Employee vs Independent Contractor Misclassification

Companies sometimes look to hire independent contractors instead of employees for a number of different reasons.  A company may choose to classify a worker as an independent contractor for legitimate business reasons but may also do so to avoid any number of the following:

1. Avoid paying/offering required & voluntary benefits such as health insurance
2. Avoid employer taxes
3. Avoid minimum wage & overtime requirements
4. Avoid state sick leave laws

By classifying a worker as an independent contractor, a company can be opening themselves up to risk.  For companies located in the commonwealth, they could be subject to audit from one of the following agencies:

1. Internal Revenue Service
2. U.S. Department of Labor
3. Massachusetts Attorney Generals’ Office

Each governmental agency/department has separate rules and tests to determine whether a worker should be classified as an employee.  For years, the IRS relied on a 20 factor test to determine proper worker classification (Revenue Ruling 87-41). 

1. The level of instruction provided by the business to the worker;
2. Whether the business provides the worker with training;
3. Whether worker’s activities are integrated into operations of the business;
4. Whether the business requires that the worker personally provide the services;
5. Whether the worker hires, supervises and pays his or her own assistants;
6. Whether there is an ongoing relationship between the worker and the business;
7. Whether the business established the worker’s hours;
8. Whether the worker is required by the business to work on a full-time basis for the business;
9. Whether the business requires that the worker perform the services on the business’s premises
10. Whether the worker is free to establish his or her own sequence or pattern of work;
11. Whether the worker is required to submit regular or written reports;
12. Whether the workers I paid by the hour, week , or month;
13. Whether the business ordinarily pays the worker’s business and/or traveling expenses
14. Whether the business furnishes the worker with significant tools, materials and equipment
15. Whether the worker invests in facilities;
16. Whether the worker may realize a profit or loss;
17. Whether the worker consistently performs services for multiple unrelated person or firms at the same time
18. Whether the worker makes his or her services available to the general public on a regular and consistent basis;
19. Whether the business has the right to discharge a worker; and
20. Whether the worker has the right to quit or terminate his or her relationship with the business.

In recent years, the IRS has attempted to simplify this test by examining evidence of the degree of control and independence based on three categories:

(1) Behavioral control: Does the company control or have the right to control what the worker does and how the worker does his or her job, through instructions, training, or other means

(2) Financial control:  Are the business aspects of the worker’s job controlled by the payer, this includes the extent the worker has unreimbursed business expenses, the extent the worker must invest in facilities or tools necessary to perform services, the extent to which the worker makes his or her services available to the relevant market, how the business pays the worker, and the extent to which the worker can realize a profit or incur a loss.

(3) Type of relationship: Are there written contracts or oral agreements describing the relationship the parties intended to create, does the business provide the worker with employee-type benefits such as insurance, a pension plan, sick or vacation pay, the permanency of the relationship, and the extent to which services performed by the worker are a key aspect of the regular business of the company.

No single factor carries more weight than another factor.  The factors must be considered as a whole based on the facts and circumstances of the case. 

A company engaged in a worker misclassification audit with the Massachusetts Attorney Generals’ office will have the same up-hill battle as an IRS audit, since the burden of proof is on the employer, but will have to support their classification based on the following three factor analysis as defined in M.G.L. ch. 149 Sec. 148B

1. The individual is free from control and direction in connection with the performance of the service, both under his contract for the performance of service and in fact, and
2. The service is performed outside the usual course of the business of the employer; and,
3. The individual is customarily engaged in an independently established trade, occupation, profession, or business of the same nature as that involved in the services performed.

When analyzing the relationship, all three prongs must be met.  The inability of a company to prove any one of the prongs is sufficient to conclude that the individual in question is an employee.

The first prong of the test examines the degree of control and direction retained by the company.  To be free from an employer’s direction and control, a worker’s activities and duties should be carried out with minimal instruction.  An independent contractor should be able to complete a job using his or her own approach with little to no direction and dictate the hours that he or she will work on the job.

Prong two of the test provides that the services of the individual must be “outside the usual course of business of the employer,” in order for the individual to not be classified as an employee.  The second prong is not defined by the law which makes this prong heavily litigated.  The courts have determined that “if the worker is performing services that are part of an independent, separate, and distinct business from that of the employer,” prong two is not implicated.

The third prong the court must consider is whether the service in question can be viewed as an independent trade or business because the worker is capable of performing the service to anyone wishing to avail themselves of the service, or conversely, whether the nature of the business compels the worker to depend on a single employer for the continuation of the services. 

Employee misclassification occurs when a company classifies a worker as an independent contractor instead of an employee for purposes of payroll taxes and employee benefits.  Failure to classify workers correctly could result in back-taxes, penalties, or damages.  Companies should consider the factors above in determining classification status of their employees. 

References:

1. Independent Contractor (Self-Employed) or Employee? | Internal Revenue Service (irs.gov)
2. Massachusetts law about independent contractors | Mass.gov