inc., 164 F. Supp. 2d 667, 671 (D. Md. 2000) and Henderson, at 570.)
The DOL (drawing from case law) also notes that, for purposes of the FLSA economic realities test, time or mode of payment is not conclusive evidence of status and the following factors are irrelevant to status:
Place where the work is conducted.
Whether there is a formal agreement.
Whether the worker is licensed by state or local government.
Another test recognized by many courts is the hybrid test. The hybrid test has been used by some courts to determine independent contractor status under statutes like Title VII and the ADEA. As the name implies, it accounts for both the common law Darden factors and the economic realities test (see, for example, Wilde v. County of Kandiyohi, 15 F.3d 103, 105 (8th Cir. 1994) and Deal v. State Farm County Mut. Ins. Co. of Texas, 5 F.3d 117, 118-19 (5th Cir. 1993)).
Although an assessment of tests states use for purposes of classification of independent contractors is beyond the scope of this Note, companies should recognize that many states do use their own tests. For more information on state-specific tests for independent contractor status, see Independent Contractors: State Q&A Tool (www.practicallaw.com/2-505-9584). Some of these tests may narrow the definition of independent contractor more than the federal tests. For example, Connecticut uses an ABC test for determining independent contractor status under its unemployment tax law (see Connecticut DOL: Fact Sheet Regarding Connecticut's Independent Contractor ABC Test).
Under the ABC test, independent contractor status is not recognized unless the worker is "customarily engaged in an independently established trade, occupation, profession or business of the same nature as the service performed." In other words, unless the worker performs the same services for another party, the worker is not classified as an independent contractor. Companies should ensure that any state-specific tests are also satisfied when considering independent contractor status of a worker.
Minimizing the Risk of Misclassification
To minimize the risk of potentially significant misclassification liability, companies should carefully evaluate their workers to ensure they are properly classified and should never classify them as independent contractors merely for convenience's sake. Steps companies can take to protect themselves include:
Conduct an audit. Outside counsel can review existing worker classifications and determine whether they are in accordance with applicable state and federal laws. Alternatively, companies can conduct an internal audit themselves, judging the worker relationship against the IRS standard (see The IRS Standard). (See also Using Independent Contractors and Outside Firms: Avoiding Employee Misclassification Checklist (www.practicallaw.com/2-501-3609).) If a misclassification is discovered, companies should promptly correct any misclassifications and pay any taxes, back wages and benefits owed. Counsel should be engaged in any reclassification process to minimize risk of related employee litigation. Companies should also consider taking advantage of the Voluntary Classification Settlement Program (see Voluntary Classification Settlement Program).
Train personnel on classification issues. Many companies are not aware that misclassification is a possible risk. Training employees that contract with independent contractors on this risk helps ensure the relevant individuals have the knowledge they need to correctly classify company workers.
Obtain a ruling from the IRS. The company can file a Form SS-8 Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS (see Requesting a Determination of Worker Status from the IRS) to ask the IRS if it is properly classifying a category of workers. It can take six months or more to get a determination from the IRS, but a ruling provides a conclusive answer and can be relied on as a reasonable basis under the Section 530 safe harbor (see Section 530 Safe Harbor). Companies should be aware that an IRS ruling that the worker is actually an employee is also a conclusive answer, however.
Draft contracts with an awareness of the independent contractor distinction. When classifying a worker as an independent contractor, companies should take care to do so under a carefully drafted independent contractor agreement that takes into account the factors discussed above (for a sample independent contractor agreement, see Standard Document, Independent Contractor/Consultant Agreement (Pro Client) (www.practicallaw.com/2-500-4638)).
Enforcement of Classification Rules
In 2010, the IRS began a planned audit of 6,000 companies over three years for improper independent contractor classification. Enforcement expanded in 2011 when the DOL joined forces with the IRS (see WHD: Employee Misclassification as Independent Contractors). The DOL is also focusing on improper classification in wage and hour audits, which have also increased in recent years (for more information, see Article, Wage and Hour Investigations (www.practicallaw.com/4-500-8999)).
State government agencies are also vigorously enforcing rules against misclassification of workers and raising related penalties. Although this Note does not address state-based independent contractor enforcement, numerous states are proactive in enforcing proper classification (for example, California, Colorado, Connecticut, Illinois, Iowa, New Jersey and New York).
New Jersey's Construction Industry Independent Contractor Act, for example, imposes severe criminal penalties and even imprisonment on company officers for knowingly misclassifying workers. The Illinois Department of Labor also imposes financial penalties and may ban the culpable company from receiving state contracts for four years. In California, if the EDD determines that the company's failure to pay employment taxes is due to negligence or intentional disregard of the law, a penalty of up to 10% of the amount of the deficiency is added to the assessment of back taxes. If the failure is due to fraud or intent to evade the law, the EDD imposes an additional penalty of 50% of the amount of contributions assessed. Because of the wide variety of independent contractor classification enforcement from state to state, it is vital to understand the law of any relevant jurisdiction to minimize risk of penalty.
For more information on state enforcement, see Independent Contractors: State Q&A Tool: Question 7 (www.practicallaw.com/2-505-9584).