JUNE 2009 Pension Plan tip of the month...

Independent Contractors vs. Employees

The decision relating to whether or not to classify an individual as an independent contractor or an employee is often a difficult and complicated determination for employers. The benefits of retaining someone on an independent contractor basis, with income reportable on IRS Form 1099, can be very favorable to employers.  There is an economic advantage to avoiding various payments required to be made for employees, such as some employment taxes (Social Security, Medicare, etc.), insurance premiums, and benefit contributions.  Many workers themselves prefer to be classified as independent contractors in order to claim certain favorable tax deductions that W-2 employees can only receive if they are able to itemize on Schedule A of their income tax returns.

Classification of independent contractors has historically been based on the IRS’ “Twenty Common Law Factors” test as the primary guideline.  Although the 20-factor guidelines are not obsolete, the IRS’ more recent approach is intended to be more simplified, focusing on three principal aspects of the worker’s relationship with the business.  Those three criteria are: 

              1.  Degree of behavioral control that the business can exercise over the individual;

              2.  Degree of financial control that the business can exercise over the individual;

              3.  Both parties’ views and perceptions of the relationship (whether they view it as

                   an independent contractor or an employment relationship).

For employee benefits, the governing law is the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).  According to the U.S. Supreme Court, the test as to whether an individual is an employee or independent contractor focuses upon the hiring party’s “right to control the manner and means by which the product is accomplished.”  The Supreme Court listed 12 other factors that are pertinent to whether an individual is an employee or independent contractor.  The list of those additional factors is below:

(1) Skill required;

(2) Source of the instrumentalities and tools;

(3) Location of the work;

(4) Duration of the relationship between the parties;

(5) Whether the hiring party has the right to assign additional projects to the hired party;

(6) Extent of the hired party’s discretion over when and how long to work;

(7) Method of payment;

(8) Hired party‘s role in hiring and paying assistants;

(9) Whether the work is part of the regular business of the hiring party;

(10) Whether the hiring party is in business;

(11) Provision of employee benefits; 

(12) Tax treatment of the hired party. 

 

Note: State labor and workforce agencies have also developed their own standards for determining independent contractor/employee status. 

Where do you go from here?

If your company hires individuals with titles such as consultants, per diem workers, project workers, freelancers, and contract workers, etc. who receives a Form 1099 for their services rather than a Form W-2, then you should evaluate each of these individuals to ensure proper classification as an independent contractor or employee. Some possible resources to assist you with this determination are your company’s accountants, and legal counsel, either internal or external.

• Once you complete this assessment for each independent contractor, those who do not qualify as independent contractors should be converted to employee status if the company wants to retain their services and avoid future liability.
• An alternative to reclassification is restructuring the company’s relationship with independent contractors.  Making certain adjustments to their relationships with the company may solve the problem.
• Ensure that your independent contractor agreement is properly drafted.
• Is a qualified employee leasing arrangement an alternative that would work?  These arrangements typically provide services to the company while minimizing company exposure to liability under the employee benefits, tax, and unemployment/workers’ compensation laws.
• Use of a leasing organization as a third-party employer of independent contractors can serve two important goals: 

              a. To substantially minimize the company’s benefits, tax, and employment liability

                   regarding those individuals whose pay is reported on Form 1099; and

              b.  To provide a more suitable alternative for companies that do not want to take

                   the steps necessary to reclassify their independent contractors as company

                   “employees.”

Note:  Recently the IRS and state labor agencies have prioritized and targeted this area for enforcement.