I have read that employers can face substantial liability if they misclassify their employees as independent contractors. I have several independent contractors working for me, but they all signed independent contractor agreements. Do those agreements eliminate my risk?


Businesses often find it advantageous to retain individuals as independent contractors rather than as employees. One advantage of this relationship is that businesses are not required to withhold and pay income taxes, Social Security taxes, Medicare taxes, and unemployment taxes for independent contractors. For that very reason, these relationships have come under close scrutiny.

Both federal and state governments are facing large deficits, and unreported tax revenue resulting from misclassification of employees as independent contractors is seen as a virtual gold mine. The federal government’s 2011 budget includes $25 million and 100 additional enforcement personnel for the U.S. Labor Department, in conjunction with the U.S. Department of Treasury, to identify and penalize employers who misclassify employees as independent contractors. California is one of at least 29 states that have entered into information sharing arrangements with the Internal Revenue Service (“IRS”) to assist in cracking down on employers that have misclassified employees as independent contractors.

The correct classification of a worker as an independent contractor depends on a combination of factors with the key question being the amount of control the business has over the worker.

Many federal agencies rely on three factors identified by the IRS to determine whether an employer has correctly classified an individual as an independent contractor: behavioral control, financial control, and type of relationship.

Behavioral_Control: If a business has the right to direct and control the worker, then the worker is an employee, not an independent contractor. Independent contractors tend to have their own tools and equipment, choose where they will perform the work, and determine the sequence in which they will perform the work. Employees are provided with tools and equipment by the business, work at a location designated by the business, and receive detailed instruction in how to perform the work. Independent contractors usually do not receive evaluations except, perhaps, of the end product. Employees receive performance evaluations that measure the details of how the work is performed. Independent contractors generally receive no training from the business, whereas employees often receive training on doing the job a certain way.

Financial_Control: Independent contractors often have an investment in the equipment used to perform work for someone else, whereas employees use the tools provided by the business. Independent contractors are more likely to have to incur their own expenses, whereas businesses will reimburse employees for expenses such as mileage. If the individual has the opportunity to make a profit or loss, that weighs toward the individual being a contractor. Contractors are free to work elsewhere and seek out other business opportunities through advertisements and often have their own visible business locations. Independent contractors tend to receive a flat fee for a job, whereas employees are paid based on the amount of time worked.

Type_of_Relationship: Even though an agreement signed by the business and individual may describe the relationship as one between a business and an independent contractor, the IRS is not required to observe those terms. Instead, it looks at how the parties work together. Contractors generally do not receive benefits such as insurance, paid vacation, and sick leave, whereas employees do. Contractors are generally retained for a specific project, whereas employees are hired for an indefinite time period. And if the work engaged in by the individual is a key aspect of the business, it is more likely that the individual is an employee. For example, if an accounting firm retains a certified public accountant, it may be difficult to argue that she is an independent contractor.

There is no set combination of the above factors that can definitively answer whether someone is an independent contractor or an employee. The IRS and federal agencies look at these factors on a case-by-case basis and evaluate the overall working relationship.

The consequences of misclassifying an employee as an independent contractor can be severe. In addition to an employer owing the various taxes that should have been paid, there can be penalties for failing to pay taxes. There may be consequences for not including the individual on one’s workers’ compensation insurance. And the individual may claim that he had a right to and did not receive meal periods, rest periods, overtime, and other benefits to which independent contractors are not entitled, but employees are.

If you are unsure whether you have correctly classified workers as independent contractors, you should review the IRS factors. When in doubt, the advice of an attorney may be helpful to avoid liability in the future.
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