by Angela Rud, Esq.
In the past two years, the IRS and state agencies have penalized an increasing number of employers for using “independent contractors” who really should have been classified as employees.
The number of Fair Labor Standards Act (FLSA) case filings involving misclassification challenges has nearly quadrupled since the late 1990s. It was up over 20% in 2010 alone. And the IRS says it plans to audit 6,000 businesses by 2013 to determine whether taxes, fines and penalties may be due. State agencies are planning to do the same.
Recently, the IRS unveiled a new Voluntary Classification Settlement Program (VCSP), which allows eligible taxpayer employers to voluntarily reclassify workers as employees for federal employment tax purposes. The program features partial amnesty for past misclassifications, limiting an employer’s liability. (See “Feds offer amnesty for contractor misclassification”.)
Even so, the recent government crackdown on worker misclassification continues to cause significant risk for employers.
What you need to know
Classifying workers as independent contractors instead of employees allows companies to avoid paying various federal and state employment law taxes. In addition, they don’t have to provide benefits. But the practice can also lead to costly litigation and administrative penalties.
There are many laws that govern the employment relationship, and as a result, many different legal standards used to determine whether an individual is an employee or independent contractor.
It is important to remember that each case requires an examination of the facts and circumstances of a particular position. Applying a formulaic test won’t suffice.
Federal common-law test
This test considers the facts and circumstances of a particular relationship in light of:
- Behavioral control: To what degree does the company direct or control how and when work is performed?
- Financial control: Does the company direct or control the business or financial aspects of a worker’s activities?
- Relationship between the parties: What are the indications of both parties’ perception of their relationship?
The federal FLSA
The FLSA offers an additional test, using factors similar to those in the common-law test.
The FLSA test focuses on whether purported contractors are economically dependent on the business to which they render service or whether they are truly in business for themselves.
Independent contractors must be free to provide services to other entities or organizations and should receive income from sources other than your company.
Minnesota’s common-law test
Minnesota courts have employed a five-factor test to determine employee or independent contractor status in cases involving the Minnesota Human Rights Act, workers’ compensation, unemployment, and the Minnesota FLSA. Minnesota’s test considers:
- The right to control the means and manner of performance (key test)
- The mode of payment
- The furnishing of tools and materials
- Control over the premises where the work was done
- The right of discharge.
Some factors that employers may consider logical have little bearing on the determination of a worker’s status, including labeling a worker an “employee” or “contractor,” his or her title and full- or part-time status.
Special cases, exceptions
A corporate officer is generally an employee, but an officer who performs no services (or only minor services), and is not entitled to pay, is generally not an employee.
A director is not a corporate employee with respect to services performed as a director.
For certain tax purposes, the following workers are considered nonemployees by statute: licensed real estate agents; companion sitters working with children, the elderly or the disabled; and certain direct salespeople.
Preventive measures
In order to ensure consistent and accurate treatment, ideally there needs to be one decision-maker following this issue. HR is usually the correct department, but that can vary. As with everything employment-law related, documentation is key.
You must use an effective and current contractor agreement, and it should be tailored to your organization’s particular needs. Your agreement may need to include a works of authorship, inventions and patents provision, nondisclosure or other provisions.
Make sure your other business records reflect contractor status. For example, don’t have the person fill out employment-related forms, and make sure you issue the correct tax forms to contractors.
A formal policy—published and distributed to the organization and maintained in regular business files—can ensure consistent practice. Following all of these suggestions may provide the basis for a good defense strategy should problems arise.
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Author: Angela Rud is a principal at Gray Plant Mooty and member of the Employment and Labor practice group. Contact her at (612) 632-3281 or angela.rud@gpmlaw.com.
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