It has become commonplace in the technology entrepreneurial community to classify most, if not all, workers as independent contractors. Many people think that if the arrangement is agreeable to both the business and the worker the classification is valid. However, whether a worker is an independent contractor is based on law—you cannot change that by an agreement in a contract. This post explains the factors that are used to determine whether a worker can be classified as an independent contract, how a misclassification can come to light, and what happens to your business if it is discovered your workers are misclassified as independent contractors.
In the past, the primary standard used to determine whether a worker was an independent contractor revolved around the amount of control the business had over how the workers performed their tasks. This is the standard that most people are familiar with. However, in July 2015, the standard became stricter in an effort to protect workers who were being denied important workplace protections such as overtime pay and minimum wage. Now courts use the “economic realities” test, a test that focuses on the whether the worker is economically dependent on the employer. Under this standard, most workers are employees under the Fair Labor Standards Act (“FLSA”).
To understand the change, you first need to understand FLSA’s definition of “employ.” “Employ” is defined as “to suffer or permit to work.” This language is indeed archaic and was originally developed to regulate child labor. At the time, businesses would hire middlemen to illegally hire and supervise children. The “suffer or permit to work” language extended liability to employers and required them to detect work being performed illegally and prevent it from happening. The “suffer or permit” standard extended the definition of employment beyond those who are directly hired or supervised by the business. A business “suffers or permits” a person to work, if the person is dependent on the business economically (i.e., whether the person is economically dependent on the business or is instead in business for him/herself.) Using the economic realities test, courts have found independent contractors to be those workers who are economically independent because they are operating a business of their own.
Several factors are considered in the economic realities test. Each factor is examined independently of the other and no single factor is more important than another. These factors typically include: (i) the extent to which the work performed is an integral part of the company’s business; (ii) the worker’s opportunity for profit or loss depending on his or her managerial skill; (iii) the extent of the relative investments of the company and the worker; (iv) whether the work performed requires special skills and initiative; (v) the permanency of the relationship; and the (vi) the degree of control exercised or retained by the business.
Application of economic realities factors
The economic realities factors are used to determine whether a worker is truly in business for him/herself. The factors must be considered and weighed against one another but there is no formulaic way to arrive at the correct result. These factors are merely a tool to help in understanding each situation on a case-by-case basis.
· The extent to which the work is an integral part of the business
The more integral the work is to the business, the more likely the worker is an employee, not an independent contractor. Work can be integral to a business even if it is only a component of the business and even if many other workers perform the same kind of work. In the modern workplace where many people telecommute, a worker’s work can be integral to a business even if it is performed remotely.
For example, a company may hire carpenters to frame the homes it is building. The work these carpenters do is integral to the company because the company is in the business of building homes. On the other hand, the same company may hire a software developer to create software to assist the company in tracking its bids for framing houses. The software developer is performing work that is not integral to the company’s business, which is indicative of an independent contractor.
· The worker’s opportunity for profit or loss depending upon his/her managerial skill
The focus in the analysis of this factor hinges on whether the worker’s managerial skill has an effect on his/her possibility of loss from performing the work; profit alone is not sufficient. This opportunity for loss is essential in determining whether a worker is truly in business for him/herself.
For example, a worker who provides cleaning services for corporate clients but only performs them as determined by a cleaning company and who does not independently schedule assignments, solicit additional work from other clients, or take action to reduce costs does not exercise managerial skill that affects his/her profit or loss. On the other hand, a worker who provides cleaning services for corporate clients and also produces advertising, negotiating, makes decisions as to which jobs to take, and decides when to perform them exercises managerial skill that affects his/her opportunity for profit and loss, which is indicative of an independent contractor.
· The extent of the relative investments of the company and the worker
The worker should make some kind of economic investment (which indicates a risk of loss) to be considered an independent contractor. This investment must be relatively significant in comparison to that of the business to suggest the worker is not economically dependent on the employer.
For example, a worker who provides cleaning services for a corporate client and, from time to time, provides his/her own cleaning supplies for certain jobs is indicative of an employment relationship rather than an independent contractor relationship because the worker’s investment does little to further the worker’s business beyond that particular job. On the other hand, if a cleaning person receives referrals and sometimes work for others and buys a vehicle for traveling to various worksites (but that is not appropriate for personal use), rents his/her own space to store the vehicle and supplies, advertises and markets his/her services, and routinely provides the supplies and equipment he/she uses to provide cleaning services is indicative of an independent contractor.
· Whether the work performed requires special skill and initiative
The special skill and initiative to which this factor is referring is not the worker’s technical skills but rather the worker’s business skills, judgment, and initiative. Even those who are highly skilled in their trade or profession are not independent contractors unless they operate as independent businesses.
For example, a highly-skilled carpenter who doesn’t make any independent decisions on the job site beyond what he/she doing for that job, who does not determine the sequence of the work being done, or think about bidding the next job is not demonstrating the skill and initiative of an independent contractor. On the other hand, a highly-skilled carpenter who builds custom, handcrafted cabinets that are made-to-order may be demonstrating the skill and initiative of an independent contractor if the carpenter markets his/her services, determine when to order supplies, and determines which orders to fill.
· Permanency of the relationship
If the worker’s relationship with the business is permanent or indefinite, that worker’s relationship is likely that of an employee not an independent contractor. An independent contractor typically works one project for a business and does not necessarily work repeatedly or continuously with the same business. This lack of permanence or indefiniteness does not necessarily indicate an independent contractor relationship, however, and each situation must be analyzed separately.
For example, an editor who has worked for a publishing house for several years, uses its software, completes his/her edits according to the publishing house’s guidelines, and only edits book provided by the publishing house suggests an employment relationship. On the other hand, an editor who has worked intermittently with several different publishing houses over the past few years, markets his/her services to numerous publishing houses, negotiates rates for each editing job, and turns down jobs because he/she is too busy with other editing jobs shows a lack of permanence with one publishing house and is indicative of an independent contractor status.
· The degree of control exercised or retained by the business
The business’s control over the worker should also be analyzed to determine whether the worker is economically dependent on the business. This degree of control factor has become more complicated over the years as more and more workers work from home and provide their own equipment to do the work. Regardless of this remote working environment, the business can still exert a lot of control over the worker’s schedules and the tasks he/she carries out on behalf of the business. In addition, this factor is no longer the single determining factor as to the status of a worker.
For example, a registered nurse who provides skilled nursing care but works for an agency who requires him/her to undergo training, requires the nurse to fill out a form before contacting any patient, requires the nurse to adhere to a certain wage range, and is required to inform the agency when he/she has to miss a shift is indicative of an employment relationship. On the other hand, a registered nurse who is registered with an agency who is free to call as many or as few potential patients as he/she wants, can work as much as he/she wants, and negotiates his/her own fees and schedules with a patient is consistent with that of an independent contractor.
How is misclassification discovered?
Usually a misclassification is discovered when a disgruntled worker (or former worker) files a complaint with the Department of Labor or IRS about their working conditions. This could include situations where the worker feels he/she should be getting paid overtime, should get paid for holiday leave, or deserves workers’ compensation. The other most common way a misclassification is found is when the IRS or another agency performs an audit.
What happens if your worker is found to be misclassified?
If your business is found to have workers who have been misclassified as independent contractors, you may have to pay back taxes, you may have to reimburse your workers for overtime and minimum wage violations, and you may have to pay hefty litigation costs.
In short, an independent contractor relationship only exists if the worker is not economically dependent on the business for which the worker is performing the work. In other words, an independent contractor relationship only exists if the worker is truly in business for him/herself. A contract cannot change the nature of the relationship—even if both parties agree.
Do not risk the costly penalties that your business will incur if your independent contractors are found to be misclassified. Contact us today and we will help you determine whether your workers are classified properly and, if they aren’t, put you on the right path.