By Christopher Minnick
Independent contractor classification is fraught with complications, the most imposing of which result from a tangled web of federal and state tax and labor laws. The potential trouble due to improper classification comes in many forms: worker lawsuits; retroactive overtime payments and benefits to workers; and back taxes, penalties and fines to the government -- to name just a few.
The difference between an independent contractor and an employee is determined in part by the concept of "right to control." With an employee, the employer determines what needs to be done (results) and controls how it is to be done (means). The person is normally directed by the employer. Independent contractors, on the other hand, are not employees but are in business for themselves. They are hired to accomplish a task or tasks as determined by the employer, but independent contractors retain the right to control how they will get the work done.
A Growing Problem
No one knows how widespread employee misclassification really is. The last comprehensive estimate of misclassification dates back to 1984. It was estimated that nationally, about 15 percent of employers misclassified a total of 3.4 million employees as independent contractors, resulting in an estimated tax revenue loss of $1.6 billion (in 1984 dollars).
Data from more recent -- yet less comprehensive -- studies suggest that misclassification is on the rise. For example, a study commissioned by the Department of Labor in 2000 found that 10 percent to 30 percent of firms audited in nine states had misclassified employees as independent contractors. These estimates confirm what we have seen in our business working with Fortune 100 companies: Companies looking to estimate quickly their potential exposure to financial liabilities can assume anywhere from 10 percent to 30 percent of their independent contractors are misclassified, with the financial exposure per worker at roughly 40 percent of the worker's pay.
In February, the Internal Revenue Service, with the help of more than 250 recently hired revenue inspectors, was expected to begin a comprehensive employment tax audit program, which will target approximately 6,000 employers over a three-year period. Companies of any size will be selected at random from across many different industries. The scope of the audits will include all aspects of a company's employment and employment tax practices, but the IRS has indicated that it will pay particular attention to independent contractor classifications.
Companies looking to evaluate their risk face challenges, even as the federal and state agencies responsible for regulating employee classifications and the courts responsible for deciding the cases cannot agree on whether a worker is an employee or an independent contractor in all cases. So what is a responsible company to do?
The best practice would be to evaluate each independent contractor situation and employ the various tests applied by the courts (e.g. the common law and economic realities tests) to determine whether any prospective or existing independent contractor is actually independent.
An Ounce of Prevention
However, even with the IRS' audit program, it is relatively unlikely that state or federal agencies will investigate a business without a worker first filing a complaint. In order to avoid worker complaints, we think that there is a straightforward, rule-of-thumb approach that all businesses can take to assess initial IC viability: only work with independent contractors who want to be in business for themselves and who are suited to do so.
After all, a person who actually desires to be an independent contractor is far less likely to complain to the authorities than someone who has IC status forced upon them.
This article explores some of the initial clues that businesses can use to determine whether an IC wants to be in business for himself and, more important, is suited for it. By assessing these two points, companies, in many cases, can quickly disqualify a worker as an independent contractor before conducting a more comprehensive qualification tests used by the courts.
Why Be Independent?
Most people in the United States know that the security of long-term, traditional employment has become a thing of the past. We all know someone who has been made "redundant" due to downsizing and has gone on to start a business. In recessions and times of high unemployment, greater numbers of people start their own businesses.
The harsh reality is that many of these individuals will fail as business owners. With such high failure rates for startup businesses, it begs the question: why do people start their own businesses? The most commonly cited reasons are:
- I cannot find a job
- I want to be my own boss
- I want to make more money
Obviously, someone who only starts their own business because they are unable to find a full-time job should raise a red flag. This person does not really want to be in business for themselves and is unlikely to be adequately set up to do so. On the other hand, someone who wants to be his or her own boss or make more money is more likely to invest the time and resources required to be successful.
So, how do we tell whether an IC is in it for the right reasons? We can never be completely sure, but there are some good clues that can help weed out those that are not well-suited to be a business owner.
Incorporation. While it is relatively easy and inexpensive for an individual to incorporate, and it does not in and of itself ensure an independent contractor classification, companies should require all ICs to be incorporated, be it as an LLC, a traditional subchapter C or S corporation, or a partnership.
An individual who has gone through the effort to incorporate has shown that he wants to be in business for himself. He is more likely to understand and appreciate the relationship with the company that retains him is not one of employer-employee than someone who has not gone through the process, thereby reducing the likelihood that the individual will file a complaint in the future.Furthermore, individuals who have incorporated are reported to be four times more compliant about paying their taxes than sole proprietors, according to U.S. General Office of Accountability. These data support the long-standing best practice of only using ICs that are incorporated.
Insurance. Insurance is one method for managing risk and is a must-have for every business. As new business owners, independent contractors are often shocked at the cost of "must-have" insurances for their profession -- often opting to forego them unless (or until) required by a client contract. However, an independent contractor that is serious about being in business for himself will likely have invested in at least a minimum level of insurance appropriate for his business.
Insurance coverage and limits required for independent contractors are different for every company. The nature of your business, the type of work being done by the independent contractor and your company's appetite for risk will factor into the decision of what coverage and limits are necessary. Commercial general liability and professional liability are two must-have insurances for every independent contractor.
In many (but not all) states, independent contractors are precluded from securing workers' compensation insurance to protect against injuries on the job. When an independent contractor is seriously injured, often his or her only recourse to indemnity and health benefits is to claim an employment relationship with the client company where the injury occurred. With this in mind, companies should require their independent contractors to secure their own disability coverage, either through workers' compensation insurance (where available) or through conventional disability insurance.
Independent contractors must be prepared to provide original certificates of insurance (not copies) citing the minimally required coverage and listing your company as an additional insured party before any work begins. Make sure that certificates of insurance are carefully tracked and coverage is current until the work is completed.
Market presence. To survive and prosper, independent business owners must establish a presence in a market. Whether physical or online, a market presence helps create new business opportunities. An independent contractor who truly wants to be in business for himself will do all he can to establish a market presence for his business.
Companies should look to see whether a prospective IC has his own Web site, and at the very least, a professional email address. Business cards, membership in independent contractor-focused associations such as Freelance Union, and active participation on online service marketplaces, such as OneWire.com, Odesk.com, Guru.com, and Elance.com demonstrate that an individual's services are available to the market. None of these things require great amounts of money or effort, but they show an intent to be taken seriously as a business.
Tools and equipment. Another clue as to whether ICs actually want to be in business for themselves is whether they have all the necessary tools and equipment to complete their work. Generally, businesses should require an IC to furnish all the tools, equipment, materials and supplies necessary for the contract.
Establishing that an IC wants to be in business for himself only takes us so far. It is also useful to understand whether he or she is actually suited to be a small business owner. How can we tell? There are some useful tips for uncovering whether an IC is suited to running his or her own business.
Specialized skills, experience and knowledge. One of the first things any enforcement agency will look at in a misclassification dispute is whether the employing organization had employees with the same skill set doing the same type of work as the independent contractor. Before hiring an IC, companies should look to see that the IC has specialized skills, experience or knowledge that do not already exist within their company. The company, in effect, should be purchasing expertise, which it does not have.
One of the clues that an IC has such specialized skills is whether or not the IC is in high demand. Look to see whether there are other clients and who they are. A lack of other clients is a show stopper. In situations where there are a few other clients, companies should understand what percentage their business would represent to the IC. If it is too great -- say greater than 25 percent to 35 percent -- that may also be a concern and you may choose not to work with them.
Infrastructure and support systems. Running a business requires more than just the specialized skills in a particular field. A person may have all the skills necessary to complete a particular project, but does he have the infrastructure to support his business? Unfortunately, many new business owners underestimate how much they drew on their former employer's systems for support. More often than not, new business owners struggle because they are separated from the people, structures, and systems that helped make them successful in the first place. It can be jarring to go from having a staff and infrastructure to doing everything yourself with little to no infrastructure.
Companies should question prospective independent contractors closely to make sure they are set up to complete the required job in a manner that is compliant with the company's policies. For example, do they have the system infrastructure necessary to comply with your company's data security policies? What are their financial and legal procedures for paying their support staff working on your project? Asking these types of questions prior to the contracting phase can uncover potential problems before they occur. It is not enough to simply have an independent contractor sign your standard contract documents and hope there is not a problem in the future.
Compliance with laws and regulations. Every business struggles with the administrative burden associated with complying with state and federal tax and labor laws. Independent contractors often find compliance especially difficult because they are responsible for all aspects of running their business and lack the legal and tax expertise required to be compliant.
However, an IC who is well-suited to running his own business will understand laws and regulations in his industry, such as those that require special licenses. While it is not possible for a hiring business to gauge whether an IC is in compliance with every law and regulation on the books, at the very least a business should request to see statements to ensure their independent contractors remain current on their estimated payroll taxes.
Leadership. Many people would agree that people who go into business for themselves are "made differently" than those who prefer the stability of being an employee. It is often an indefinable characteristic that is hard to describe but you know it when you see it.
Independent business owners understand the power of creating and communicating a vision for their business. Ask your ICs to share their vision for their business. An underdeveloped and under-communicated vision does not bode well for either party. Closely evaluate the role you are asking an IC to play. As someone with specialized skills and experience, ICs must be capable of influencing others to create a shared vision on a project.
There is no way to know for sure whether every IC is classified properly, but there are certain steps that companies can take in order to limit their risk. Assessing their independent contractors' motivations and business standings are among them.
One thing is for sure: not everyone is suited to running his or her own business. Engagement managers and prospective ICs have become adept at answering IC qualification questionnaires in a way that may seem to favor IC status. However, a company that first considers whether or not an individual is even cut out for a life as an entrepreneur will undoubtedly avoid employee misclassification more than those that do not. Don't take my word for it -- try it!