Did you hire an employee or an independent contractor?
Hiring employees can be costly. Payroll expenses are typically a large line item in any business budget, especially for small business owners. Often, small businesses seek to mitigate their costs by paying workers as independent contractors rather than employees. “I will just pay them on a 1099 so I don’t have to pay the payroll tax and have all that headache,” they tell themselves.
Unfortunately, the decision of how to classify workers is not up to the discretion of the business owner. The federal Fair Labor Standards Act and the Internal Revenue Code have tests to determine whether an individual is an employee or, in fact, an independent contractor. And the costs for misclassifying individuals can be substantial, including back pay for failure to pay overtime, fines, and back taxes for failure to pay that payroll tax. Recently the U.S. Wage and Hour Division recovered more than $1 million based on misclassification of employees. See here.
Under the FLSA, an “employee” must be paid minimum wage and overtime for hours worked over 40. The FLSA defines “employ” as including to “suffer or permit to work.” This is the broadest definition of employment under the law because it covers work that the employer directs or allows to take place. Applying the FLSA’s definition, workers who are economically dependent on the business of the employer, regardless of skill level, are considered to be employees, and most workers are employees. On the other hand, independent contractors are workers with economic independence who are in business for themselves.
Some Determining Factors
A number of “economic realities” factors serve as guides in resolving whether a worker is an employee or independent contractor. The Supreme Court has stated there is no single rule or test for determining whether an individual is an employee or independent contractor for purposes of the FLSA. The totality of the working relationship is determinative. In other words, all facts relevant to the relationship between the worker and the employer must be considered.
The following factors are generally considered when determining whether an employment relationship exists under the FLSA:
1) The extent to which the work performed is an integral part of the employer’s business. If the work performed by a worker is integral to the employer’s business, it is more likely that the worker is economically dependent on the employer and less likely that the worker is in business for himself or herself. For example, work is integral to the employer’s business if it is a part of its production process or if it is a service that the employer is in business to provide.
2) Whether the worker’s managerial skills affect his or her opportunity for profit and loss. Managerial skill may be indicated by the hiring and supervision of workers or by investment in equipment. Analysis of this factor should focus on whether the worker exercises managerial skills and, if so, whether those skills affect that worker’s opportunity for both profit and loss.
3) The relative investments in facilities and equipment by the worker and the employer. The worker must make some investment compared to the employer’s investment (and bear some risk for a loss) in order for there to be an indication that he/she is an independent contractor in business for himself or herself. A worker’s investment in tools and equipment to perform the work does not necessarily indicate independent contractor status, because such tools and equipment may simply be required to perform the work for the employer. If a worker’s business investment compares favorably enough to the employer’s that they appear to be sharing risk of loss, this factor indicates that the worker may be an independent contractor.
4) The worker’s skill and initiative. Both employees and independent contractors may be skilled workers. To indicate possible independent contractor status, the worker’s skills should demonstrate that he or she exercises independent business judgment. Further, the fact that a worker is in open market competition with others would suggest independent contractor status. For example, specialized skills possessed by carpenters, construction workers, and electricians are not themselves indicative of independent contractor status; rather, it is whether these workers take initiative to operate as independent businesses, as opposed to being economically dependent, that suggests independent contractor status.
5) The permanency of the worker’s relationship with the employer. Permanency or indefiniteness in the worker’s relationship with the employer suggests that the worker is an employee, as opposed to an independent contractor. However, a worker’s lack of a permanent relationship with the employer does not necessarily suggest independent contractor status because the impermanent relationship may be due to industry-specific factors, or the fact that an employer routinely uses staffing agencies.
6) The nature and degree of control by the employer. Analysis of this factor includes who sets pay amounts and work hours and who determines how the work is performed, as well as whether the worker is free to work for others and hire helpers. An independent contractor generally works free from control by the employer (or anyone else, including the employer’s clients). This is a complex factor that warrants careful review because both employees and independent contractors can have work situations that include minimal control by the employer. However, this factor does not hold any greater weight than the other factors. For example, a worker’s control of his or her own work hours is not necessarily indicative of independent contractor status; instead, the worker must control meaningful aspects of the working relationship. Further, the mere fact that a worker works from home or offsite is not indicative of independent contractor status because the employer may exercise substantial control over the working relationship even if it exercises less day-to-day control over the employee’s work at the remote worksite.
Some factors are immaterial in determining the existence of an employment relationship. For example, the fact that the worker has signed an agreement stating that he or she is an independent contractor is not controlling because the reality of the working relationship – and not the label given to the relationship in an agreement – is determinative. Likewise, the fact that the worker has incorporated a business and/or is licensed by a State/local government agency has little bearing on determining the existence of an employment relationship. Additionally, the Supreme Court has held that employee status is not determined by the time or mode of pay.
Conclusion
Small businesses should perform a thorough analysis of the status of their workers to determine if there is a misclassification issue. If they have a degree of control over the work, the work is relatively permanent, and it relates directly to the business, there’s a good chance you have an employee and not an independent contractor. Businesses should err on the side of caution to avoid all of the potential damages in a wage claim. It may be the difference between on-going operations and shutters on the doors.