Businesses are using more independent contractors instead of hiring employees during these challenging economic times in an effort to maintain flexibility and control overhead costs. But for those who misclassify their workforce, the costs may far outweigh the benefits. Increasingly, government agencies, both state and federal, are scrutinizing these relationships, and sloppy relationships are costing businesses thousands of dollars.
In an article appearing in the April 2011 edition of ABA Journal, the author reports that the IRS is auditing 6,000 randomly selected businesses to determine whether they have workers who’ve been classified as contractors when they should have been treated as employees. When hit with audits, these employers face devastating damages calculations on back-pay alone.[1]
Federal Scrutiny
IRS Publication 15-A (Rev. 2011), Employer’s Supplemental Tax Guide, states the general rule that “an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the results.[2] A business that misclassifies a worker as an independent contract is liable for employment taxes for that worker.[3]
The IRS uses balancing tests to determine the status of an employee. No single condition, including a written agreement, is determinative. Facts providing evidence of the degree of control and independence fall into three categories: behavioral control, financial control, and the type of relationship of the parties.[4]
Behavioral control includes instructions about when, where, and how to do the work. The amount of instruction may vary among different jobs, but even where no instructions are actually given, retaining a right to provide instruction may be sufficient for a finding that an employer exercises behavior control.[5] Independent contractors ordinarily use their own methods for performing the work; training provided by the business suggests behavioral control.[6]
Financial control is evidenced by the intertwining of the business’s and the individual contractor’s financial liabilities. It is important that the worker have ongoing fixed costs that are incurred regardless of whether work is being performed.[7] If a worker’s income is primarily provided by a single business, financial control is evident; independent contractors are generally free to seek out business opportunities throughout the relevant market, including from business that compete with each other.[8] If the worker is paid in any fashion other than on a flat fee or a time and materials basis, there may be sufficient financial control for employee status; employees receive a regular wage amount based on an hourly, weekly, or other period of time.[9] An independent contractor may complete the assigned task and still lose money; unlike an employee, an independent contractor can realize a profit or a loss.
The type of relationship between the parties is shown by the presence of a written contract, benefits other than pay for performance, the permanency of the relationship (project or time-bound), and the extent to which the services being performed are a key aspect of the regular business of the company.[10] This can be tricky for a company using independent sales representatives when much of the work performed by the company comes from contracts secured by those sales representatives.
Minnesota Scrutiny
In Minnesota, several administrative agencies have an interest in worker classification. The Department of Revenue, like the IRS, prefers to have employers withhold taxes from employees and forward those withholdings to the State. The Department of Labor & Industry oversees the state’s Worker’s Compensation system. Employers are obligated to provide worker’s compensation insurance coverage for their employees.[11] The Department of Employment and Economic Development oversees the State’s unemployment compensation system and requires that employers pay a tax on the wages earned by their employees.[12]
A determination that an independent contractor is, in fact, an employee is often initiated by that worker’s application for unemployment insurance benefits. It was just this event that brought rise to Miller v. Nolan, an appeals court case in which a contract worker was held to be an employee for unemployment compensation purposes.[13] Miller is an unemployment benefits case in which the appellate court upheld the unemployment law judge’s determination that Miller was an employee for unemployment-benefits purposes.
Courts balance five factors to determine the employment status of an individual: “(1) The right to control the means and manner of performance; (2) the mode of payment; (3) the furnishing of material and tools; (4) the control of the premises where the work is done; and (5) the right of the employer to discharge.”[14] Of the five factors, the two most important are those that indicate the right or the lack of the right to control[15] (emphasis added) not merely what is to be done but how it is to be done,[16] and the ability to discharge the worker without incurring any liability.
The determination of control follows thirteen criteria defined in Minnesota Rule 3315.0555.[17] Control may be found where the employer hires and pays persons who assist the individual and supervises the work; where the individual is required to follow the employer’s instructions, even in situations where the individual is proficient enough not to need those instructions; and where the individual is required to provide on-going reports other than the completion of invoices or other customarily-used forms.[18] Control can be indicated where an individual is required to report to the company’s location, although in some professions working away from the employer’s premises may still be indicative of employment.[19] The existence of a continuing relationship between the parties indicates to the Department that an employment relationship exists.[20] Independent contractors more typically enter into a relationship for a defined period of time or to perform a particular task or achieve a specific objective.
When a company retains a right to discharge an individual who is satisfactorily performing services prior to the completion of the contract, without liability, it suggests an employment relationship.[21] This is often evidenced by an agreement, either written or oral, that fails to identify a milestone at which the contract is fulfilled. The milestone could be a specific term for the agreement, an identified task such as the completion of a user’s manual or the completion of a building, or the achievement of an objective, such as the winning of a particular contract.
Another factor cited in the rules that may catch an employer with unintended employees is when the services for which the independent contractor has been engaged are a part, process, or ancillary service of the employer’s business that are generally performed by individuals in employment.[22] Included in the services that meet the part, process, or ancillary services classification is selling,[23] an activity which companies frequently assign to independent contractors. Like the other criteria, this one is not to be used as a sole determinative factor, but it can be harmful to a company’s argument that an individual is an independent contractor.
To arrive at a determination of control for purposes of classifying a worker, the department will review written contracts, interview the individual or employer, obtain statements from third parties, examine the regulatory statutes governing the business, examine the books and records of the employer, and make any other investigation necessary to determine if the element of control exists.
In Miller, the unemployment law judge expanded its finding that the individual was an employee to reach beyond that individual and include all other similarly engaged individuals.[24] The appellate court, noting that the issue of other individuals was not before the unemployment law judge for a determination, nor that there was any factual evidence to support such an expansion of the finding, remanded that portion of the decision for amendment. The appellate court’s decision leaves open the possibility that DEED could open a more expansive investigation in an attempt to levy unemployment tax on Nolan for all of her independent contractors.
Conclusion
The engagement of independent contractors to perform activities in your company involves more than an economic analysis; it demands a legal one as well. Taxing authorities disfavor independent contractor status as they perceive that it costs the state revenue. During these times of severe governmental deficits, employers should expect an increase in administrative scrutiny over the classification of employees. In this author’s experience, the government’s posture is to determine that the individual is an employee and to shift the burden to the company to prove otherwise. This is a heavy lift for the employer, as the posture of the courts is to review the factual findings in the light most favorable to the unemployment law judge’s decision and to affirm that judge’s fact findings if they are supported by substantial evidence.
With the risks great and the scrutiny increasing, all businesses are well advised to review with their attorney current and new independent contractor relationships and programs used in their company.
© 2011 Alden Pearson, P.A. All rights reserved.
[1] Susan A. Berson, ABA Journal, April 2011, pg. 27-28.
[2] IRS Publication 15-A, page 4.
[3] Id. Pg. 6.
[4] Id.
[5] Id. Pg. 7.
[6] Id.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] Minn. Stat. § 176.021 (rev. 2010).
[12] Minn. Stat. § 268.051 (rev. 2010).
[13] Miller v. Nolan, A10-921, 2011 WL 382742 (Minn. App. 2011) (unpublished).
[14] Id.
[15] Minn. R. § 3315.0555.
[16] Miller, A10-921.
[17] Minn. R. § 3315.0555.
[18] Minn. R. § 3315.0555 Subp. 3.
[19] Id.
[20]
[21] Id.
[22] Minn. R. § 3315.0555 Subp. 2.
[23] Id.
[24] Miller, A10-921.
