Employee vs. Independent Contractor Status: Risk and Reward

January 29, 2008
Jeffrey A. Leighton

Businesses have in recent years hired more independent contractors and fewer employees. From an employer perspective there are significant advantages to independent contractor status for individuals who are providing services:

  • Companies do not have to withhold federal, state, income and social security (FICA) taxes. Paperwork is therefore reduced.
  • Companies are not required to pay unemployment or workers compensation insurance.

Companies are not required to offer benefits like paid sick leave, vacation, health insurance, etc. Given the escalating cost of health insurance, this creates enormous incentive for companies to favor independent contractor status. Also, independent contractors are not eligible to participate in any pension/retirement plan that a company may offer.

  • Increased flexibility in matching “head count” to work flow.
  • Minimal legal risk in terminating an independent contractor.

Generally the only legal protection an independent contractor has against termination is set forth in whatever contractual agreement he or she has with the company.  Often there is no agreement at all.  If there is an agreement, it is likely that both the individual and the employer can easily terminate the relationship.  When a company terminates an independent contractor there is little or no risk of a discrimination or other typical workplace cause of action.

Governmental entities have been quite aggressive in analyzing and attacking determinations by companies that specific workers are independent contractors.  New York has been particularly vigorous. If a company erroneously classifies an individual as an independent contractor, the company will typically be liable for employment tax, interest and a penalty. If there are numerous individuals involved, the burden for a company can be onerous.

It is not necessarily easy to determine whether an individual should be characterized as an independent contractor or an employee.  When examining the issue, different governmental bodies (IRS, state labor departments, U.S. Department of Labor) apply somewhat different tests. One comprehensive test that takes into account agency law criteria and numerous other factors courts have created to define independent contractor status was developed by the IRS in a 1987 revenue ruling. Known as the 20-factor test, the enumerated criteria generally fall within three categories: “Behavioral control” covers the amount of control the employer has over the worker in terms of where, when and how the job was done, among other factors. “Financial control” dictates how much control the company has over a worker’s pay, expenses and facility investment. “Type of relationship” is based on written agreements, employee benefits and length of relationship between the company and worker. The 20 factors serve only as a guideline. Each factor's degree of importance varies depending on the occupation and the facts involved in a particular case. Reference should be made to IRS Form SS-8, “Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding,” which can be utilized by companies seeking a formal determination of the status of an individual worker. Form SS-8 asks for responses based on the various factors grouped in the three main categories set forth above.

Every company should monitor its classification of workers on an ongoing basis and perform internal audits in order to ensure compliance. Companies should also have the assistance of an experienced human resource professional and an employment attorney.

Any company that employs individuals classified as independent contractors should also be careful to develop, in coordination with counsel, a written agreement that delineates and details the workplace relationship. An independent contractor should also be required to have insurance. The agreement can address certain criteria that governmental entities use to decide employee vs. independent contractor status, particularly “behavioral control” and “type of relationship” issues—thereby making it more likely that the company’s independent contractor status determinations will survive a governmental review.