A Tough Target: Employee or Independent Contractor?

Improperly classifying workers can plunge you into hot water.

It sounds like a great deal: Instead of putting Fred Smith on the payroll, the company hires him as an independent contractor. The firm likes the arrangement because it doesnt withhold income taxes, doesnt withhold and pay Social Security and Medicare taxes, and doesnt pay unemployment taxes on what Smith earns. Smith likes it because his check is fatter than it would be if he were a regular employee.

But theres a catch: Many independent contractor relationships are not legally valid, a lesson that employers are learning the hard way as they face tax audits and lawsuits with potentially huge payouts.

Under federal and state laws, an independent contractor must be just thatindependent. He or she must provide a product or service without punching a time clock or being told how to do the job.

Laws governing independent contractors, designed to protect workers from being shortchanged, have drawn increasing scrutiny and significance with the growth of the contingent workforce in recent years.

Many HR professionals and employment lawyers say the rules are too complex and confusing. The Society for Human Resource Management and other organizations have urged Congress to simplify them. But experts say confusion does not excuse employers from improper decisions about who is an independent contractor and who is an employee.

A worker must be one or the other, says Russell A. Hollrah, an employment lawyer with Littler Mendelson in Washington, D.C.

Some employers violate the rules unknowingly, say HR professionals, employment lawyers and consultants. Other employers know or suspect that theyre breaking them but hope that they wont get caught.

I see a lot of people playing the game way out on a limb, says Gary C. Pierson, an attorney with McAfee & Taft in Oklahoma City.

Few People Qualify

Very few people qualify as independent contractors, says Eugene Hartwig, an attorney with Butzel Long in Detroit and a former chair of the American Bar Associations Section of Labor and Employment Law.

Some employers check with an accountant but not with the company lawyer before taking on an independent contractor, says Wendy L. Roe, PHR, a senior human resources consultant with Human Resource Advisors in Lafayette, Calif. But often when questions are raised about the legal basis for the arrangement, says Roe, employers go oopsand then theyre in trouble.

Its not uncommon for a worker whose contract period has ended to apply for unemployment insurance benefits with a state or local agency. Or the individual seeks workers compensation benefits because of an injury.

Officials ask: Where do you work? says Ned Fine, an employment attorney with Fine, Boggs, Cope and Perkins in Half Moon Bay, Calif. They dont see any earnings reported for the worker, and that often leads to an investigation.

Most employment beefs are triggered not by the agencies but by the employees who are aggrieved, says Fine. The big bucks in these situations are in the benefits or the overtime.

Unsettling Settlements

Officials at Microsoft Corp. know that kind of trouble all too well. They were hit with a class-action suit filed on behalf of thousands of individuals who had been classified as contingent workers while the company was growing by leaps and bounds.

Eventually, Microsoft was forced not only to pay back salary but also to compensate former workers for the value of the stock they would have been eligible to buy if they had been on the payroll. The settlement will be close to $97 million.

In addition, Time Warner Inc., which recently merged with America Online, agreed to pay more than $5 million to settle a lawsuit with the U.S. Department of Labor for allegedly misclassifying regular workers as independent contractors and temporary employees.

With cases such as these in mind, some employment law experts say the potential pitfalls of retaining independent contractors can outweigh the short-term savings in benefits and reduced paperwork for some firms.

I tell employers that theres very little reason to go down the independent contractor path, says Fine. It aint worth it.

Others say that the headaches can be justified if HR professionals and legal counsel tread carefully along the 20 steps that the Internal Revenue Service uses to determine if a worker qualifies as an independent contractor (see The IRS 20-Factor Test, p. 71).

This is one of those areas where preventive steps are incredibly valuable, says attorney Felice Ekelman, a partner with Jackson, Lewis, Schnitzler and Krupman in New York.

Put It in Writing

Its critically important that the employer and independent contractor sign an agreement laying out the conditions of the work, experts say. However, notes Susan D. Nattrass, an employment lawyer in Cardiff-by-the-Sea, Calif., Dont think youre going to get away with much by calling them independent contractors if they dont qualify.

If theres significant doubt about the legality of the relationship, its better to eat the cost of making them employees, says Nattrass. An audit is expensive. Its relatively inexpensive to pay withholding taxes.

A typical contract requires the contractor to pay workers compensation premiums for the contractor and his or her staff. Often, the agreement spells out that the employer retains the right to patent the result or will own any intellectual property produced under the contract.

One of the key principles in determining whether an employer can retain someone as an independent contractor is behavioral control. Does the employer have the right to direct or control how the worker performs the task for which he or she was retainedeven if the employer doesnt exercise that right?

Generally, someone who is told when and where to do the work, what tools or equipment to use, what workers to hire, where to purchase supplies, and the order in which to do the work should be classified as a regular employee of the firmnot as an independent contractor, experts say.

Another important element is financial control: the workers investment in the facilities he or she uses, the extent to which the worker makes his or her services available to other companies, how the worker is paid, and whether or not the worker can realize profits and losses.

A third principle is the nature of the relationship: whether the business provides the worker with benefits, whether the relationship is expected to continue indefinitely, and whether the services provided by the worker are essential to the regular business of the company.

The 20-step test is not a balancing test, says Nattrass. Any one question can determine that an individual is an employee, not a contractor, and is entitled to benefits and other rights of regular employees.

Taking the Plunge

Among the firms acccepting the challenge of retaining independent contractors in the face of these sticky rules is Northridge Group, a Rosemont, Ill.-based firm that provides telecommunications services through nearly 80 consultants, who are considered independent contractors.

We know that these can be dangerous waters to navigate, says HR Director Tim Moore. Our agreement with contractors has six pages of little bitty type dealing with vital issues, says Moore. Though his company is making an absolutely good faith effort to live above the law, he notes, there always are things you arent able to anticipate and must work out.

For example, says Moore, some contractors asked if they could have e-mail addresses at Northridge Group. After some research, the answer was yes. Some wanted office space between assignments. There is a meeting room they can use, says Moore, but we dont want them coming in five days a week.

LifeServ Corp., a Chicago firm that licenses lifestyle-oriented software, has a mix of technical consultants, freelance writers and part-time employees as well as full-time workers. Using different categories of workers might not be a tidy way to run a small business, but in todays market there is a lot of gray, says Leigh Hannan, LifeServs HR director.

The technical consultants are independent contractors who are hired for a period of time for their particular expertise, says Hannan. She finds some of the consultants herself and uses an agency to retain others.

The freelance writers are independent contractors as well, she notes. They are paid a fee for each article, and the articles become the property of LifeServ under the terms of its writing contract.

The part-time workers, who type data into computers, are on the payroll even though they average only about 10 hours of work each per week. Thats what the law dictates, says Hannan. We withhold all the appropriate taxes, she says. I dont have the time for an IRS audit or a lawsuit.

When the IRS Calls

In 1998, the most recent year for which the IRS has statistics, it conducted just over 40,000 audits of independent contractor arrangements. The audits generated nearly $1.2 million in revenue that otherwise would have gone uncollected, according to IRS spokesman Larry Wright.

Some audit targets are selected at random, says Wright. Other probes are triggered by paperwork, such as a change in the number or type of tax forms filed by an employer.

Wright could not estimate how much money the government loses each year because of improper classification of contingent workers, but he stated, We know its a substantial amount of money. Added Wright, Some people know theyre misclassifying employees.

Some employment attorneys say IRS investigations of independent contractors have been relatively uncommon in recent years, in part because of tight IRS budgets and congressional hearings in which small-business owners complained about the burden of meeting the murky standards for retaining independent contractors.

Now, however, the honeymoon might be over, says Hollrah of Littler Mendelson. If I were a company, Id be prepared.

In addition, lawsuits such as the one that stung Microsoft hold lessons for HR professionals. A lot of people are looking more closely at their employment practices because of the Microsoft ruling, says Hannan of LifeServ.

Microsoft says it will retain independent contractors and hire other types of contingent workers as needs dictate. To be competitive, companies are going to have to go into some of the gray zones, says Carrie Olesen, senior strategy manager for Microsofts Staffing Solutions Group.

Olesen says the company has educated its managers so they know the standards for independent contractors and other types of contingent employment. Our contracts get more cumbersome, says Olesen, but people want different working relationships.

Time for a Checkup

Employment lawyers say HR professionals shouldnt wait until their companies are audited or sued before determining if they have classified workers improperly.

HR professionals who discover independent contractor arrangements that dont meet the IRS criteria have a clear duty to talk with company executives about the problem, says Patrick Higgins, HR director of the Southeast Alaska Regional Health Consortium in Sitka, Alaska. You have to say: I dont recommend this; I think this is wrong.

HR professionals need to investigate each individual situation, says consultant Roe. If you are bringing on several people for a project, she says, Dont make blanket decisions such as Well make them all independent contractors.

In addition, employers need to look at definitions of employees in their benefits plans, says attorney Ekelman of Jackson Lewis. They might want to exclude a certain category of worker, to make it clear that temporary workers or independent contractors do not qualify for benefits.

You dont want to give an individual an employee ID if he or she is an independent contractor, continues Ekelman. You dont want to give them a personnel evaluation or take disciplinary action against them.

Other suggestions from employment lawyers for dealing with independent contractors: Dont print business cards or make nameplates for them. Dont provide them with company credit cards or stationery. Dont make travel arrangements for them. And dont schedule recreational or social functions for them.

Some executives think that even if a government agency finds that it classified workers improperly as independent contractors, the worst thing that could happen is that youre going to have to pay the money you would have had to pay anyway, says Higgins. Some companies compare it to a speeding ticket, but its tax evasion, he says. Sooner or later youre going to have trouble.

Steve Bates is senior writer for HR Magazine.