If you use independent contractors, be sure you classify these workers correctly. If you don’t, you may owe the IRS, DOL, and even state agencies lots of money in back taxes and penalties.

Independent contractors can provide an efficient and cost-effective way to get work done. For example, you might hire a consultant to install the new upgrade to your computer system or a benefits expert to work on a new insurance proposal. Typically, these workers aren’t on your payroll; they are self-employed. As a result, you don’t have to pay taxes, benefits, or cover them for unemployment or workers’ compensation. But if you classify these workers incorrectly, you may find that your organization owes thousands of dollars in back taxes, overtime, and penalties.

Advantages of Independent Contractors

Clearly, there are many advantages to using independent contractors. First, if you have a special project that requires a level of expertise none of your employees have, hiring a consultant to do the work can jump-start the project and ensure it is completed correctly. In addition, using independent contractors gives employers more flexibility to "staff up" or cut back, without incurring the costs of hiring or layoffs. Because independent contractors are not considered your employees, the organization does not have to pay taxes on their behalf or allow them to participate in any benefits plans. Also, they typically are not covered under state workers’ compensation or unemployment compensation statutes; they are not entitled to overtime under wage and hour laws; they cannot sue under discrimination statutes; and they cannot take leave under the Family and Medical Leave Act.

Misclassification Costs Big Money

There is a downside to using independent contractors, however. If you miscategorize an employee as an independent contractor, you may face claims under the many laws that protect employees. The agencies that enforce these laws aggressively pursue claims against employers that misclassify employees as independent contractors. Both the Department of Labor (DOL) and the Internal Revenue Service (IRS) have collected millions in back taxes and penalties from employers that incorrectly categorized employees as independent contractors.

Classify Correctly; Know the Standards

So, how do you prevent misclassification? Answering that question is particularly tricky since three different standards commonly are used by the courts and agencies to determine independent contractor status: (1) the IRS 20-factor analysis, for coverage under federal withholding requirements; (2) the "economic reality" test, used to determine compliance with requirements of the Fair Labor Standards Act (FLSA); and (3) the common law "right to control" test, used by many courts to administer discrimination and benefits statutes. These three tests, discussed below, share several common factors, the most important of which is the amount of control the employer exercises over the work relationship.

The IRS 20-Factor Test

The IRS considers the existence of an employer-employee relationship to depend on whether the worker is subject to the will and control of the employer, based on the following factors:

1. Instructions. Employees typically must follow instructions as to when, where, and how to perform the job.

2. Training. Requiring training supports employee status.

3. Integration. Integration of the worker’s services into the business operations suggests that the hirer directs and controls the worker.

4. Services rendered personally. If services must be rendered personally by a specific worker, the hirer controls the methods used to complete the work.

5. Control of assistants. Control by the hirer over the hiring, supervision, and pay of assistants implies employee status.

6. Ongoing relationship. A continuing relationship suggests that an employer-employee relationship exists.

7. Set hours of work. The establishment of set hours by the hirer implies control over the worker.

8. Full time work. A worker who must devote full working time to the hirer is being controlled.

9. Work on hirer’s premises. On-premises work indicates employer control, especially when the work could be done elsewhere.

10. Order or sequence. Work that must be performed in an order or sequence established by the hirer suggests control.

11. Reports to hirer. A requirement that the worker submit regular oral or written reports to the hirer implies control.

12. Payment method. Payment by the hour, week, or month generally indicates an employer-employee relationship. Payment by the job or commission indicates independent contractor status.

13. Payment of expenses. Payment of the worker’s business or travel expenses suggests an employer-employee relationship; the hirer is regulating and directing the worker’s activities.

14. Furnishing tools, materials. Provision of tools, materials, and other equipment by the hirer shows an employer-employee relationship.

15. Significant investment. Independent contractor status is implied if the worker invests in the facilities used for the work. Absence of investment indicates an employer-employee relationship.

16. Realization of profit or loss. A worker who can realize a profit or suffer a loss as a result of providing services is usually an independent contractor.

17. Serving more than one firm. A worker who provides services to several unrelated firms at the same time generally is an independent contractor.

18. Serving the public. A worker whose services are regularly available to the general public is an independent contractor.

19. Right to discharge. The right of the hirer to discharge the worker at any time is a factor indicating an employer-employee relationship. But, an independent contractor may not be fired if his result meets contract specifications.

20. Right to quit. A worker with the right to terminate the relationship with the hirer at any time without liability is generally an employee.

The presence or absence of any one of the 20 factors is not determinative or conclusive; rather the IRS will consider all of the factors affecting the relationship.

The FLSA Analysis

The DOL uses the "economic realities test" to determine coverage under, and compliance with, the minimum wage and overtime requirements of the FLSA. The following are among the factors considered by the DOL: (1) the degree of control exercised by the hiring party over the manner in which the work is performed; (2) the relative investments by the hiring party and the worker in materials and equipment; (3) the degree to which the worker’s opportunity for profit and loss is determined by the hiring party or the worker’s own managerial skill; (4) the skill and initiative required in performing the job; (5) the permanency of the relationship; and (6) whether the service is an integral part of the hiring party’s business.

Common Law "Right to Control" Test

The common law "right to control" test is used by courts to determine employee status in various types of cases, including employment discrimination and benefit cases, tax cases, and tort (wrongful act) liability cases. The common law test, as applied by the courts, includes the following ten factors: (1) the extent of control which, by agreement, the hiring party may exercise over the hired party; (2) whether the hired party is engaged in a distinct occupation or business that is usually done by a specialist without supervision; (3) how the worker’s helpers are hired and whether they are paid by the hiring party or the worker; (4) the skill required in the particular occupation; (5) who supplies the means, tools, and place of work; (6) the length of time for which the person is hired; (7) the method of payment, whether by time or the job; (8) whether the work is part of the regular business of the hiring party; (9) whether the parties believe they are creating an employment relationship; and (10) whether the hired party is an actual business entity.

Five Simple Steps Towards Compliance

A few simple steps can protect your organization against misclassifying employees. First, make sure you understand the various tests and apply them to each independent contractor relationship. It is not enough to meet the standards of one of the tests. You could face a challenge from one agency that results in an investigation by another, so you should try to comply with all of the factors.

Second, enter into a contractual agreement with the worker that explains the independent contractor relationship. The contract will help show what both the hiring party and the worker understood and in-tended the relationship to be. However, the contract by itself is not determinative; the worker still must meet all independent contractor criteria. Third, use independent contractors that are set up as separate business entities. In addition, if you are using an independent contractor to perform a job that is also performed by current employees, consider carefully whether the independent contractor really meets the criteria. Courts and administrative agencies are less likely to accept the classification if the independent contractor is doing the same job as employees. Finally, be particularly careful if you have an employee who works two jobs for you, and you classify the second position as an independent contractor. This action may raise a red flag.