VI.  DISTINCTION BETWEEN EMPLOYEES AND INDEPENDENT CONTRACTORS AND RELATED ISSUES

A. Wage and Hour Laws

The term "independent contractor" is not defined in the FLSA. However, the federal courts have applied an "economic realities" test to determine whether an individual is an independent contractor. The fundamental question is: Does the employer have the right to control the worker's terms and conditions of employment? The most important factors in answering this question are:

1. the degree of the alleged employer's right to control the manner in which the work is to be
   performed;

2. the alleged employee's opportunity for profit or loss depending upon his or her managerial skill;

3. the alleged employee's investment in equipment or materials required for his or her task, or his or her employment of assistants;

4. whether the service rendered requires a special skill;

5. whether the service rendered bears an integral relationship to the alleged employer's business;
   and

6. the degree of permanence of the working relationship.¹

 The courts generally examine all of these factors to determine whether, as a matter of economic reality, the workers were dependent upon the organization to which they rendered service, thereby creating an employment relationship.

 B. Employee Benefits

Generally, issues arising under most broad-based employee benefit plans (e.g., pension, 403(b), health care, disability, life insurance, etc.) are governed by the Employee Retirement Income Security Act of 1974 (ERISA) or, in the case of tax qualification issues, the Internal Revenue Code (the Tax Code) rather than by state law. Under ERISA, the Supreme Court has held that the following thirteen factors should be considered in determining whether an employer-employee relationship exists:

1. the hiring party's right to control the manner and means by which the project is accomplished;

2. the skill required;

3. the source of the instrumentalities and tools;

4. the location of the work;

5. the duration of the relationship between the parties;

6. whether the hiring party has the right to assign additional projects to the hired party;

7. the extent of the hired party's discretion over when and how long to work;

8. the method of payment;

9. the hired party's role in hiring and paying assistants;

10. whether the work is part of the regular business of the hiring party;

11. whether the hiring party is in business;

12. the provision of employee benefits; and

13. the tax treatment of the hired party.^1a

C. Employment Tax Issues

Employers must be careful when classifying a worker as an independent contractor to avoid later imposition of a tax liability for misclassification of that worker. While a determination that a worker is not an employee relieves the employer from the tax liabilities and reporting responsibilities that otherwise are required, the misclassification of a worker as an independent contractor can result in harsh employment tax penalties.

To determine whether a worker is an employee or an independent contractor, the IRS looks at facts that fall into three main categories: Behavioral Control, Financial Control, and Type of Relationship.^1b Although some of the factors within each category are unique to federal tax analysis, many are the same as those used by the courts to resolve the issue in a variety of contexts. Note that no one factor is determinative; all factors need to be considered. When in doubt, the safest course is to treat the worker as an employee.

Moreover, an organization that contracts with government agencies for funding cannot rely on the classifications given to individuals by the government contracting agencies. A worker deemed a "consultant" or "contractor" under a government contract might be deemed an employee for IRS purposes. 

The factors considered by the IRS within each category are: 

1. Behavioral Control

1. Types of Instructions Given: An employee is generally subject to the business’ instructions about the work performed, including:

1. When and where to do the work.

2. What tools or equipment to use.

3. What workers to hire or to assist with the work

4. Where to purchase supplies and services.

5. What work must be performed by a specified individual.

6. What order or sequence to follow when performing the work.

2. Degree of Instruction:  The more detailed the instructions, the more control the business exercises over the

3. Evaluation System: If an evaluation system measures the details of how the work is performed, then these factors would point to an employee. If the evaluation system measures just the end result, then this can point to either an independent contractor or an employee.

4. Training:  If the business provides the worker with training on how to do the job, it is strong evidence that the worker is an employee.

2.  Financial Control

1. Significant Investment: An independent contractor often has a significant investment in the equipment he or she uses. However, there are no precise dollar limits that must be met in order to have a significant investment.

2. Unreimbursed Expenses: Independent contractors are more likely to have unreimbursed expenses than are employees.

3. Opportunity for Profit or Loss: Having the possibility of incurring a loss indicates that the worker is an independent contractor.

4. Services Available to the Market: An independent contractor is generally free to seek out business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market.

5. Method of Payment: An employee is generally guaranteed a regular wage amount for an hourly, weekly, or other period of time. This usually indicates that a worker is an employee.

3.  Type of Relationship

1. Written Contracts: Although a contract may state that the worker is an employee or an independent contractor, this is not sufficient to determine the worker’s status.

2. Employee Benefits: Employee benefits include things like insurance, pension plans, paid vacation, sick days, and disability insurance. Businesses generally do no grant these benefits to independent contractors.

3. Permanency of the Relationship: If you hire a worker with the expectation that the relationship will continue indefinitely, rather than for a specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.

4. Services Provided as Key Activity of the Business: If a worker provides services that are a key aspect of the business, it is more likely that the business will have the right to direct and control his or her activities.

Managerial personnel are considered employees. A member of the board of directors of an organization, in his or her capacity as such, is not an employee of the organization. 

An independent contractor is considered self-employed and the company for whom services are provided need not comply with the tax rules on the independent contractor's behalf.²  For federal tax purposes, the three separate employment tax schemes (i.e., income tax withholding, social security and Medicare taxes (FICA), and employment tax, (FUTA), do not apply if the worker is properly classified as an independent contractor.  For example, the employer is not required to obtain the Form W-4 from the worker, provide a Form W-2 to the worker and the Social Security Administration (with the transmittal Form W-3), or include payments with respect to the worker in the quarterly filed Form 941 with the IRS. The employer's sole responsibility is to file Form 1099-Misc, except in certain limited circumstances, documenting the amount of payment made to the independent contractor. The remainder of the tax responsibilities is shifted to the worker.

Various types of employment taxes and withholding obligations imposed at the state level are also based on the existence of an employee relationship and do not relate to independent contractors.³  In New Jersey, however, payments to independent construction contractors are subject to a withholding rate of 7% unless the individual contracting for services is a homeowner or tenant.⁴

[2] 26 U.S.C. § 1401, 1402, see also IRS, Forms and Associated Taxes for Independent Contractors, http://www.irs.gov/businesses/small/article/0,,id=179114,00.html (last visited July 22, 2009).

[3] See N.Y. Tax Law § 671(a)(1); N.Y. Lab. Law § 570, New York State Department of Taxation and Finance, Employer’s Guide to Unemployment Insurance, Wage Reporting, and Withholding Tax, 25 (Revised May 2006), available at http://www.tax.state.ny.us/pdf/2006/wt/nys50_506.pdf, Department of Revenue Services, State of Connecticut, Circular CT, 12 (Effective January 1, 2009), available at http://www.ct.gov/drs/lib/drs/publications/pubsip/2009/ip09-1.pdf.