You’d Better Know the Difference Between Independent Contractors & Employees

Tax DocumentsStruggling businesses are examining every possible avenue to cut costs in order to stay afloat.  Personnel costs are often one of the largest areas of expense, and a mighty tempting place to start cutting back.

One way that companies have cut employment costs is by utilizing a contingent workforce, which includes independent contractors.

While using independent contractors can save a business the costs of employment taxes, overhead, and employee benefits, the practice is not legal in all circumstances. 

Businesses that don’t understand the difference between employees and independent contractors run the risk of finding themselves in some seriously hot water.

Businesses that misclassify employees as independent contractors have a bullseye on their backs.

While businesses are looking for ways to reduce their costs, the government is looking for ways to raise revenue. Creating new tax laws and revising current ones aren’t the only ways for the government to raise revenue.  It has another means at its disposal:  stringently enforcing revenue-producing laws that are already on the books.

This means cracking down — and cracking down hard — on the misuse of workers as independent contractors, to ensure that payroll taxes are appropriately being paid on a state and federal level.

  • In February, when President Obama announced his 2013 Budget, it included special funding for the Department of Labor to “detect and deter” companies from misclassifying their employees as independent contractors. 
  • In 2010 the GAO provided Congress with a report which urged agencies to address the issue, both federally and on a state level.  According to the GAO, in 2007, states found over 150,000 misclassified workers, and in 2008 the IRS assessed over $64 million in taxes and penalties for worker misclassification.

Why does the government care about worker misclassification?

Both the federal and state governments have a vested interest in the misclassification of employees as independent contractors.

Companies don’t pay payroll taxes on independent contractors, nor do they pay unemployment insurance tax or workers compensation tax.  At the end of the year, independent contractors are liable to pay their entire share of social security and Medicare taxes themselves.

Furthermore, independent contractors are not eligible to collect unemployment insurance when their positions end, and if injured on the job, they are not covered by workers compensation.  Oftentimes, companies find themselves the subject of an audit when a former independent contractor files for unemployment insurance, or files for workers compensation, after being injured on the job.

It’s understandable that the government is concerned that workers be classified properly under state and federal laws.

Why are companies tempted to classify employees as independent contractors?

It all boils down to cost savings.

For starters, independent contractors are not covered by the myriad federal and state leave laws.  Nor are they covered by the Fair Labor Standards Act, or other acts that relate to employment.

Companies don’t have to withhold income taxes from their checks, pay social security or Medicare taxes, or pay for workers compensation or unemployment insurance.  Independent contractors do not qualify for minimum wage or overtime pay, nor do they receive any employee benefits, such as health insurance, 401(k), holiday pay or sick pay.

How to tell the difference between an employee & an independent contractor:

Although it may be tempting to assume that a worker is an independent contractor, the IRS has very strict guidelines on what constitutes an independent contractor.  The worker must meet all of the prescribed tests in order to qualify.

The first area to consider is what type of control you have over your worker’s behavior.  Do you tell the worker when and where to do the work, what types of tools and equipment to use, where to get supplies and service, which workers will assist them in the work, and what order to follow in performing the work?  These are examples of an employee vs. an independent contractor. The more instructions given to a worker, the more direct the evaluation of their performance and the more training they’re provided, the more likely it is that the worker is an employee.

The next area to consider is the worker’s financial situation.  An independent contractor typically has a significant financial investment in equipment, whereas an employee does not.  An independent contractor often incurs unreimbursed expenses, and has the potential for incurring a loss.  Also, an independent contractor makes their services available to others in the marketplace through advertising.  The method of payment you use is also indicative of the person’s status, as an independent contractor is usually paid for the job, while an employee is paid by the hour or on a salary.

The last area to consider is the type of relationship you have with someone who is doing work for you.  Employees are often given benefits, are governed by an employee handbook, and they have an ongoing relationship with the business.  An independent contractor is generally governed by a contract, has no benefits, and is hired for a specific project or service for a defined period of time.

Washington State’s “economic realities” test:

In Washington State, the Department of Labor uses the “economic realities” test to determine a worker’s status, which is different from the Fair Labor Standards Act.

The “economic realities” standard has six factors:

  • Degree of control the company has over the worker
  • Worker’s opportunity to make a profit or incur a loss
  • Worker’s investment in equipment or materials
  • Degree of skill required to do the job
  • Permanence of the working relationship
  • Whether the service rendered is an integral part of the employer’s business

An example of an independent contractor might be a bookkeeper who works out of his home office, processing the accounts for several small businesses.  He would use his own computer and software, working on his own schedule, and would charge a monthly fee for his services, regardless of the amount of time it took each month.

On the other hand, if a company had a bookkeeper in-house, who was required to be onsite each day for certain hours, utilizing the company’s equipment and software, and working as part of a team, this would probably not pass the bright line test.

In 2004, a group of FedEx drivers filed a class-action lawsuit for overtime wages and uniform expenses, stating that they were not “independent contractors,” but rather employees.  The Washington Court of Appeals rules that due to FedEx’s “right to control” the manner in which the drivers performed their jobs, they were indeed employees, and thus the “economic realities” test was born for Washington state.

The benefits of independent contractors, employees, and temps:

Independent contractors:  There are obviously benefits to utilizing true independent contractors.  It reduces overhead, as they can be utilized on an “as needed” basis.  Since they are in business for themselves, they do not have to be provided with benefits, and often work from their own offices, eliminating the need for adding workspace and equipment.  But you will give up some control over their performance, and may not have the loyalty that you would have in a dedicated employee.

Employees:  When you hire an employee, you can utilize them for many projects, tapping into all of their talents and expertise, and asking them to wear many hats.  They become part of your team, adding to your human capital, and because they are dedicated to your company, they are focused on helping the business grow and prosper in order for their own career to advance.

Temporary workers:  If you’re in a pinch, one way to strike a balance between your budgetary needs and the government’s strict employment tax regulations is to use temporary staffing.  By using someone on a temporary basis through a staffing company, you can enjoy the flexibility of an independent contractor type relationship, while the staffing agency takes on the responsibility of paying the appropriate taxes and employment expenses, including workers compensation, unemployment insurance and even benefits.

The wrap-up:

The misclassification of employees creates an enormous tax gap, and in these times when governments are badly hurting for revenue, they cannot afford to let any dollars slip through their fingers.  It may be tempting to reclassify employees as independent contractors in order to cut costs, but in the long run, the government will get their money.

Trust me, fudging someone’s employment status isn’t worth the additional penalties that your business will incur.  As is always the case in employment, it’s better to play by the rules up front, no matter how inconvenient they may seem, than it is to pay the price for breaking them.

Originally published in the Kitsap Peninsula Business Journal.

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2 Responses to “You’d Better Know the Difference Between Independent Contractors & Employees”

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