Employee or Independent Contractor? Determining Worker Status

Many businesses are turning to independent contractors in an effort to reduce labor costs and improve workforce flexibility. This can be a smart solution for the right roles and employment situations...but there is a caveat.

The misclassification of an employee as an independent contractor can have costly and extensive legal consequences. These may include the payment of back taxes, reimbursed overtime and benefits, back pay, penalties and interest. That’s to say nothing of the lost time and stress dealing with multiple federal and state government agencies.

It is absolutely critical that businesses correctly determine whether the workers that provide their services are employees or independent contractors.*

* These are not the only two worker classifications that exist in the private sector. There are also statutory employees and statutory nonemployees, which have their own rules for determination. For the purpose of this article, we are comparing the two most common classifications: employees (common-law) and independent contractors. For more information on employee classifications, see this page for IRS guidelines.

Determining Whether Workers Are Employees or Independent Contractors

There is no one legal test that applies in every worker classification situation. For example, the Internal Revenue Service (IRS) and Department of Labor (DOL) use different, though similar, frameworks. State agencies have standards of their own, in dealing with matters such as workers’ compensation and unemployment insurance.

The general rule, however, is that a worker is an independent contractor if the paying business has the right to control or direct only the result of the work—not what will be done and how it will be done. In other words, the worker is “independent.”

A worker is an employee when the paying business has the right to direct and control the worker. This is true even if the business gives the worker freedom of action. What’s key is that the business has the right to direct and control the way the work is done, whether or not they actually do so.

In determining whether a worker is an employee or independent contractor, all information that provides evidence of the degree of control and independence is considered.

Common Law Rules for Determining Employment Status

While the frameworks for determining worker status vary among federal and state agencies, the Common Law Rules provided by the IRS offer a good basis. Factors fall into three categories, or “rules.” These factors are considered relevant and applicable, but none are determinative on their own.

The Behavioral Rule: Does the paying business control—or have the right to control—what the worker does and how he or she performs the services?

Factors considered include:

• Type of instructions given (for example, specifications about the tools and equipment to be used, where to purchase supplies, what workers to hire, the hours to work, and sequence of tasks to complete the work)
• Degree of instruction – the more detailed the instructions, the more control the payer exercises over the worker
• Training provided to the worker – Training, especially periodic or ongoing training, indicates that the job is to be done a specific way. This is a strong indication that the worker is an employee. Independent contractors generally use their own methods.
• Evaluation systems – do they measure only the end result of the work, or the details of how the work was performed?

The Financial Control Rule: Does the paying business have the right to control the economic aspects of the worker’s job?

Factors considered include:

• Method of payment – Employees are generally paid a regular wage (hourly, weekly, monthly, etc) while independent contractors are paid a flat negotiated fee. There are common exceptions in some professions, such as law, in which independent contractors are paid at an hourly rate.
• Significant investment by the worker in tools and equipment
• Unreimbursed expenses – independent contractors are more likely than employees to have these expenses
• Services available to the market – Independent contractors are generally free to seek out business opportunities. They may advertise their business or services and have their own business location. If the paying business dictates exclusivity to a worker’s services, it is unlikely he or she will be considered an independent contractor.
• Opportunity for profit or loss – the possibility of incurring a loss on a job performed (due to a significant investment in tools or unreimbursed expenses) indicates that a worker is an independent contractor

The Type of Relationship Rule: How do the paying business and worker perceive the employment relationship?

Factors considered include:

• Written contracts – The contract on the whole is used to help determine the relationship between the parties. A statement in the contract that the worker is an employee or independent contractor is not, on its own, sufficient to determine status.
• Employee benefits – Benefits such as insurance, retirement plans and PTO are generally not given to independent contractors. Workers who receive them are likely to be considered employees.
• Permanency of the employment relationship – If a worker is hired for an indefinite amount of time, rather than for a specific project or time period, this may indicate an intent to create an employer-employee relationship
• Services provided as a key activity of the business – if a worker performs services that are a crucial or key aspect of the business, it is more likely that the business will have the right to direct and control those activities

Look at the Big Picture

Just as there is no one legal test that applies in every worker classification situation, there is no “magic number” of factors that add up to a determination of either “employee” or “independent contractor.” No one factor stands alone. Businesses must consider all the factors in making a determination.

The general information contained in this article is not a substitute for legal advice. For assistance with legal issues related to employment law in Kansas, including employee classification, contact Fleeson Gooing today.