Deborah Neyens is an attorney, educator, and freelance writer with a B.A. in political science and a J.D. from the University of Iowa.
Mistaking Employees for Independent Contractors
A fundamental issue in employment law is whether a worker is an employee or an independent contractor. A lot hinges on the answer as far as the worker is concerned. Only employees are protected under federal and state employment laws governing wages and hours, prohibiting unlawful discrimination, and setting workplace safety standards. Also at stake are access to critical benefits, including both employer-provided benefits like health insurance and retirement plans and legally-mandated benefits such as workers' compensation and unemployment insurance.
Why Many Employers Prefer Independent Contractors
From the employer's perspective, there are a number of advantages to using independent contractors instead of employees. Independent contractors are less costly because they are not subject to minimum wage and overtime laws, they aren't eligible for employee benefits, and the employer invests minimal resources in providing training and other direction on the job. Because there are no payroll and other employment records to be kept or employment taxes to be withheld, contract workers present less of an administrative burden than employees. Employers generally have greater flexibility in adding and eliminating contract positions to address fluctuating workloads or temporary needs. Federal and state employment laws don't apply to the relationship, insulating an employer against liability for workplace claims.
In this day and age of virtual workplaces and mobile workforces, there can be a fine line as to what distinguishes employees from independent contractors. The advantages using independent contractors may incentivize some employers to cross that line. The U.S. Department of Labor Wage and Hour Division has noted an "alarming trend" of employee misclassification in recent years. Of the 10.3 million U.S. workers classified as independent contractors, 30 percent or more may be misclassified, the Government Accountability Office has said.
Other Names for Independent Contractors
Independent contractors are found in all industries and may be referenced by many different terms, including:
- Contract labor
- 1099 workers
- Project workers
- Contingent workers
- Per diems
What Is Employee Misclassification and Why Is It a Problem?
Quite simply, misclassification of an employee occurs when an employer improperly classifies a worker as an independent contractor, rather than an employee. Misclassification creates problems at multiple levels of society.
Employee misclassification adversely impacts the improperly-characterized workers, who are denied the protections and benefits of the employment relationship. It also negatively affects law-abiding employers who play by the rules and are at a competitive disadvantage to those who don't. Finally, it hurts the economy.
Substantial tax revenue is lost to the federal treasury, to Social Security and Medicare funds, and to state unemployment and workers’ compensation funds due to employee misclassification. An estimated $2.72 billion was lost in 2006 due to underreporting. Indeed, many misclassified employee are forced to pay employment taxes their employers should have paid.
The Penalties for Misclassifying Employees
In 2012, employers across the United States had to pay significant amounts to employees who were misclassified as independent contractors. Here are a few cases:
- Jan. 9: A Tennessee security company was required to pay $62,000 in back wages to 34 guards.
- May 3: A suburban Chicago maid service had to pay more than $500,000 in back pay and liquidated damages to 75 cleaning employees.
- May 14: After a Department of Labor investigation, a California home healthcare provider had to pay $654,082 to 108 nurses.
- Aug. 23: A Texas pipe company was required to pay over $100,000 for unpaid overtime to 55 shop employees who were treated as independent contractors during a 90-day probationary period.
- Aug. 20: A Washington, D.C. drywaller owed over $100,000 in unpaid overtime to 120 workers who were paid on a piece-rate basis regardless of hours worked.
Source: DOL Press Releases: Employee Misclassification as Independent Contractors
What Happens When an Employer Gets It Wrong?
Recent years have seen increased governmental efforts to stem the tide of employee misclassification. Through targeted and multi-agency initiatives and an increased enforcement budget, employers have been audited for compliance at greater frequency. The Department of Labor has budgeted $14 million for 2013 to detect and remedy employee misclassification. Many states have passed or introduced legislation intended to address the problems caused by employee misclassification. Legislation also has been introduced at the federal level.
The cost to an employer of getting it wrong can be great. The financial risks of an IRS proceeding include liability for unpaid federal employment and state unemployment taxes and for income tax the employer did not withhold. Penalties also may apply.
In a Department of Labor proceeding, the employer may be liable for payment of back wages owed to misclassified employees who were not paid minimum wage or overtime. Willful violations may result in criminal prosecution, monetary fines, and imprisonment in severe cases. The employer also may be subject to civil money penalties.
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How Do You Determine If a Worker Is an Employee or Independent Contractor?
There is no single test to determine whether a worker should be classified as an employee or an independent contractor. Each government agency has its own test. While they all have some similarities, each test has its own nuances.
The IRS Factor Test
The IRS identifies employers who are failing to withhold taxes from the worker's pay and make contributions to FICA (Social Security and Medicare) and FUTA (unemployment) by considering a number of factors under three major criteria:
- Behavioral Control: Considers who has the right to direct and control the details and means by which the worker performs services. If the employer maintains the right to direct how, when, and where the employee performs the job, the relationship looks more like an employment relationship.
- Financial Control: Assesses the worker's financial independence and risk. If the worker has a significant investment in the work, is responsible for his or her own expenses, and has an opportunity to make a profit (or incur a loss), the relationship looks more like an independent contractor relationship.
- Relationship of Parties: Looks at the overall nature of the relationship and the parties' intent. How do the parties view the relationship? If there is a written contract between the parties, its terms generally will be great significant weight.
No one factor is determinative. Instead, the IRS independent contractor test considers the totality of the relationship to see if the employer maintains a right to control the worker.
The IRS Factors
Does the employer provide instructions?
Does the employer provide training?
Does the worker make a significant investment of his/her own?
Does the employer pay the worker's expenses?
Are the worker's services available to others?
Is the worker paid in increments?
Does the worker bear the risk of profit or loss?
Is the work part of the employer's regular business activity?
Does the worker receive benefits?
Does the worker have a written contract with the employer?
Do the parties have a right to terminate the relationship at any time?
Does the employer have the right to withhold payment for unsatisfactory work?
The Department of Labor Economic Realities Test
The Department of Labor (DOL) enforces laws requiring payment of minimum wage and overtime under the Fair Labor Standards Act. It applies the Economic Realities Test to determine whether workers who should be classified as employees are getting the pay to which they legally are entitled.
The DOL looks at the economic realities of the parties' whole business relationship to determine whether the worker is economically dependent on the employer or is truly in business for himself or herself. The test considers the following factors:
- How much control the employer has over the way the work is done.
- Whether the worker has an opportunity for profit or risk of loss independent of the employer.
- Whether the worker has invested in the facilities and business equipment.
- The permanency of the relationship.
- The degree of skill needed to do the work.
- Whether the work is an integral part of the employer's business.
Like the IRS Factor test, no one factor is determinative.
The EEOC Test
The Equal Employment Opportunity Commission (EEOC) applies a variation on the common law agency test to determine if workers are employees covered under law prohibiting employment discrimination. The EEOC looks at a number of factors around the employer's right to control the worker. The following factors suggest a worker is an employee:
- The employer has the ability to control how, where, and when the job is performed.
- The worker does not need a high skill level or special expertise to perform the job.
- The employer provides the worker with the tools and equipment to do the job.
- The worker performs the work at the employer’s worksite.
- There is an on-going relationship between the worker and employer.
- The employer may assign additional projects to the worker.
- The employer sets the work hours and job duration.
- The worker is paid based on increments of time (hourly, weekly, monthly, etc.) rather than upon completion of the project.
- The worker does not have his or her own employees or subcontractors to assist with the work.
- The work is part of the employer's regular business.
- The worker does not have his or her own business.
- The employer provides benefits to the worker.
- The employer can terminate the relationship at will.
- The parties intended to create an employment relationship.
Joint Employer Liability
A worker may be deemed to have two employers if two entities have the right to exercise control over the worker’s employment. For example, the staffing agency that payrolls a worker and the business for which the worker performs services may be deemed joint employers of the worker.
If there is a joint employer relationship, both employers have the following obligations to the worker under federal and state employment laws:
- To provide a workplace free from discrimination and harassment.
- To provide reasonable accommodations under the Americans with Disabilities Act.
- To reinstate a worker returning from leave under the Family Medical Leave Act.
- To provide a safe work environment under the Occupational Safety and Health Act.
Joint employers who are found in violation of employment laws will be jointly and severally liable for back pay and other damages to the worker.
Ways to Minimize Employer Liability for Misclassification
An employer can minimize the risk of employee misclassification by taking the following steps with respect to its independent contractors:
- Avoid contracting with former employees (including retirees) to provide services similar to the services they performed as employees.
- Contractors' access to company facilities and systems should be limited to what they need to perform the work.
- Contractors should not be provided with company business cards, stationery, uniforms, or other materials that create an appearance of an employment relationship.
- If possible, contractors should work off premises or under their own on-site management.
- Contractors should have, or acquire at their own expense, the basic skills training and equipment to perform the work.
- Contract work arrangements should be project specific and of limited duration.
- Contractors should be paid on a project basis, not an hourly or salary basis.
- Contractors should not be referred to as employees and should be distinguished from employees in employer directories and on organizational charts.
- Use an independent contractor agreement indicating the parties' intent to establish an independent contractor arrangement and not an employment relationship.
- Use contractors who are employed by another entity, like a staffing agency, pursuant to a written agreement making the other entity responsible for withholding taxes and complying with other employer obligations.
- Periodically perform self audits to determine if workers are appropriately classified, using the agency tests for guidance.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2012 Deborah Neyens
Deborah Neyens (author) from Iowa on September 15, 2014:
Thanks, niveaboy. Welcome to Hubpages. I'm glad you have found my hub useful in organizing your own hubs.
M. Subandi from Sumedang, West Java, Indonesia on September 13, 2014:
Excellent hub, adds my ideas in organizing...mine.
Deborah Neyens (author) from Iowa on July 24, 2014:
Homeplace Series, thank you for the thoughtful comment. I'm glad you found my hub useful. Do you have any hubs on the subject or is your work elsewhere? I am curious to see it.
William Leverne Smith from Hollister, MO on July 20, 2014:
Excellent hub, Deborah, thank you for sharing. I've written on this subject many times, over the years. It continues to be an area of great confusion... and problems for folks that really don't deserve it. Thanks for this update. Extremely useful! ;-)
Deborah Neyens (author) from Iowa on February 02, 2014:
It does sound like a fine line, bn9900, but as long as you have the flexibility your need, it sounds like the arrangement works pretty well for you. The big concern can be when the employer is trying to take advantage of the worker by trying to the exert the control of an employee-employer relationship but without the benefits. Thanks for commenting.
Clayton Hartford from Alger WA on February 01, 2014:
Very interesting Hub, I am an IC but it is set up through a Corp that is the go between myself and the client, they set up the training, the pay and such. I am a virtual call center, I make my own hours, but have a signed Statement of work (SOW) that states a minimum numbers of hours worked. I have a bit of leeway on that. I do my own taxes, but am promised an hourly wage. So it is a fine line for me, but when you are helping manage ATT accounts there has to be some control on both ends.
Deborah Neyens (author) from Iowa on October 28, 2013:
Good luck with the new business, ElleBee!
ElleBee on October 26, 2013:
interesting - I am looking in to starting some freelance/consulting work of my own, and this brought up a lot of the legal concerns which I hadn't yet thought of. I will definitely be referring back to this as I get my business (of sorts) going.
Deborah Neyens (author) from Iowa on August 19, 2013:
Good point, neotropic. If the injury was caused at least in part by the company's negligence, the contractor potentially could recover under a tort claim. But a showing of negligence would be required whereas a workers comp claim does not require a showing of negligence.
neotropic on August 19, 2013:
Deb, great article! Thank you. One thing: You write, "Federal and state employment laws don't apply to the relationship, insulating an employer against liability for workplace claims." But actually, if a person is an independent contractor and injured on the job, no workers' compensation benefits are received, which means that there’s no limitation on their ability to sue the business for whatever damages the court will award.
Eric Dierker from Spring Valley, CA. U.S.A. on May 29, 2013:
Oh goodness no, my job is to clean up crap, and they cannot get any one else to do it.
Those of us that will take on the garbage of the world are still in demand.
Deborah Neyens (author) from Iowa on May 29, 2013:
I am amazed that your clients are agreeing to do that, Eric. So many companies are so concerned with headcount and keeping their employee numbers down these days. You must do great work for them!
Eric Dierker from Spring Valley, CA. U.S.A. on May 29, 2013:
Interesting this came up right now, I have switched to making clients make me an employee. Yes it means less take home cash, but well worth it for matters of bookkeeping, insurance and taxes.
I also puts the responsibility back on them, to pay attention to what I do.
Ten years ago I would have said "NO way". But times have changed and we need to progress with them.
Thanks again for a great hub that I hope people in writing pay attention to.
Deborah Neyens (author) from Iowa on May 29, 2013:
Thanks for the comment, Eric. I think one of the main reasons employers use contractors instead of employees is to avoid paying for medical insurance. It will be interesting to see what happens when the Affordable Health Care law kicks in.
Eric Dierker from Spring Valley, CA. U.S.A. on May 09, 2013:
As medical insurance is becoming a bigger and bigger issue, this hub should be revisited. When does the contractor/employee become eligible for insurance programs. And are the companies required to provide it to employees gaming the system?
I thank you again for a great hub.
Deborah Neyens (author) from Iowa on May 09, 2013:
Thanks for reading, Audrey. Yes, I should probably write more legal hubs but it seems too much like work. : )
Audrey Howitt from California on April 27, 2013:
Excellent hub on the subject! I forgot that you are an attorney! No wonder the hub is so accurate!
Deborah Neyens (author) from Iowa on April 22, 2013:
Thank you for reading and commenting, Martie and Rasta. It's a tricky area of employment law, for sure.
Marvin Parke from Jamaica on April 09, 2013:
Great informational resource for freelancers. I never took all the legal regulations into consideration before.
Martie Coetser from South Africa on April 09, 2013:
Very interesting and most-needed information. Some employers take advantage of their contractors, treating them like employees, until the s*it hits the fan...
Information very well-presented. Thank you, Deborah!
Deborah Neyens (author) from Iowa on March 19, 2013:
Thanks for your perspectives, Au fait. I agree about the construction industry. That has been true in my experience, also.
C E Clark from North Texas on March 11, 2013:
My former husband did a fair amount of employment law when I was working with him. That's when I actually learned the difference between independent contractor and employee. Prior to that I was married to a construction contractor and the construction industry is rife with workers who work as contract workers, because no one wants to withhold or pay payroll taxes. Technically, however, they are not contract workers in most cases.
This is a very interesting and useful hub. All employers, especially small employers, should read this, as well as people who think they want to be contract employees (when really they're not, but aren't contributing to SS by pretending to be contractors) to get that little extra in their checks.
Deborah Neyens (author) from Iowa on November 15, 2012:
Great points, Eric. I really appreciate you advancing the discussion.
Eric Dierker from Spring Valley, CA. U.S.A. on November 15, 2012:
I agree, but that paradigm will soon shift, for instance if they insist we use google, MS, gmail. Seems like those are becoming the tools and the employer is picking them for us. I think this is a shift for the notion of workspace also. As the IRS keeps making home work space more difficult to use as a tax benefit the only location required is in front of a computer.