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Same work, fewer expenses and less hassle.

That’s the perceived advantage of using independent contractors. But many employers have opted for freelancers only to find a new set of problems: lack of control, unreliable workers and, in some cases, litigation. It’s a complex issue that has invited wide scrutiny.

A host of federal and state agencies are cracking down on employers that misclassify workers as independent contractors to avoid paying employment taxes, benefits or overtime. New York recently appointed a task force to examine employee misclassification. Illinois passed a law that automatically classifies construction workers as employees unless they meet specific exceptions.

Even Congress has acknowledged that the rules for classifying workers are complex. The Workforce Protections Subcommittee of the U.S. House Education & Labor Committee met in March 2007 to address the problem. “If a team of lawyers is necessary to determine whether a worker is an ‘employee’ or an ‘independent contractor,’ an employer working in good faith is saddled with the time, energy, and expense of trying to classify them correctly, often with no guarantee that down the road they won’t be found to have gotten it wrong,” the committee noted. 

The cost of getting it wrong  

FedEx got it wrong to the tune of $17.8 million, the amount awarded to California drivers in a civil suit, plus another $8 million in back taxes to the state. FedEx has abandoned its independent contractor model in California, at a further cost of roughly $25,000 to $33,000 per contractor, and still faces class-action lawsuits in 30 states. California Maid Services and Carpet Cleaning was hit with a $4.5 million tab for misclassifying its cleaners. Rife Industrial Marine, of Texas, had to pay offshore welders $2 million in unpaid wages following a U.S. Labor Department investigation.

How to get it right 

Under current law, there are dozens of tests used to determine whether a worker is an independent contractor or an employee, including:

  • A 10-factor common law “right to control” test, which the courts frequently rely on.
  • A six-factor analysis of the Fair Labor Standards Act, which focuses on “economic realities” as set forth by the Labor Department.
  • An IRS test, which focuses on the relationship between the worker and the business. This test relies heavily on who controls the work.

The IRS test

The IRS estimates that 80% of workers classified as independent contractors don’t meet its test requirements and should be considered employees. If the IRS comes calling, its already predisposed to reclassify your independent contractors.

Generally, the more control you exert over how, when and where a person’s work is performed, the more likely that person should be declared a full-fledged employee, not an independent contractor.

The IRS currently looks at these three main issues when making the employee/independent contractor decision:

  1. Do you have behavioral control over the worker?
  2. Do you exert financial control over the worker?
  3. What type of relationship exists between the worker and the employer?

Expect the IRS to look at contracts, payment methods, whether your independent contractors have specialized training, whether they have other clients and how they run their businesses.

The Labor Department test

The Labor Department has a relatively simple and broad definition of employment: Whenever you “suffer or permit” someone to work, the department presumes an employer/employee relationship. Again, the more control you exert over when, how, how much and how fast the work is performed, the more likely Labor officials will view your independent contractors as employees.

State labor departments are not only taking on big companies over large sums. A complaint from a caddy at a Tacoma, WA, golf course resulted in a full-scale labor department investigation. The department ordered the golf course to reclassify its caddies. Golfers, the golf course and the caddies themselves were upset by the decision, since most of the caddies did the work part-time on their own schedules and did not want to be tied down like regular employees.

Online resources

Making the contractor/employee call:

  • The U.S. Labor Department offers a fact sheet to help you determine whether your workers are properly classified. Visit www.dol.gov/esa/regs/compliance/whd/whdfs13.htm.
  • You also can find numerous articles on the Internal Revenue web site, www.irs.gov. Search under “independent contractor.”

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