Independent Contractor vs. Employee: New IRS & FLSA Crackdown

The classification (or misclassification as the case may be) of workers as independent contractors instead of employees is a hot one right now for our government. In these times of budget cuts, Uncle Sam is looking for sources of revenue. Targeting misclassifications is one way that the Internal Revenue Service (IRS) brings in dollars through the back taxes and penalties that the employer incurs. In addition to the IRS, the Department of Labor (DOL) is auditing employers to ensure that their independent contract labor are correctly classified and are not labor that should be classified as employees, who are eligible for overtime, minimum wage and other rights under the Fair Labor Standards Act (FLSA).

Many companies, particularly those that are small and/or start-ups, have workforces that include a high percentage of independent contractors.

  • Independent contractors are generally individuals who are in an independent business in which they offer their services to the general public and have control over what and how the work is done to arrive at the end product for a company. It is important to understand that whether an individual meets this definition depends on the facts in each case and can be very subjective.
  • Employees are generally individuals who perform services for an employer and the employer has the control over what will be done and how it will be done. This is so even when the employer gives the individual freedom of action. What matters is that the employer has the right to control the details of how the work is performed.
  • Employers are often attracted to independent contractors because as non-“employees” they are less of a cost to the company. Unlike with employees, the company is not required to pay “wages”, which include employment taxes like FICA, FUTA and worker’s compensation. They are also not expected to offer employee benefits, such as paid vacation, profit share plans or any other employee perk or benefit.

In addition, independent contractors can be hired to work at the company’s request unlike employees who are typically hired with the expectation that they will be long term. Many companies, especially small companies, do not always need full time help so they will hire an independent contractor who will do the task as needed (maybe only 10 hours/week or once a quarter).

The IRS has a “test” it uses to determine independent contractor or employee status. This test is subjective and the determination is ultimately up to the IRS. The test is based upon three factors – control, financial and relationship. How each relates to an independent contractor is outlined below:

1. Control factors are based on the type and degree of instruction given, evaluation and training. Typically a worker correctly classified as an independent contractor controls their own work, obtains their own training and is evaluated on the end result only. Employees, on the other hand, are typically controlled by their employer who provides training and dictates how, when and where the tasks are completed.

2. Financial controls have to do with investments, expenses, opportunity for loss/profit, services available, and method of payment. Typically, with a worker correctly classified as an employee, the Company provides their equipment and suffers any losses (or incurs any profits) resulting from the employees’ efforts. Independent contractors typically provide their own tools, work for many employers at the same time and are paid a flat fee for a job.

3. Type of relationship has to do with written contracts, employee benefits and permanency of the relationship. The IRS does not recognize a contract designating an individual’s status as an independent contractor responsible for paying self-employment taxes. The IRS makes the determination based on how the parties work together.
When an IRS audit finds an incorrect classification the penalty is steep for the employer. Not only in terms of back taxes to the IRS and to the worker who was misclassified, but also in terms of significant penalties to the employer.

In addition to the IRS focus on this topic, in the last year the Department of Labor has made the issue of misclassifying contractors an FLSA priority. An independent contractor is not covered under the FLSA. Consequently, the employer does not have to pay independent contractors minimum wage, overtime, or anything else provided under the FLSA.

Recently, FedEx lost an appeal of where the drivers were found to be employees, rather than independent contractors. The cost to Fed Ex was around $11 million by the time they paid overtime, taxes, penalties and numerous other costs incurred in litigation. Some of the reasons that the court found the workers to be employees rather than independent contractors was the drivers used company scanners and paperwork with the company logo, the managers were allowed to change their routes unilaterally and the company had a large degree of control over them including what uniform they wore and how they kept their hair.

Right-to-Know regulations from the Department of Labor have been proposed and are expected to become effective in 2011. These will require employers with workers excluded from the protection of the FLSA to prepare a written analysis describing why an individual is classified as an independent contractor instead of an employee. The DOL has said that its proposed rule making will address burdens of proof when the employer fails to provide it.

If you are unsure whether you may have independent contractors misclassified, contact Resourceful HR to conduct an analysis.

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