Why Independent Contractor vs. Employee Status Matters

By: Jon Avidor and Tyler Horowitz

Among the various questions that employers face is whether to classify certain personnel as independent contractors rather than as employees. Many new entrepreneurs will rely on the advice of colleagues and friends who will encourage categorizing new hires as independent contractors to avoid paying employment taxes and providing benefits, which isn’t always bad advice but isn’t that simple. Despite how an employer labels its personnel or even drafts its services agreement, the determination finally rests with the Internal Revenue Service and Department of Labor in light of how the relationship actually carried on.

Company’s Right to Control and Other Guideposts for Determining Status

Distinguishing an employee from an independent contractor is often difficult in the absence of bright-line rules, though the standard focuses on the employer’s “right to control,” which balances three considerations:

  1. Behavioral Control: Beyond requesting certain services and deliverables, does the employer have the right, or exercise an ability, to direct and control what, how, and when the individual’s work is performed, whether through instructions, training, or other means?
  2. Financial Control: Does the employer direct or control the financial and business aspects of the individual’s performance, such as paying service fees according to the company’s standard payroll schedule, exercising discretion over expense reimbursements, or providing the tools and supplies to perform the tasks at hand?
  3. Relationship of the Parties: If there’s a written contract between the parties, is it structured like an employment agreement or services agreement? Does it afford the individual employee-type benefits (such as insurance, a pension, etc.? Is the relationship open-ended in terms of length and type of service provided? Is the “independent contractor” given certain responsibilities and discretion typical of an employee?

Ultimately, does the company have the right to control not only what is to be done by the “independent contractor,” but also how it is to be done? If so, the worker is most likely an employee. On the other hand, if the company doesn’t control the means and methods of the work product, the worker is most likely an independent contractor. Employers should analyze the entire relationship and pay attention to the degree of control it has over the worker.

Administering the Relationship

Especially in the employment context, companies should set forth the terms of its personnel’s engagement in a written contract―for employees, an employment agreement, and for independent contractors, a services agreement. As discussed, state and federal authorities will look past a written agreement to how the relationship actually exists or existed, though an written agreement is an employers best tool to clarify expectations. For example, a standard services agreement should always state that the individual is performing his or her services as an independent contractor and is not entitled to employment rights or benefits, nor is he or she authorized to act on behalf of the company. The agreement will disclaim the company’s tax withholding and reporting obligations as well. The services agreement may also say that any work product is considered a “work made for hire” and belongs to the company. Each of these provisions make clear to the independent contractor that he or she is not an employee and shouldn’t assume otherwise.

Additionally, employers are required to deduct payroll taxes from its employees and issue them W-2s, while companies who engage independent contractors do not withhold payroll taxes and, if they have paid the independent contractor $600 or more during that tax year, issue them 1099s. Independent contractors are required to calculate their own payroll taxes and may have to make quarterly estimated tax payments to the IRS, in addition to remitting applicable state and local taxes. Companies should consult an accountant to ensure they withhold and remit the proper payroll taxes and issue the appropriate tax forms to their employees and independent contractors.

Risks of Misclassification

Employers are often tempted to label as many of their personnel as independent contractors as possible―they wouldn’t have to contribute to Social Security and Medicare or remit unemployment tax, provide workers’ compensation insurance, or provide employee benefits, including health insurance and paid sick leave and vacation time. However, a company that misclassifies employees as independent contractors could face serious consequences if they’re ever audited. This often arises when a former “independent contractor” applies for unemployment and lists among his or her previous employers a company that hadn’t reported the individual as an employee, triggering a state investigation. If caught, the company may owe back taxes and be subjected to fines at the state and federal levels for uncollected income tax, Social Security, Medicare, and unemployment tax. Worse yet, a misclassification could open a flood-gate of litigation from past or current “independent contractors.” Don’t fall into the trap of improperly classifying your workers as a cost-savings tool.

 *We would like to thank our intern Tyler Horowitz for his contribution to this article.