A common issue many businesses face is whether workers are correctly classified as independent contractors rather than employees. These issues arise because of the various standards employed by government agencies and the courts to determine whether a worker should be deemed an independent contractor or an employee. According to the Internal Revenue Service, a business generally must withhold income taxes, withhold and pay Social Security and Medicare taxes, and pay unemployment tax on wages paid to an employee. In contrast, these requirements are usually inapplicable to independent contractors. Furthermore, courts and government agencies, such as the Internal Revenue Service, the Washington Department of Labor and Industries, and the Equal Employment Opportunity Commission, apply different tests in determining if a worker is an independent contractor or an employee. According to the US Department of Labor, “[t]he plethora of tests defining independent contractor status applied across federal and state laws makes it possible for a worker to be classified as an independent contractor under one law, but as an employee under another.” Outlined below are various tests that are utilized in determining whether a worker is an independent contractor or an employee.
Some of the Factors that Washington Courts Consider:
- The extent of the company’s right to control the details of the work;
- Whether or not the worker is engaged in a distinct occupation or business that is the object of the contract;
- Whether the type of work to be done is usually performed under the direction of the company or by a specialist without supervision;
- The skill required;
- Whether the worker supplies the instrumentalities and tools;
- Whether the worker supplies the location for the work to be done;
- The length of time for which the worker is employed;
- The method of payment, whether by the time or by the job;
- Whether or not the work is a part of the regular business of the company;
- Whether or not the parties believe they are creating the relation of master and servant; and;
- Whether or not the worker is in business.
Washington Department of Labor and Industries
The Department of Labor and Industries has an independent contractor test which helps businesses determine whether they should be providing workers’ compensation coverage. Your independent contractor must pass the Department of Labor and Industries tests in order to be exempt from receiving workers’ compensation coverage. Based on how the business responds to the questions below, it can help evaluate whether the workers’ compensation coverage should be provided. For example, if the business owner responds “yes” to the most of the questions, it will likely imply that coverage is not required.
- Does the individual bring more than their personal labor?
- Consider if the individual is bringing his or her own employees and equipment to perform the work. If so, it is likely that the individual/worker is an independent contractor.
- Is the individual working without your direction and control?
- If you are not providing training or equipment, setting the individual’s schedule, or supervising how the work is done then it is likely that the worker is an independent contractor.
- Does the individual have his/her own separate business?
- Consider if the individual’s business provides work that is different than your business; whether the work is conducted away from your business; and whether the worker is obligated to pay costs affiliated with its headquarters. (If the answer is “yes” to one of the factors outlined under 3(a), then the individual is likely an independent contractor in response to this question).
- Does the individual have a business that was established before you started working with him or her?
- At the time you began working with the individual, was he or she filing business tax returns with the IRS?
- Does the individual have an open Department of Revenue account as well as all required licenses and registrations for the business?
- Does the individual maintain a separate set of books or records to track business income and expenses?
- If the individual is a construction contractor, does the individual have a valid contractor registration?
Internal Revenue Service
Although the Internal Revenue Service traditionally looked at twenty questions to determine the proper classification of a worker, the IRS now utilizes a three-factor test.
- Behavioral: Does the company control or have the right to control what the worker does and how the worker does his or her job?
- The more instructions and training provided to the worker, the more likely that he or she is an employee. Independent contractors generally set their own schedule and perform the job without instructions or supervision.
- Financial: Are the business aspects of the worker’s job controlled by the payer?
- An employee is typically working for one employer and is paid on a specific date. The employer also reimburses the business expenses of the employee. On the other hand, an independent contractor is paid for the service provided and is likely working for more than one company.
- Type of Relationship: Are there written contracts or employee type benefits? Will the relationship continue and is the work performed a key aspect of the business?
- An independent contractor typically signs an independent contractor agreement, does not receive any employee benefits and is hired for a specific project. It is also important to note while it is critical to have a well-drafted independent contractor agreement, such an agreement alone is not sufficient to classify the status of the worker. Employees typically receive benefits such as health insurance, retirement benefits, paid vacation, sick leave, etc.
Key Provisions to Include in an Independent Contractor Agreement
In order to prepare an effective independent contractor agreement, it is crucial to understand the relevant tests used to classify the worker as an independent contractor. There are certain provisions which you will want to include in your independent contractor agreement so that there are no questions that the individual is an independent contractor. Critically, there are also provisions to exclude that would typically work in favor of establishing that the individual is an employee.
Title and Status: The agreement should correctly be titled to avoid any confusion. For example, the agreement can be titled “Independent Contractor Agreement.” Additionally, the agreement should clearly state that the worker’s status under the agreement is that of an independent contractor. The parties should be correctly identified throughout the agreement and terms such as “employer” and “employee” should be excluded.
Expenses: The agreement should state that the independent contractor is responsible for expenses incurred and materials necessary to perform the services. These costs should not be reimbursable by the company. Otherwise, it could indicate that the individual is an employee.
Manner of Compensation: The company should carefully select a method of payment that is different than how the company’s employees are paid. For example, if employees are paid hourly or monthly, the independent contractor can be paid based on completion of the service. The agreement should set forth that the contractor is not entitled to overtime compensation.
Duties: While the agreement should specify the services to be performed, the agreement should not control how the contractor will work. Contractors should not have a set schedule and generally have freedom to choose their own hours and how to complete the work.
Term: The agreement should specify a term for the agreement. An engagement that is limited to a short duration or that terminates once the project is complete typically implies a contractor status.
Benefits: The independent contractor should not be entitled to sick leave, vacation, health insurance, or other benefits that are typically offered to an employee. The agreement can clearly state that the contractor will not be entitled to such benefits that are provided to the employees of the company.
Training: The agreement should set forth that training will not be provided to the independent contractor. Typically, the more instructions and training provided to the worker, the more likely that the relationship suggests that the individual is an employee.
Non-Compete: Unlike an employee, independent contractors typically work for many companies. As a result, if possible, the agreement should provide that the contractor is free to work for other companies and should not include a non-compete clause. Although it may be possible to include a narrowly-tailored non-compete clause, such a clause is usually avoided as it restricts the contractor from working for other companies which could imply an employee status. Alternatively, confidentiality, non-solicitation, and non-disclosure agreements should be in place to protect the company.
Benefits of hiring an Independent Contractor
It is typically less costly to hire an independent contractor than an employee. For example, independent contractors do not receive benefits such as health insurance, retirement, unemployment, paid vacation, sick days, etc. Companies also do not have to pay social security, workers compensation, or federal unemployment insurance for independent contractors. Additionally, companies also enjoy great flexibility, as independent contractors are able to complete their work without supervision and control.
Benefits of hiring an Employee
When you hire an employee, the employee typically works for just one employer, whereas an independent contractor usually works for more than one company. As the employer, you are able to train the employee and direct their performance in an ongoing work relationship. As part of this ongoing work relationship, the employee is generally motivated to contribute and advance their career in the company.
Why Correct Classification Matters:
The Misclassification of Employees can expose an employer to significant penalties and fines. In the event that it is determined that your worker was an employee, and not an independent contractor, the Washington Department of Labor and Industries may seek payments for industrial insurance premiums, with interest and penalties. Additionally, the Employment Security Department may seek payments for unemployment insurance premiums. Last, the IRS penalizes employers who wrongfully designate a worker as an independent contractor, as you generally are required to pay Social Security, Medicare taxes and unemployment taxes when you have an employee.
As it is clear from the various tests, there is not one specific factor that establishes whether the worker is an independent contractor or employee. Companies classifying their workers as independent contractors should carefully review the relationships and agreements in place to ensure that the workers are properly classified and if necessary, incorporate changes in the relationships and agreements to support that classification.