There are benefits and risks to utilizing independent contractors (ICs) and it is critical that an employer know them before hiring an IC. It is equally critical to understand how to minimize the risks. This article discusses what it means to be an independent contractor, the governmental programs that may result in more scrutiny, the risks and benefits of having ICs, and how employers may minimize the risks.
An IC is a worker who is free from the employer’s right of direction and control, as well as free from actual direction and control, over the manner in which he provides his services. This is the common law definition. It is applied by the Internal Revenue Service (IRS) and most states. It is not the definition used only by the U.S. Department of Labor’s (DOL) under the Fair Labor standards Act or by many states. Instead, they use tests known as the economic substance and the ABC test, respectively.
The IRS determines whether the employer has the right to direction and control by analyzing twenty factors. These factors, in turn, are categorized as behavioral control, financial control, and the type of relationship contemplated and include supervision, instruction, training, reports, evaluation, financial risk of loss, paying one’s own expenses, investment in equipment, purchasing supplies and holding oneself out to the public as being in business, an IC agreement, benefits and issuance of Form 1099.
The IRS, DOL and many state governments have been active increasing their arsenals to find misclassifications of independent contractors. Beginning in 2007, the IRS encouraged individuals who believe they have been misclassified as independent contractors to pay only the employee’s portion of the employment taxes. Eligible employees may use Form 8919, Uncollected Social Security and Medicare Tax on Wages, to pay the employee’s shares and have the taxes credited to their social security records.
The IRS has initiated a comprehensive nationwide employment tax examination program to, in part, identify employers who misclassify their workers. Since 2007, the IRS has been entering into agreements with states to share information regarding misclassification.
The IRS has a new program called the Voluntary Classification Settlement Program. It provides taxpayers with an opportunity to reclassify their workers for federal employment tax purposes with partial relief.
The DOL has hired more investigators and expanded its misclassification program to investigate companies that have misclassified employees and failed to pay overtime.
State unemployment tax divisions are more frequently determining that workers classified as ICs should be reclassified as employees. Often an audit of the employer will follow an unemployment compensation benefits claim and result in unemployment tax for all similarly situated ICs of the employer being assessed.
Why then have ICs? Despite increased scrutiny, utilizing independent contractors is permissible under existing laws, the relationship can be structured to avoid or minimize the risk of reclassification and ICs can generate significant costs and tax savings.
Among the benefits that should be weighed with the disadvantages are:
- The employer probably saves money. Benefits, office space and equipment, retirement plans, employees’ share of social security, Medicare taxes, state unemployment compensation insurance, and workers’ compensation insurance are not provided, paid for or contributed, as applicable. Together these payments and contributions could cost 30% or more.
- ICs often have special expertise which results in increased efficiency and requires no direct supervision and training.
- ICs are not protected by many laws that protect employees from such matters as discrimination and wrongful termination, resulting in lower cost of compliance and less exposure to lawsuits.
- ICs facilitate expansion and contraction of the workforce.
- Among the disadvantages of utilizing ICs are:
- Lack of direction and control.
- Lack of continuity.
- Potential for lawsuits seeking redress for injuries otherwise covered by workers’ compensation insurance.
- Risk of governmental audit and misclassification resulting in increased federal taxes (unless relief is available under a liberal provision known as Section 530), increased state taxes and benefit entitlements.
Despite the increased governmental scrutiny and the risks of misclassification, there are steps that an employer can take to avoid misclassification of workers. These include having a self-audit of the relationship with the guidance and advice of counsel, making decisions and adjustments as recommended in the audit and having an independent contractor agreement that addresses the common law factors and other federal and state laws and, particularly, negates the right to exercise direction and control over the manner in which the IC provides his services.