Using independent contractors instead of employees can save companies money, increase their staffing flexibility and reduce their exposure to litigation under federal and state employment laws. Properly classified independent contractors are not employees and are not entitled to the rights granted solely to employees. Employers do not have to pay employment taxes on their behalf or pay them minimum wage or overtime pay under the Fair Labor Standards Act (FLSA).
Independent contractors are not protected by laws that specifically cover only employees, such as Title VII and state workers' compensation statutes. In addition, independent contractors are not provided the same benefits as employees, including vacation and sick leave and participation in employee health and welfare plans.
The downside is that misclassifying employees as independent contractors can result in significant penalties. If employees are misclassified, the company may be liable for unpaid taxes, wages and overtime compensation, as well as the value of employee benefits previously denied the worker. Compliance is complicated by the fact that different independent contractor tests may apply. For example, the IRS's test is different from the test applied to misclassification claims under the FLSA.
In addition, the IRS, the US Department of Labor (DOL) and several of their state counterparts have made independent contractor misclassification an urgent focus of compliance in recent years. Enforcement is a state and federal priority for several reasons. First, misclassified employees are often denied employment benefits and protections, such as family and medical leave, overtime, minimum wage and unemployment insurance. Second, misclassification results in substantial losses to the Treasury and the Social Security and Medicare funds, as well as to state unemployment insurance and workers' compensation funds. Third, companies that enjoy cost savings as a result of misclassifying their workforce make it difficult for companies that are in compliance to remain competitive. Federal and state collaboration, often formalized in a Memorandum of Understanding (MOU), facilitates the sharing of information and coordination of enforcement efforts.
David Weil, Administrator of the DOL's Wage and Hour Division (WHD), has promised to target industries where "fissured workplaces" are common. A "fissured workplace" refers to independent contractor arrangements and other business models that, according to the WHD, obscure the link between the company and the worker. The industries which are particularly vulnerable to intensified scrutiny include janitorial, construction, home health care, staffing, transportation and trucking, security, hotel and motel, landscaping and nurseries, restaurants and catering, car services and limousines, and oil and gas. In addition to corrective measures, Weil intends to deter future misclassification by increasing the civil money penalties for minimum wage and overtime pay violations under the FLSA.
As companies increasingly rely on independent contractor arrangements, they can expect intensified scrutiny from federal and state agencies. Companies using independent contractors should not wait to review and evaluate those relationships. The following best practices are a good starting point for any independent contractor relationship.
1. Get it in writing.
A written agreement explicitly stating the worker is an independent contractor is not enough on its own to avoid liability for misclassification. However, that agreement is one factor among many that can support a company's treatment of workers as independent contractors. Every independent contractor should sign an agreement that specifies the nature of the relationship. Always include a specific end date or tie the end date to the completion of a particular task or work. Do not leave the agreement open-ended. If the arrangement is extended, the parties should sign a new agreement. In addition, all documents applicable to independent contractors hired for similar work, including the agreement, should be consistent.
2. Limit supervision and control.
A company's exercise of control over the worker is important to an independent contractor determination. Generally, employees are instructed on the manner, method and means of doing their work. Independent contractors, on the other hand, are generally free to determine how to perform the work, with what method and with what tools and equipment. Though independent contractors may be required to submit progress reports, for example, they are typically free from the supervision and control inherent in an employment relationship. Companies should limit supervision and control over independent contractors, both in practice and in any independent contractor agreements. Companies should train the appropriate personnel to ensure that supervision and control are limited in actual practice. Address performance problems according to contract terms, not as disciplinary issues.
3. Do not require set work hours.
Requiring set work hours and recording time worked is an extreme form of supervision and control that is inconsistent with an independent contractor relationship. Also, requiring and tracking specified workhours suggests that the worker is paid for the amount of time worked, rather than for completing a specific job or project. Similarly, where possible, do not require that the work be performed on the company's premises. The independent contractor should be free to perform the work where and when he chooses.
4. Do not pay by the hour.
Similarly, if a company pays the worker by the hour, the arrangement suggests that the worker is being paid strictly for the time he works, rather than for a job or project. In addition, independent contractors should be paid from accounts payable, not payroll. Do not provide independent contractors with a W-2.
5. Do not provide supplies, tools or equipment.
If a company provides supplies, tools and equipment, it is controlling the manner, method and means of the work. In addition, if the company provides all the necessary tools, then the worker has been classified as an independent contractor without the means of performing that work for the company or any other entity. Both are factors that weigh in favor of an employment relationship rather than a contractor relationship.
6. Do not reimburse work-related expenses.
Independent contractors are generally expected to pay for their own work-related expenses. Often those expenses are factored into the cost of completing the job or project. However, if a company reimburses a worker for expenses incurred while performing services for the company, the distinction between employee and independent contractor becomes less clear. In some circumstances reimbursement may be necessary, but it should not be the norm. Instead, the independent contractor should include his business expenses in the cost of his services.
7. Do not require exclusivity.
Independent contractors are generally free to offer (or not offer) their services to any person or entity. If a company requires the worker to adhere to full-time or set hours, the worker's ability to engage other clients may be severely limited. In addition, an independent contractor agreement that requires the worker to provide services to the company exclusively during the project duration is likely to be too restrictive. Instead, the company should consider prohibiting the worker from engaging in business activities that compete with the company or providing services to the company's direct competitors. Also, the company should require the worker to sign a confidentiality or non-disclosure agreement to protect the company's proprietary information. In addition, do not require that the independent contractor personally perform the services. The independent contractor should be free to determine who will do the work, including for example, delegating the job or hiring a helper.
8. Avoid the outward appearance of an employment relationship.
Another factor for consideration is how the worker appears to third parties. If the worker has business cards, an e-mail address, ID badges and so on issued by the company, third parties may believe he is an employee of the company, rather than an independent contractor. In situations where these items are necessary, such as security badges, companies should have different versions for employees and independent contractors. Do not invite independent contractors to employee-only events or meetings.
9. Treat similar workers the same.
Companies are unlikely to be able to justify classifying one worker as an independent contractor if another individual, doing similar work, is classified as an employee. An internal audit, including comparisons between independent contractors and employees performing similar functions, will help determine if inconsistencies exist. Do not hire a former employee as an independent contractor to perform the same or similar job duties he had as an employee.
10. File Form 1099-MISC.
Companies are not required to pay employment taxes or make certain withholdings on behalf of independent contractors. A company may have to file Form 1099-MISC to report payments for services performed on its behalf. Any time a worker is paid at least $600 for his services during a single tax year, the company should determine if a Form 1099-MISC must be filed.
Correctly classifying workers as independent contractors or employees is necessary to determine the extent of a company's employment obligations. Improper classification can mean significant liability. Further, classification decisions do not end once an independent contractor is hired. Companies should regularly review their existing independent contractor arrangements to make sure the classification is still proper.
About the Author
Suzanne Brown is a Senior Legal Editor for Practical Law Labor & Employment. Suzanne joined Practical Law from Epstein Becker & Green, P.C., where she was a litigation associate in the labor and employment group, concentrating on wage and hour litigation and compliance. Previously Suzanne was a labor and employment associate with Gibbons, P.C., McElroy Deutsch Mulvaney & Carpenter, LLP, and the Law Department of the Port Authority of New York and New Jersey.
Practical Law provides legal know-how that gives lawyers a better starting point. Our expert team of attorney editors creates and maintains thousands of practical resources across all major practice areas. We go beyond primary law and traditional legal research to allow you to practice more efficiently and improve client service. For a list of key Practical Law resources on using independent contractors, see Independent Contractor Toolkit. All related resources are available with a free trial to Practical Law.
The information in this Top Ten should not be construed as legal advice or legal opinion on specific facts and should not be considered representative of the views of its authors, its sponsors, and/or the ACC. This Top Ten is not intended as a definitive statement on the subject addressed. Rather, it is intended to serve as a tool providing practical advice and references for the busy in-house practitioner and other readers.
Reprinted with permission from the Association of Corporate Counsel (ACC) 2014 All Rights Reserved.