Classifying Workers as Employees or Independent Contractors

Hello, my name is Spencer Pittman, and I am an attorney with the law firm of Winters & King, which is located in Tulsa, Oklahoma.  Winters & King represents and advises businesses across the nation on employment-related issues, such as rights under various state or federal rules or laws, carefully crafting employment agreements or independent contractor agreements, and ensuring our clients properly classify their workers to minimize liabilities.  This Podcast episode is going to focus on the key differences between an employee and independent contractor, why the distinction is important, and what types of legal exposure and liabilities can result in the misclassification of one of these types of workers.

It is critical that employers understand these differences and correctly determine whether an individual providing services is an employee or independent contractor.  Many employers (in addition to contractors) incorrectly assume that all that is needed to classify a worker as a independent contractor is a 1099 or some “independent contractor agreement” stating the worker is an independent contractor.  The determination is not this simple and a variety of factors must be weighed, often by professional legal counsel or tax advisor.  To guide in the process of making this determination for cases in which the classification is not readily apparent, the IRS has implemented three tests to help a business determine whether a worker is an employee or an independent contractor. These tests include the behavioral control, financial control, and relationship type tests. These tests evaluate different aspects of the worker’s relationship with the business to determine the level of control the business has over the worker and whether the worker is operating as an independent contractor or an employee.

The first test is the behavioral control test.

The behavioral control test examines the level of control the business has over the worker’s behavior. One factor under the behavioral control test is the type of instructions and training given by the business to the worker.  More detailed instructions given by the business means more control the business exercises over the worker, which points towards an employee rather than an independent contractor.  For instance, a worker is usually classified as an employee when the business has the right to direct and control the worker. It is important to note that the business does not have to actually direct or control the way the work is done, but rather, the business only has to have the right to direct and control that work.  If the business trains the worker on how to do the job, especially on a periodic or on-going basis, it indicates the business is directing the worker on how to do the job in a particular way, which weighs in favor of an employment relationship.  On the other hand, an independent contractor has control over their own work and is responsible for its completion.  They are provided little to no instructions or details on the methods on how to perform the work, and are expected to use their own methods and training to perform and complete the work in a good and workmanlike manner, and in accordance with generally-accepted practices in their industry.

Another factor is how the worker is evaluated on their job.  Employees are evaluated on the details of how the work is performed, similar to performance reviews, whereas contractors are reviewed on the end-result of the job.

The second test is the financial control test.

The financial control test looks to whether or not the business has the right to control certain economic aspects of the worker’s job, such as reimbursement of expenses, tax-statuses, and payment methods.

Primary parts of this test is the investment of the worker in the equipment and the realization of profits and losses in the completion of the work.  For instance, if a worker has a greater chance of incurring a loss based on his or her investments in tools, equipment, and unreimbursed expenses, the worker is more likely to be classified as an independent contractor.  Another factor that comes into play in this test include whether the worker is free to seek out additional business opportunities (if so the worker is more likely an independent contractor).  Financial control also dictates how the worker is paid.  An employee is generally paid a regular wage amount, such as a salary, for a period of time.  On the other hand, an independent contractor is usually paid a flat fee for the job.  A difference between an employee and an independent contractor is their tax statuses. Employers are required to withhold income taxes, Social Security taxes, and Medicare taxes from their employees’ paychecks. These taxes are commonly referred to as Federal Insurance Contributions Act withholdings, or FICA. Again, FICA contributions are withheld from a wage earning employee’s gross pay, and employers must match the FICA taxes paid by their employees. In contrast, independent contractors are responsible for paying their own income taxes and self-employment taxes.  Unlike an employee that receives a W2 each year, an independent contractor is issued a Form 1099 reflecting the compensation from the prior year.  As you can probably see, misclassifying an employee as an independent contractor means the business would not be properly withholding FICA, which leads to obvious concerns and the potential for liabilities.

The third and final test is the relationship type test.

The relationship type looks to how the worker and the business perceives their relationship to each other.  One of the most important factors under this test are the terms of a written agreement between the worker and the business.  Of course, an independent contractor agreement may suggest the business and the worker intend their relationship to not be employer-employee based, but this alone is not sufficient to determine the worker’s status.  Even if the written agreement expressly states that the relationship is intended by the parties for the worker to be an independent contractor, the IRS is not required to follow these terms if the other factors suggest the worker is an employee.

The benefits offered by the business to the worker are indicative of the relationship between the parties.  Employers may be required to provide benefits such as health insurance, retirement or pension plans, sick days, and paid time off or vacation to their employees. While the lack of these benefits and other types of similar benefits does not necessarily mean the worker is an independent contractor, businesses generally do not grant these benefits to independent contractors.  Independent contractors are also expected to provide their own benefits to their own employees if they have any.

Also, workers that have the expectation that the relationship with the business will continue indefinitely is more likely to be classified as an employee whereas independent contractors usually only work on a specific project or a fixed time period.

Many of the factors in the behavioral control, financial control, and relationship type tests have some overlap, and not all factors under these tests are discussed in this podcast.

Misclassifying an employee as an independent contractor can result in significant legal liability exposure and consequences for businesses. One significant liability is the potential for back taxes and penalties due to the IRS. If the IRS determines that an employee was misclassified as an independent contractor, the business may be required to pay back taxes and penalties for failing to properly withhold taxes and pay their share of Social Security and Medicare taxes. The business may also be liable for unpaid overtime wages and other employee benefits.

Another potential liability is the risk of a private legal action by misclassified employees. Misclassified employees could file a lawsuit against the business claiming they were not paid overtime wages or were denied employee benefits discussed earlier that may be mandated by law upon the business or guaranteed under an employee policy manual. These types of lawsuits do not help a business’s public reception.

Correctly evaluating whether a worker is an employee or an independent contractor is not always an easy and straightforward task. For instance, if the behavioral control test weighs in favor of an employee, the financial control test weighs in favor of an independent contractor, and the relationship type test is unclear, what should the business do?  Obviously, flipping a coin to make the decision is not a good option and would not be in the best interest of the business, so the business should consult with legal counsel at the earliest opportunity to avoid the potential liabilities, tax ramifications, private actions, and other fines.

If you want assistance with classifying your workers or want to know whether you have been correctly classified by a business, consult with the attorneys at Winters & King by calling 918-494-6868.