A frequent area of confusion for business owners and managers concerns the difference between employees and independent contractors. This issue has long been especially vexing in certain sectors such as home health care, trucking, and construction, but many businesses are faced with the employee/independent contractor dilemma. Given that the penalties for incorrect classification can be steep, employers should understand the differences in the two types of workers.
Employees vs. independent contractors
In general, employees are under closer control than independent contractors. Independent contractors tend to work only when their services are required and using their own materials, while employees typically function on a regular schedule and at the employer’s facility.
The IRS and the Department of Labor have separate, but similar, tests for determining whether a worker is an employee or an independent contractor. The IRS applies a “right to control” test that examines three key considerations in the relationship:
1. Behavioral: Who controls what the worker does and how the work is performed?
2. Financial: Does the employer control fiscal considerations, such as reimbursing expenses and providing tools and supplies?
3. Type of Relationship: Is the working relationship controlled by written contracts, are benefits provided, and will the relationship continue long-term? Caveat: a written contract designating the relationship as an independent contractor will not overrule the economic realities of the relationship.
If these questions still leave doubts as to the nature of the worker’s status, the business in question can submit a form SS-8 to the IRS to receive an official determination.
The Department of Labor, on the other hand, uses six factors to determine a worker’s status:
1. The extent to which the work performed is an integral part of the employer’s business;
2. Whether the worker exercises managerial skills, and whether this affects his or her opportunity for profit and loss;
3. The relative investments in facilities and equipment by the worker and the employer;
4. The worker’s skill and initiative;
5. The permanency of the worker’s relationship with the employer;
6. The nature and degree of control by the employer.
For a good (but not infallible) rule of thumb, look at how closely the worker is controlled and how predictable the work is. One hypothetical to consider is, “Does the worker more closely resemble an office clerk, who comes to the office on a predictable schedule regardless of how much work is to be done that day, or a plumber, whom one calls and asks to do a specific job when the need arises?”
Penalties for misclassification
The next consideration for a business owner is the penalty for mislabeling a worker. If a company identifies someone as an independent contractor, but the IRS or Department of Labor determines that the worker is an employee, what are the repercussions?
Several considerations may arise in this case. Back pay, taxes, and benefits may be issues. Unlike an independent contractor, employees are entitled to minimum wage and overtime pay, and these — along with taxes and benefits — could be owed retroactively if the worker is indeed an employee, along with penalties and interest.
If a worker is injured on the job, the consequences are quite different for an independent contractor than for an employee. An injured employee is entitled to workers’ compensation, which operates outside of the tort system. An independent contractor, however, is not eligible for workers’ compensation and may sue the company for negligence, perhaps even punitive damages, if injured. Such a case could go to a jury trial and is likely to be quite costly, even before a verdict and/or damages award is reached.
While the line between an independent contractor and an employee may at times appear somewhat ambiguous, these fine distinctions can have dramatic real-world consequences. Careful consideration and informed decision-making are the best insurance against potential and costly litigation down the road.