Employee Or Independent Contractor?
Guidelines for the Potential Employer

by Charles H. Van Gorder

I.Introduction

II.Income-Related Taxes

III.Worker's Compensation/Industrial Insurance

IV.Unemployment Insurance/Compensation

V.Vicarious Liability for Acts of an Employee

VI.Conclusions

I. Introduction
Oftentimes companies will hire individuals on an occasional or part-time basis to undertake specific tasks.  In the outdoor recreation industry, this is often the case for instructors, guides and trip assistants. These individuals may be part-time workers on a year round basis, or full or part-time workers on a seasonal basis. Companies are faced with the dilemma of treating these individuals as either employees or independent contractors.  Some companies may prefer to treat those individuals as employees, thereby taking advantage of workers' compensation laws to potentially protect the company from a lawsuit on behalf of an injured worker. Most often, however, companies prefer to treat these individuals as independent contractors, thereby saving the cost of employer contributions for various state and federal taxes, as well as employee benefit packages.  The potential cost of erroneously classifying a worker as a independent contractor rather than as an employee is great, and can more than wipe out the anticipated savings of classification of workers as independent contractors rather than as employees.

This article is intended to inform employers of the potential cost of misclassifying employees as independent contractors, and to advise them of applicable guidelines for determining which classification is most appropriate.  Also noted are steps that companies can take to ensure that their proposed classification is correct.  Areas of particular concerns are employee income taxes, workers' compensation/ industrial insurance, unemployment insurance/compensation, and the potential liability of the employer for the acts of the employee.  Although this article addresses federal law as well as general state law topics, it is important to remember that state law varies depending upon the state within which a company operates.  This article cannot address specific applicable state law, neither can it do more than simply give an overview of the complicated issues that an employer must face in this area of the law. For this reason, employers are advised to seek the advice of their own attorney or tax advisor if they have questions or potential problem in this area, and if they need to decide how to classify employees.

II.Income-related Taxes

A. Liabilities
There are several income-related taxes at both the federal and state level (and perhaps at the local level as well) for which an employer is responsible. At the federal level, an employer is responsible for paying to the federal government both the employer's and the employee's share of "FICA" taxes, including social security (generally 6.2% of an employee's gross wages) and Medicare (generally 1.45% of an employee's gross wages). The employee's share of these payments is withheld from the employee's gross wages.  An employer is also responsible for paying to the federal government an appropriate amount for potential individual federal income tax liability, which amount that has been withheld from the employee's wages.  Finally, the employer may be responsible for paying federal unemployment taxes (generally 6.2% of an employee's gross wages, but subject to quarterly and annual maximum contributions).

B. Potential Penalties for Misclassification
If an employer is found to have failed to pay income-related taxes that were due to the federal government, the employer will likely be required to (a) retroactively pay all past due taxes, (b) pay the interest that has accrued since the payments were originally due, and (c)  pay a penalty of up to 100% of the original amounts due. These financial costs are in addition to the cost of the employer's attorney and/or tax advisor that will almost always be incurred as the employer attempts to rectify the situation. There is also the possibility that the employer's operation will be shut down for an indefinite period of time.  Clearly, the cost at the federal level of misclassifying an employee as an independent contractor is high. While theoretically an employer may recover from the employee his or her share of past income-related taxes that were not properly withheld, the cost of trying to collect those funds might be greater than the recoverable amounts, even if the employee had the resources to pay.

C. Criteria Under Federal Law for Classifying Workers
Federal law does not have a specific list of criteria, set forth in either federal law or regulations, for determining whether a worker is an employee or an independent contractor.  Federal courts look to "common law" for guidance in making this decision, and have adopted a list of criteria they will utilize to determine whether a worker should be classified as an independent contractor or an employee.  Note that if the IRS challenges the manner in which a company has classified its workers, the burden will usually be on the COMPANY to prove that its classification is correct, i.e., guilty until proven innocent!

In determining the correct status, the court will look at the totality of the circumstances. No one criteria is determinative, in and by itself!

Major Factor
Whether the employer had the right to control the manner and method of performing the work, as well as the result to be accomplished.

Minor Factors
1.Instructions:  A worker who must comply with another person's instructions about when, where and how to work is more likely to be an employee.

2.Training:  Requiring in-house training implies an employee status; a higher level of specialized skill implies an independent contractor.

3.Integration: Integration of a worker's services into the company's business indicates that the worker is subject to the control of the company and is an employee.

4.Personal Services: If the company requires that the services be personally supplied by the worker, this implies an interest in the method and manner in which the work is done and indicates employee status.

5.Assistants:  If the company is in control of people who assist the worker in question, it implies control of the manner in which the job is done and thus implies employee status.

6.Continuing Relationship: If there is a permanent or long-term relationship, it implies employee status; if there is a transient relationship, it implies an independent contractor status.

7.Work Hours:  If there are set work hours, it implies employee status.

8.Full Time: If the worker works full-time for the company, it implies employee status.

9.Work Location: If the work is done on the company's premises, it indicates employee status.

10.Sequencing: If the sequence of the tasks to be done is set by the company, it is indicative of employee status.

11.Reporting:  If the worker is obligated to give oral or written reports to the company, it is indicative of employee status.

12.Payment:  If the company pays the worker a salary or wage, it is indicative of employee status.  If the company pays an agreed amount according to a set formula, it may indicate independent contractor status.

13.Expenses: If the company pays the worker's travel or business expenses, it is indicative of employee status.

14.Tools & Materials:  If the worker provides his or her own tools and equipment (but more than simply hand tools), it indicates independent contractor status.

15.Capital Investment: If the worker has a significant capital investment in the work, it indicates independent contractor status.

16.Profit/Loss:  If the worker has a financial risk in the project and may realize a profit or loss when completed, it indicates independent contractor status.

17.Multiple Jobs:  If the worker performs services for multiple companies or businesses during the same time period, it is indicative of independent contractor status.

18.General Public: If the worker makes his or her services available to the general public on a regular and consistent basis, it is indicative of independent contractor status.

19.Right to Discharge: If the company has the absolute right to discharge the worker, it is indicative of an employee status.  If the company must adhere to the terms of a contract for services, it is more likely an independent contractor relationship.

20.Right to Terminate: If the worker has the right to terminate his or her relationship with the company at any time, it is indicative of an employee relationship.

21.Industry Custom/Practice: Does the company's industry have a general practice concerning hiring workers as employees or independent contractors?

22.Intent of Parties:  Was there an intent between the company and the worker to specifically create either an employee or an independent contractor relationship?

23.Written Agreement:  Is there a written agreement between the company and the worker specifying either an employee or an independent contractor relationship? Note that although such an agreement may be a significant factor in deciding the status, it will not be conclusive in and by itself.

24.Benefits: If the worker receives benefits that are typical of employee benefits, i.e., vacation, sick leave or health insurance, it will be indicative of an employee relationship.

One option available to employers worried about the classification of their workers under federal law is to seek a written ruling from the Internal Revenue Service as to the proper classification of the questioned workers.  This can be done by submitting to the IRS a completed Form SS-8 ("Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding") (copy attached).  Once an initial determination has been made, an employer may depend upon that determination and, even if the IRS determination is subsequently held to be wrong, it will likely insulate the employer from most of the potential interest and punitive fines, and may even limit liability for past due taxes. 

III. Worker's Compensation/Industrial Insurance

A.Liabilities and Benefits
This is an area where state law governs the determination of an employer's responsibility.   Worker's compensation is addressed by specific state laws which will vary from state to state. Usually, an employer must pay the state an amount that is calculated according to a specific rate per hour worked by an employee.  The rate depends upon the classification by the state of the risks involved in the type of work being undertaken by the employee. As with the other categories of taxes addressed in this article, worker's compensation/industrial insurance involves financial costs to the employer. Unlike the other categories, however, employers enjoy a major benefit in this area when a worker is classified as an employee.  If an employee is injured on the job, compensation is paid out of a state fund, and the amount of that compensation (either temporary or long-term) is fixed according to state law or is subject to determination by binding arbitration. Remedies under a state worker's compensation/industrial insurance program are usually exclusive. This means that an employee generally cannot sue the employer for damages greater than that set forth in state law or determined by arbitration. This is an important safe haven for employers that are involved in hazardous undertakings, and can be a principal reason why an employer may seek to have a worker classified as an employee rather than as an independent contractor.

B.Potential Penalties for  Misclassification
These penalties are a matter of state law, but will often include (a) retroactive payment of all premiums that would have been due to the state, (b) payment of interest on the unpaid premiums since the time they became due, and (c) payment of a penalty of a certain percentage of the past due premiums. 

C.Criteria for Classifying Workers and Recommendations
The criteria for classifying a particular worker as an employee or an independent contractor will vary from state to state and cannot be summarized in this article. Such criteria may be set forth either in state statutes or in the written decisions of state courts.  The guidelines of "common law," as discussed above, may be generally applicable in many states.  Employers need to consult their own legal or tax counsel for guidance on the law of their particular state.  Many states have already made rulings for specific categories of workers (guides or seasonal workers, for example), or have procedures whereby employers may seek the advice of the appropriate state agency.  Consideration may be given to obtaining a formal opinion on the proper classification of a particular category of worker, thereby potentially limiting future liability for any misclassification.

D.Recommendations
Contact the appropriate state agency to request advice and/or a ruling on whether people working for your company are employees or independent contractors. First, request advice concerning how people in your industry have generally been classified in the past.  Second, give them the specifics of your business and request a written ruling or opinion on your situation.

IV.  Unemployment Insurance/Compensation

A.Liabilities and Benefits
This is another  area where state law governs the determination of an employer's responsibility. Unemployment insurance is dealt with under specific state which will vary from state to state. An employer must pay to the state an amount that is calculated according to the specific history of that employer for unemployment claims. If an employer is a start-up company without a history of unemployment claims, the state may impose an initial rate that is based upon the average of that industry for unemployment claims.  Following a set time period, the rate may be converted to reflect the specific employer's history. Note that in many states, there is a minimum length of time that an employee must have worked for an employer, i.e., a certain number of weeks with a certain minimum number of hours per week, in order for the employee to qualify for unemployment benefits.  This threshold test is particularly important in industries where seasonal employment is a major factor.

B.Potential Penalties for  Misclassification
These penalties are a matter of state law, but will often include (a) retroactive payment of all premiums that would have been due to the state, (b) payment of interest on the unpaid premiums since the time they became due, and (c) payment of a penalty of a certain percentage of the past due premiums. 

C.Criteria for Classifying Workers and Recommendations
As was the case with worker's compensation, the criteria for classifying a particular worker as an employee or an independent contractor for purposes of unemployment compensation will vary from state to state, and they cannot be summarized in this article.  Such criteria may be set forth either in state statutes or in the written decisions of state courts.  Employers need to consult their own legal or tax counsel for guidance on the law of their particular state.

D.Recommendations
Contact the appropriate state agency to request advice and/or a ruling on whether people working for your company are employees or independent contractors. First, request advice concerning how people in your industry have generally been classified in the past.  Second, give them the specifics of your business and request a written ruling or opinion on your situation.

V. Vicarious Liability for Acts of an Employee

A.Liabilities and Benefits
Although once again the applicable law may change from state to state, it is generally the case that an employer may be "vicariously" liable for the negligence of an employee, but will not be liable for the acts of an independent contractor.  Such liability of an employer is not automatic, however, and will depend upon the specifics of the case. For example, the acts of the employee that resulted in the alleged injury must have occurred within the scope of the employee's work for the employer. Did the employee put aside the interests of the employer in order to pursue his or her own interests? Although the question of vicarious liability often entails complex legal and factual determinations, it is certainly preferable from the company's point of view that the worker be considered as an independent contractor rather than as an employee. Note that in the event of damages or injury caused by an independent contractor, the injured party will almost always try to find some basis for asserting a claim against the company that retained the contractor to perform the particular task.

B.Criteria for Classifying Workers
States will varying in the criteria used to determine whether a worker is an employee or an independent contractor.  However there are some general major and minor criteria that are often used by state courts in making such determinations.  Major criteria includes whether the company has the "right of control" over the work that is performed by the worker, regardless of whether or not that right is exercised.  Does the company have the right of control of the details of the manner in which the work is performed? This question includes both the result of the work and the manner in which it is accomplished.  Does the company provide the worker with the "tools" necessary to perform the work?

Minor criteria for making this determination examine the "entrepreneurial aspects" of the worker.  This aspect includes the following questions: Does the worker have his or her own business?  Does he or she have a business license?  Is income reported as an employee or as a self-employed individual?  Does the worker have a proprietary interest in his or her own business? Does the company have the right to choose whether and when to hire or fire the worker? Does the company pay wages, or is compensation based upon some criteria other than hours worked?  The more entrepreneurial the nature of the worker's situation, the more likely that he or she should properly be classified as an independent contractor. Another minor criteria is whether the worker has any potential for profit or loss, or is he or she guaranteed an income regardless of the financial outcome?

VI.  Conclusions
The first thing that a company should do is consult with its attorneys and/or tax advisors to determine whether the company would benefit the most from classifying specific workers either as employees or independent contractors.  Then, having set an initial classification as a goal, examine the relevant criteria to determine the manner in which the workers might most likely be classified by appropriate state and federal authorities. Inquire if authorities have previously determined the proper classification for the workers in question.

Usually, there will be no problem should a company elect to treat a worker as an employee. The most telling criteria are the withholding of the worker's share of payroll taxes and the payment of an employer's share of payroll taxes and employee benefits.  The more difficult position to document is a company's decision to classify a worker as an independent contractor.  Where the decision is made to take that route, both the company an the worker should sign an independent contractor agreement (sample copy attached). Such an agreement documents the intent of both parties to have the worker thus classified. 

The company should also be sure to report payments to the independent contractor on an IRS Form 1099 MISC (sample copy attached). The company will need to have the social security number or other tax idntification number for the contractor. The worker should be advised in writing to file an IRS Form 4669 - Statement of Payments Received (sample copy attached).  Finally, the independent contractor should provide the company with proof of suitable liability insurance. Request that the company be named as an additional insured if possible.

When determining the proper classification of a worker as an employee or an independent contractor, a company should play it completely straight.  Request the advice of a legal and/or a tax advisor. Where there is doubt as to the proper classification, seek the assistance of the appropriate state or federal agency. A company should not try to beat the system in an attempt to save money. In the long run, an erroneous classification will almost always be much more costly to a company than the original expense of the proper classification!