A. Introduction
An individual who provides services to another in exchange for payment may be classified as either an "employee" or "independent contractor." Simply stated, an employee works for the organization and is controlled by the organization. For example, the organization supervises an employee's work, sets an employee's schedule, and determines the method the employee uses to perform his work. On the other hand, an independent contractor works for himself but provides particular services to an organization. The organization has much less control over an independent contractor and an independent contractor may set his own schedule, work without supervision, and determine the method used to perform the assigned work. Thus, the way someone is classified (i.e., whether as an employee or as an independent contractor) is not dispositive of proper classification. Rather, deciding an individual's proper employment status requires considering a number of factors, as explained in detail below.
Employers must take care to properly determine each individual's employment status because the law treats employees and independent contractors very differently. For example, an organization does not need to provide certain employment benefits to independent contractors or withhold income taxes from their compensation. Since there is considerable liability for misclassification, including potential personal liability for an organization's managers and directors, proper classification is essential.B. Is A Worker An Employee Or An Independent Contractor?
Although an individual's employment status can have major consequences on an employer's obligations under various state and federal laws, none of the laws clearly define the term "employee" or "employment." Instead, New York courts consider a number of factors to classify individuals as employees or independent contractors.
However, the most important factor in determining whether an individual is an employee or an independent contractor is: the organization's right to control the individual's results and the method or means he uses to achieve those results. In general, organizations have much more control over employees than independent contractors who, as their name implies, work more "independently." Generally, if an organization can dictate only the result of the work, as opposed to the means or the manner by which the work is done, the person is more likely an independent contractor. Examples of independent contractors may include certain professionals, such as: certified accountants, whose work entails a large degree of independence; artists, whose work requires expressive freedom; and skilled laborers such as plumbers and electricians.
While the level of control over the individual is of primary importance, to determine if person is an employee or an independent contractor, courts examine all facts and circumstances of the working relationship, including the following:1
(1) whether, and to what extent, the individual is required to follow the organization’s instructions;
(2) the amount of training of the individual related to the particular job;
(3) amount of integration of the individual into the organization's business;
(4) whether the individual’s services are rendered personally;
(5) whether the organization hires, fires, and pays assistants used by the individual, or whether the individual has discretion to use assistants as he/she sees fit;
(6) the existence of a continuing relationship between the individual and the organization;
(7) the establishment of a set amount of work hours;
(8) whether the individual must devote substantially full time to the organization;
(9) whether the individual works on the organization's premises;
(10) whether the individual works according to a sequence set by the organization;
(11) whether the individual must submit regular or written reports to the organization;
(12) whether the individual is paid by time rather than by project;
(13) whether the individual is reimbursed for expenses;
(14) whether the individual furnishes his or her own tools and materials;
(15) whether the individual has invested in the facilities for performing the services;
(16) whether the individual can realize a profit or a loss;
(17) whether the individual works for more than one organization at a time;
(18) whether the individual makes his services available to the general public;
(19) whether the organization has the right to discharge the individual; and
(20) whether the individual has the right to terminate his or her relationship with the organization.
Determining whether a worker is an independent contractor or an employee is always a fact-specific determination and no single factor discussed above is conclusive. The key however, is to remember that control is the most significant issue when determining a person's employment status. In addition, it is not enough that a worker's contract may call him an "independent contractor" or that he agreed to work as an independent contractor. Rather, organizations must consider each of these factors to properly classify its workers.
Independent contractors and employees are treated very differently under state and federal law. Independent contractors are granted far less protection than employees, and organizations have fewer obligations and liabilities toward independent contractors than they do toward employees. For example, independent contractors are not protected by the federal anti-discrimination laws, the federal Wage and Hour law (the "FLSA"), the New York State Human Rights law, the New York Workers' Compensation law, the New York Unemployment law, and ERISA. These laws apply only to employees.
In addition, independent contractors are usually not covered by an employer's benefit package or workers' compensation insurance. Independent contractors are also taxed differently than employees and are responsible for their own tax withholding, so organizations provide independent contractors with an IRS Form 1099 rather than a Form W2. Thus, non-profits may have many financial and administrative incentives to use independent contractors rather than traditional employees.
However, because of the serious implications of misclassifying employees as independent contractors, organizations must carefully analyze each individual's employment status using the general factors outlined above. In addition, organizations should also review the specific definitions used to determine employment status under various state and federal laws, which are outlined in Appendix B.VI.
D. Implications Of Misclassifying Employees As Independent Contractors
1. FLSA/Wage and Hour Law
Because independent contractors are not "employees" entitled to the protections afforded by the FLSA, it is critical to properly identify and differentiate between employees and independent contractors. Appendix B.VI discusses the definition of "employee" under the FLSA.
An audit under the wage and hour laws could result in substantial financial liability where an individual the employer identified as an independent contractor is determined to be an "employee." Proper classification is especially important because wage and hour violations may result in significant fines and penalties to individual managers as well as to the hiring organization.
2. Workers' Compensation Law
State workers' compensation laws provide for compensation to any employee who is injured during the course of his or her employment. Organizations must contribute to the workers' compensation system and carry workers' compensation insurance on behalf of their employees. Independent contractors are not covered under New York's law. If a misclassified independent contractor is injured on the job and files a claim for workers' compensation, the employer may be subject to workers' compensation claims, civil tort actions, fines, and criminal convictions if it is determined that the injured individual is actually an "employee." Organizations should secure workers' compensation insurance for its employees to protect against potential workers' compensation claims. Thus, proper classification of independent contractors is imperative.
3. Unemployment Insurance Law
While independent contractors are not covered by New York' Unemployment Insurance Law, an organization's classification of an individual may be scrutinized if an individual files a claim for unemployment benefits or if the agency performs an audit of the organization. Organizations must contribute to the New York unemployment compensation system on behalf of their employees, but not for its independent contractors. Organizations that misclassify their employees as independent contracts and do not contribute to the system must pay the amount that they should have contributed and are also assessed interest for each month that they have in default. In addition, organizations that are found to have willfully misclassified their employees to avoid paying unemployment benefits may be found guilty of a misdemeanor.
4. Anti-Discrimination Law
Generally speaking, state and federal anti-discrimination laws only afford their protections to "employees." However, a cautious employer should take care to draft its policies to protect all employees, independent contractors, volunteers, interns, workfare assignees, and customers. In addition, policies should be distributed to all individuals who work for the employer or on the employer's premises.2
5. Employee Benefits
Often, a significant motivating factor in an employer's use of independent contractors is to avoid the cost of providing employee benefits to a segment of its workforce. However, there are several potential pitfalls to this strategy, so careful planning in this area can be critical. In addition to the onerous employment tax liabilities, discussed below, that an employer and "responsible persons" can face if it has misclassified employees as independent contractors, there are also potentially serious liabilities under the employer's benefit plans regarding retroactive benefit entitlements, tax penalties for failure to comply with COBRA, potential disqualification of Tax-Qualified Plans such as pension and 403(b) plans, and possible ERISA liability. Appendix B.VI discusses the definition of "employee" under ERISA.
6. Tax Law
Employers must also be careful when classifying a worker as an independent contractors to avoid later imposition of a tax liability for misclassification of that worker. Appendix B VI discusses the definition of "employee" under the Tax Code. While using independent contractors relieves the employer from the tax liabilities and reporting responsibilities that are required with employees, the misclassification of a worker as an independent contractor can result in harsh employment tax penalties.
Since organizations do not withhold or pay employment taxes on independent contractors, if the IRS determines that the organization misclassified an employee as an independent contractor, the organization is generally liable for the employment taxes it otherwise was required to pay or withhold on the wages paid to the employee in addition to penalties, interest, and FICA. However, organizations that misclassified their employees but indeed complied with the Form 1099 reporting requirements may qualify for a reduction on the amount of employment taxes that they owe the government.3 Thus, in addition to carefully classifying its employees and independent contractors, organizations should always comply with the Form 1099 reporting requirements for their independent contractors to further reduce any implications of misclassification.
In addition, organizations that misclassify employees and therefore underpay FICA taxes or income tax withholding will need to pay the outstanding amount plus interest and may also face numerous civil penalties including (1) late filing of a tax return; (2) failure to deposit employment taxes; (3) negligence or intentional disregard of the rules and regulations; (4) fraud; (5) willful failure to provide employment wage statements; and (6) aiding and abetting the understatement of tax liability.4 Numerous criminal penalties may also be asserted against the employer, including (1) willful attempt to evade or defeat tax; (2) willful failure to collect or pay over tax; (3) willful failure to file a return, keep records, supply information or pay tax; (4) willful failure to provide employment wage statements; and (5) willful filing of a false return.5
In addition to these consequences, the IRS may also impose a 100% penalty on the individuals responsible for the willful failure to withhold or pay over to the IRS the employee's share of FICA taxes or income taxes.6 This penalty appears to be directed at persons who have the control or responsibility over the organization's finances and courts have imposed the penalty on people who ignored an obvious and known risk that the funds would not be paid.7 Thus, any person who exercises hands-on-control over an organization, participates in decisions concerning the disbursement of funds, salaries and payments to creditors, and/or has authority to sign checks, may be held liable individually for these penalties.
Notably, the Tax Code also includes a "safe harbor provision" for organizations. Section 530 of the Revenue Act of 1978 protects employers from having their independent contractors reclassified by the IRS to the status of employee and from incurring penalties for misclassification. Section 530 provides that the IRS is bound by the employer's classification if (1) the employer consistently treated the worker as an independent contractor, (2) the employer filed all federal tax returns consistent with its position, and (3) the employer had a "reasonable basis" for that position.8E. Liability To Third Parties For Independent Contractors Vs. Employees
A worker's status also determines whether an organization will be held liable to third parties who are injured as a result of the worker's conduct. Organizations are generally liable for the willful or negligent acts of its employees, committed within the scope of his employment. For example, an organization may be held responsible for injuries caused to third parties if a truck driver that it employs is involved in a traffic accident. Organizations are not, however, generally responsible for the acts of independent contractors.
Organizations must take special precautions when employing non-traditional workers such as temporary workers. Although an organization may consider a temporary worker an independent contractor, it may still be held liable for injuries caused to third parties by temporary employees under their control under the theory of respondent superior. In short, organizations should be aware that using independent contractors and other types of non-traditional workers generally will not shield them from liability for personal injury or property damage arising out of these workers' job performance.9 Organizations should therefore review their general liability insurance policy to ensure that the language of the policy is broad enough to cover acts by, and injuries to, non-traditional employees.
1 The common law "right to control" test takes its factors from Section 220 of the Restatement (Second) of Agency (1958).
2 With respect to contingent workers, the EEOC has issued guidelines indicating that both the personnel staffing company and the customer-employer will be held liable for discrimination and harassment. EEOC Policy Guidance on Contingent Workers available at http://www.eeoc.gov/policy/docs/conting.html.
3 See I.R.C. § 3509. For example, the employer's liability for income tax withholding is reduced to 1.5 percent of wages paid to the employee, and the employee's share of FICA tax is reduced to 20 percent. See I.R.C. § 3509(a).If the Form 1099 requirements were not complied with, the percentages are 3 percent and 40 percent, respectively. See I.R.C. § 3509(b). However, the Tax Code does not reduce the remainder of the employer's employment tax liability (i.e., the employer's share of FICA taxes) and there is no reduction in penalties and interest.
4 See I.R.C. §§ 6651, 6656, 6662, 6663, 6674 and 6701, respectively.
5 See I.R.C. §§ 7201, 7202, 7203, 7204 and 7206, respectively.
6 See I.R.C. § 6671(b).
7 See, e.g., United States v. Leuschner, 336 F.2d 246 (9th Cir. 1964); Feist v. United States, 607 F.2d 954 (Ct. Cl. 1979).
8 Reasonable basis is established expressly by section 530 by "reasonable reliance" upon (1) judicial precedent, published rulings, technical advice with respect to the employer, or a letter ruling to the employer; (2) a past IRS audit of the employer where no employment tax was assessed in connection with workers holding a substantially similar position; or (3) a long-standing recognized practice of a significant segment of the industry in which such individual was engaged. See Revenue Act § 530(a)(2).
9 For example, based upon Local Law No. 39, enacted in 1991, New York City employers who hire independent contractors may be liable for the actions of those independent contractors as if they were employees. N.Y.C. Admin. Code § 8-101, et seq. The New York City Human Rights Law covers discrimination based upon actual or perceived characteristics of race, color, creed, age, national origin, religion, disability, gender, alienage, citizenship, marital status, sexual orientation, criminal arrest and conviction record. N.Y.C. Admin. Code § 8-107. Under this law, employers are also liable for discriminatory conduct of independent contractors when the discriminatory conduct was committed in the course of furthering the employer's business enterprise if the employer had actual knowledge of and acquiesced in such conduct. Id. at § 8-107(13).