What Is An Independent Contractor? Part II
Risks of Hiring Independent Contractors
By Johnny Duncan
There are many horror stories told by businesses who have been penalized by the Internal Revenue Service (IRS) for neglecting to properly classify a worker as an IC or an employee. However, it is not just the IRS that can come after a business for failure to identify workers correctly, audits by state agencies are even more common. They occur when workers classified as ICs apply for unemployment compensation after their services are terminated. State unemployment insurance agencies, state workers’ compensation insurance agencies, state tax departments, the U.S. Labor Department, and the National Labor Relations Board are just a few other governmental agencies who develop and enforce guidelines concerning the classification of workers. Because each of these agencies is concerned with worker classification for different reasons, they have different biases and practices. It is possible for one agency to find that a worker is an IC and another agency to find that he or she is an employee.
The only way for a business to successfully avoid any governmental interference is to spend the time and effort necessary learning how these agencies utilize different testing procedures to classify workers. About one-third of audited firms are required to reclassify contractors as employees. The penalty for misclassifying a worker as an IC can be economically devastating. The firm must pay the IRS all back taxes owed, with interest, plus a penalty of 12% to 35% of the tax bill.
One other disadvantage of hiring ICs is that they can sue the firm for negligence if they are injured on the job. Normally, employees covered by workers’ compensation cannot do this. If a firm is considering hiring an IC, it is wise for the firm to be certain the IC has the proper insurance-- general liability, state workers’ compensation, errors and omissions, and a surety fidelity bond -- and know the limits of the coverage.
Qualifications of Independent Contractors
Many statutes and regulations are based upon the "common law" test. Under the common law test, an employment relationship will be found if the employer exercises (a) "control" or (b) has the "right of control" over the individual’s performance of the job and how he or she accomplishes the job. The common law test was applied in the Dart Industries, Inc. v. Department of Labor and Employment Security, Division of Unemployment Compensation case. This case cites the Restatement (Second) of Agency § 220 (1958) which sets out factors for determining whether one is an employee or an independent contractor. After defining the ten factors used to determine if the worker is an IC or an employee, it was stated "of these factors, the principal factor for consideration is the employer’s right of control over the mode of doing the work." The common law test or the right of control of the employer is the foundation of all the tests used by the many governmental agencies concerned with worker classification. The following sections detail just a few of the tests used by different agencies to determine the correct classification of a worker.
The Internal Revenue Service Test
The reason the IRS is concerned with determining whether a worker is an independent contractor is because employers are required to arrange for three types of employment taxes. These are required under the Federal Insurance Contributions Act (FICA), which governs employer and employee contributions to the Social Security system; IRS rules governing employee personal income tax withholding; and the Federal Unemployment Tax Act (FUTA), which governs employer contributions to the unemployment fund. Employers may avoid this hassle if the worker is classified as an independent contractor. The problem however, is that many employers mis-classify their workers and end up paying substantially more in back-taxes, interest and fines than if they had correctly identified the worker as an employee.
The IRS test is in essence the common law test to which 20 "right of control" factors have been added. A copy of The IRS’s 20 Factors Used to Determine Employment Status is included in Appendix A.
Unemployment Compensation Test
Many state unemployment compensation agencies use a special statutory test called the ABC test to determine worker status. The ABC test focuses on just a few factors:
Again, the basis of the test is whether or not the employer has control of the worker in the accomplishment of the project.
- Whether the hiring firm controls the worker on the job
- Whether the worker is operating an independent business
- Where the work is performed
The Fair Labor Standards Act (FLSA) Test
The FLSA governs the federal minimum wage and overtime obligations of employers. As stated earlier, employers may sometimes try to reduce these obligations merely by classifying workers as independent contractors. The employer is subject to severe penalties if the U.S. Department of Labor determines that the workers are indeed employees. Penalties may include the payment of unpaid overtime premiums to liquidated damages, fines, and imprisonment for willful violations.
The "economic realities" test is used by the FLSA to focus on whether an individual is economically dependent on the business to which services are provided, consequently establishing employee status, or whether the worker effectively is in business for himself or herself. The "right of control" under the FLSA is usually determined by reference to one of six approximately equal factors:
- The extent to which the services in question are part of the company’s business
- The amount of the individual’s investment in the company’s facilities and equipment
- The nature and degree of control retained by management
- Individual opportunity for profit and loss
- The amount of initiative, skill or judgment required
- The permanency and duration of the relationship
The employment arena is heavily regulated to prohibit different types of discrimination. For example, Title VII of the Civil Rights Act of 1964 prohibits employers from discriminating against employees on the basis of race, color, religion, sex or national origin. Similarly, the Age Discrimination in Employment Act (ADEA) prohibits employment discrimination on the basis of age. Florida state and federal contractors are required to engage in affirmative action to encourage employment of minorities, women, the disabled and Vietnam era veterans. By their stipulations, these laws protect only employees with few provisions, if any, to protect independent contractors.
To decide whether an individual is an employee, and therefore entitled to the protection under the discrimination laws, some courts have applied the "economic realities" test. As with most tests used by the government, other factors are looked at to determine the correct classification of the worker including: method of payment; furnishing of supplies, tools, and workplace; skill required; work supervision; terminability at will; and duration of employment. Of all these factors, the "right of control" is the most important, but courts that have applied a combination of both the "control" and the "economic realities" tests were able to provide a more definitive ruling.
In some cases the plaintiffs, who were ICs, argued that discrimination led to denial of a privilege that is basic to an employment relationship. In Gomez v. Alexian Bros. Hosp. of San Jose, 698 F.2d 1019, 1021 (9th Cir. 1983), a Hispanic doctor could sue a hospital for discrimination in not awarding an emergency room care contract to his medical group. A similar Title VII case, but where the right to control and economic dependency was found was in Diggs v. Harris Hospital-Methodist. Inc., 847 F.2d 270 (5th Cir. 1988), cert. denied, 109 S.Ct. 394 (1988). In this case, a black, female obstetrician/gynecologist was not a hospital employee for purposes of Title VII because: 1) there was no evidence that staff privileges were necessary to medical practice; 2) the hospital did not direct the manner or means by which the doctor provided medical care; 3) she was not required to admit her patients to the hospital; and 4) the hospital did not pay her for her services. Employers need to be aware of the extensive interpretation of Title VII’s language, and the potential discrimination claims from not only employees, but ICs as well.
California’s Borello Test
California uses an approach in regulating employment that is different in many respects from that of the federal government. One interesting approach is the application of the California’s Supreme Court decision found in S.G. Borello & Sons v. Department of Industrial Relations, supra, 48 Cal.3d 341. On March 23, 1989, the Court rejected the application of the common law right of control to determine independent contractor status under at least California’s workers’ compensation statute. Instead, the Court relied heavily on three different legal tests. The Court noted that the guidelines regarding:
The final outcome is that the Borello Court seems to bring California more closely in line with the IRS’ 20 factor analysis. In the Borello case, the Supreme Court of California held specifically that cucumber pickers were "employees" entitled to workers’ compensation coverage based on the following facts:
- The common law "right of control" test "remain a useful reference"
- The standards set forth in Labor Code section 2750.5 are also a "helpful means of identifying the employer/contractor distinction"
- Six factors adopted by other courts to consider the remedial purpose of the legislation were also helpful to draw lines between the status of employees and independent contractors
In summary, California has determined that in a workers’ compensation setting, independent contractor status is found "when the provider of service has the primary power over work safety, is best situated to distribute the risk and cost of injury as an expense of his own business, and has independently chosen the burdens and benefits of self-employment."
- The "sharefarmer" workers at issue had no control over the operation as a whole such as crop cultivation, selection of the buyer and price
- Sharefarmers had no particular skill or expertise
- The work was seasonal, but permanent
- The sharefarmers had no distinct trade or calling
- Sharefarmers did not hold themselves out in business
- Workers invested only their personal service and hand tools
- There was no opportunity for profit and loss; the possibility that the crop would fail is the chance faced by any at-will wage earner that his or her services will not be needed after all
- The sharefarmers relied solely on field work for their livelihood
- There was no practical opportunity for the sharefarmers and their families to self-insure for workers’ compensation coverage
- There was no real opportunity to negotiate over the preprinted contract that was offered to heads of families who would harvest the crop
In our third and final issue, we will examine further tests for determining the existence of an independent contractor and the effects of worker’s compensation laws.