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Independent Contractor vs. Employee Get It Right

September 1, 1997
How many independent contractors work at your company? Fewer than you may think. Companies these days are dallying in the contingent workforce concept a little too carelessly. Yes, it's tempting to use "independent contractors." They don't bring with them all the duties that employees do: payroll tasks, benefits issues, management chores. But they aren't the HR panacea that many employers seem to think they are. For one thing-and a lot of executives out there seem to be ignorant of this-you can't just decide to classify a worker as an independent contractor, sign on the dotted line and let that be that. You in fact, don't make the decision as to who is and isn't an independent contractor at all. The job and the nature of the employment relationship under IRS regulations make that decision. It's not something to be taken lightly, as Microsoft Corp., a company facing the possibility of a gruesome financial pounding for misclassifying employees, can tell you.

Howard A. Simon, a partner in the labor, employment and benefits law group of Landels, Ripley & Diamond LLP in San Francisco, explains the must-knows of classifying workers as independent contractors vs. employees.

How common is it for employers to think their classifications are legal when they're not?
It's very common, particularly in industries that use a lot of independent contractors, such as the software industry and some sales-support industries like inventory takers or merchandisers in stores. Industries that tend to use them a lot, both large industries and small, make mistakes pretty frequently.

Is the use of independent contractors a new and growing trend?
I wouldn't say that it's new, but I'd say that it's growing. People have been using independent contractors for a long time. The reason it has grown is really twofold. One reason is independent contractors aren't entitled to benefits, by and large. And as benefits costs skyrocket, particularly medical benefits, employers are trying to save money by putting individual workers in nonbenefits categories like independent contractor, so they're not eligible.

What's the other reason for its growth?
The second reason is there's a business culture of downsizing right now, and a lot of companies are downsizing with smoke and mirrors. What they'll do is downsize their headcount, because they have some sort of headcount restriction. Then they'll backfill these positions with folks they're calling independent consultants or contractors. So on paper it looks like they've got a reduced payroll and lower headcount when in fact they're just backfilling the jobs with people who have a different status. They're getting the work done so their bosses are happy, but they're just robbing Peter to pay Paul because it's coming out of a different budget.

What are the crucial differences between independent contractors and employees?
Let's say you get blueprints from the architect, and you walk over to Ms. Contractor and say, "Can you build me this house? And how much will it cost, and when will it be done?" She says that you can have it January 1 and it'll cost $250,000. Now, do you care what kind of labor she uses? If she wants to use ancient, single-celled Martian labor, you don't care, and you have no control over that. Do you care where she buys her lumber? No. Do you care if she only works on alternate Thursdays between 2 and 4 in the morning? No, you don't care. You've bought a house by a date at a price. If she gets that done, terrific. If it costs her $100,000 to build, then she's going to make a lot of money. If it costs her $300,000, she's going to lose a lot of money because she underbid the job. But that's not your problem, that's hers. That's an independent contractor.

So what's the key to being an independent contractor?
The key concept is what's called the right to control. When you hire an independent contractor, you're purchasing a product; you're purchasing an end. To the extent you retain the right to control the means by which that's done, then [the worker] looks more and more like an employee. The Internal Revenue Service has developed a 20-factor test to determine whether you have the right to control. It includes who sets the hours of work, where the work is performed, who provides the tools necessary to do the work, who controls any assistants, how much training is given, and how regularly the person has to report the progress of his or her work [as determining factors]. To the extent that you as the hiring person tell the person where to be and when to be there, require weekly reports, provide training, control the assistants-all those things show [whether] you're exercising control over the means. The more control you have over the means, the more you look like an employer.

So to use the example of building the house, what would that look like with an employee?
You'd say, "Here are the blueprints. Work from 9 to 5 Monday through Friday. I want you to report to me weekly. I want you to buy your lumber here and buy your nails there. I want you to give me a bunch of reports on your progress because I want you to be on budget." Then the key there would be [whether] there's any risk of loss. "You go over budget, we'll fix it in the budget. You go under budget, we'll all save money." That would be an employee.

What are the common mistakes employers make?
A written agreement is one of the 20 factors the IRS will look at-what is each party's own understanding of the relationship? But that by no means is definitive. That's a big mistake people make: They think if they have an independent-contract agreement, then they're fine. The IRS can look right past that. They're going to be looking at what's really going on-the facts and circumstances.

To the extent you retain the right to control (how) the work is done, the (the worker) looks more and more like an employee.

What are the red flags for the IRS?
There are two really big red flags right now. One is called inconsistent treatment. Say you've got somebody in your firm who's designing software, writing source code for a computer-aided design software program. You need to beef up the ranks because you're trying to get a product out the door, and you don't have enough bodies to write the source code. So you bring in a consultant to help with the writing. You call that person an independent contractor because you're just hiring the person on a short-term basis to help you out. The problem is, you've got somebody in-house also doing this function. The IRS will presume that because you've got one person on a W-2 basis who's an employee performing function X, that presumptively everybody performing function X is an employee. You've got to prove that the person is not an employee. If you've got two people doing the same work functionally but you're calling them different things, that's vulnerable.

How can an employer safeguard against this problem?
Hire the person through a temp agency. That way you have an independent-contractor relationship with a temporary-service agency, and there's no question whether this person is an employee. The bottom line here is that the IRS wants to make sure it gets income tax withholding.

What's the other big red flag?
The other big red flag is what's called a centrality analysis. That is: You're not likely to contract out your fundamental service. If you're in the business of producing a magazine, are you going to farm out to a contractor the editing function? No, because that's the most central thing to what you do. Take the software industry-you wouldn't hire just anyone to write your software, your primary function. On the other hand, does anybody care if you hire a contractor to paint the building you work in? No, because you're not in the business of painting. The more central the function is to the fundamental business of the company, the higher the scrutiny on whether it's an independent-contractor type of job.

The most common mistake is assuming a written agreement is all you need (to protect yourself.)

Why is the IRS so watchful in this employment area?
The IRS cares because the cash flow the federal government runs on is personal income tax withholding and employment tax withholding. Take the 30 percent of our wages we don't see because it's withheld and multiply that by every employee in the country. That's a huge amount of money and that's the money the federal government runs on. So when the [IRS] doesn't get it, [its administrators aren't] happy. So they look very closely at employment structures that don't provide for the withholding of payroll taxes, and of course, independent contractors don't pay payroll taxes. That's why they care. And there are other issues. For example, you don't pay workers' compensation premiums for independent contractors, so if they get hurt on the job, the cost [may] fall into Medicaid. It's those kinds of things as well.

What are other common mistakes employers make in classification?
The most common mistake is assuming a written agreement is all you need, that if you have a contract you can do whatever you want. Another common mistake occurs [when] you've had a downsizing or an early-retirement program, and you rehire a person as a consultant after the [employee] left through the downsizing or retirement program. And the employee is doing the same work on Tuesday that he or she was doing on Monday, you're just calling the person a consultant now. The employer will lose that [argument] 100 times out of 100. It's a very common [practice] now-and very suspect.

How should an employer handle such a situation?
The solution is to make sure that functionally, the nature of the task is really different. If somebody has been a software designer, don't give that person a design function, maybe give him or her a coaching function. If he or she had been managing a process, then give the person some business consulting on process management that isn't directly related. Giving [employees-turned-consultants] a different function is the key. And don't violate any of the 20 IRS factors. Let them work from home, set their hours of work and pay them by the job not the hour.

So it's also how the job is paid and performed that matters?
Ideally, independent contractors should be paid by the job, not by the hour. A lot of software folks just get paid by the hour. If you have to do that because there's no other way to manage it, bill against a contract maximum. In the written contract put: "This is a contract of $40,000, payable at the rate of $30 for each hour incurred." Then if you reach the contract maximum, you renegotiate.

What about providing the contractor with the necessary equipment?
If you really want to establish an independent contractor relationship, you'd charge rent; you'd rent out the equipment, and you'd rent out the office space. There are all kinds of accounting tricks you can do to fix that-you just jack up the contract price and imbed the rent in it. So it's form over substance, but it's the kind of thing the taxing authorities look for. If you're providing the place and the equipment, then charge the person rent. And if that means you, with a wink and a nod, increase the contract price, you still lower your risk.

So should you never hire former employees to do their former jobs on a contract basis?
That's correct, because of the inconsistent treatment argument. What I'd do in that case: Under your benefits plans, you can define who's eligible and who's not essentially in any way you want, as long as you pass nondiscrimination tests. So the better solution is to hire the person on as a W-2 employee and do payroll-tax withholding but define eligibility for benefits as full-time employees who aren't, for instance, recently downsized employees hired back. You can do that. There's nothing illegal about defining benefits eligibility around classes of employees. The better way to deal with the downsizing or retirement rehire is to bring that person back as a part-time employee and define your benefits plan such that the person in that classification isn't eligible.

What are some other problems employers have?
Another common mistake is hiring somebody 40 hours a week and expecting him or her to be an independent contractor. Independent contractors are independent businesspeople who have multiple clients, who make their living at this. If you occupy their entire working life, you're hiring them full time. The IRS is going to assume you're an employer because this person couldn't really be an independent business person out there hustling for business. So you really want people to have more than one client. Now, in a situation in which you have a very short but very intense need, you can get around that. If you hire somebody full time for a few months to make a deadline, that's different.

What's key for employers to know?
The key notion is the right to control. It's not the exercise of it; it's the retention of it. So even if you retain the right to control but don't exercise it, you still have it. These are independent professionals-provide limited instructions. These are supposedly highly skilled professionals-provide no training. Generally speaking, in most circumstances, the services don't have to be rendered personally. Do you care if it's actually Ms. Contractor holding the hammer in her hand or someone who works for her? It's built according to the plans; you don't care, so don't require that a specific individual do the work unless it's very highly skilled. If the work is essential to your hiring firm, to what you do, then it's not a contract function.

What else?
It shouldn't be a continuing relationship. If somebody's with you for six months or more, you're very vulnerable. One project shouldn't lead right into another. Long-term relationships are better handled by temporary-service relationships. The person has the right to control his or her own assistants. If he or she wants to hire somebody to help do the work out of whatever contract fee you're paying, you shouldn't have a problem with that. Unless it's not practical, the contractor should decide where the work gets done. If the work can be done just as well at the contractor's terminal as your terminal, the person should do it at home. Where it's practical, the contractor should decide the order in which to do the work-you shouldn't be dictating, "Do A, then B, then C," unless it's absolutely necessary. The contractor shouldn't be providing interim reports to you. The more regular the reporting, the more it looks like employment.

Contractors generally shouldn't be considered at-will employees. Employees are people you can fire.

What about the financial aspects?
In terms of financial control, contractors generally should be paid by the job, not the time. Charge rent for services you provide, as I said. Generally speaking, you shouldn't be paying business expenses for contractors. Let them imbed them in the contract. If they have to travel, they should charge $40 instead of $30. Don't provide tools, or charge rent for them if you do. But the contractor should have most of his or her own equipment. The idea is this is a person trying to make a living as an independent businessperson. If the person hasn't invested anything in the business, what kind of business does he or she have?
The contractor should be offering services to the general public. Have the contractor print up his or her own business cards. Encourage the person to put an ad for his or her services in the paper. The contractor should have the risk of profit and loss. You shouldn't be the guarantor that the contractor is going to make money no matter what.
Contractors generally shouldn't be considered at-will employees. Employees are people you can fire. Contractors are people you fire when they breach the contract; you fire them for nonperformance. But you can't say, "We don't need you anymore, bye." You've got a contract.

Can you explain the Vizcaino v. Microsoft case?
This is really important. It's a 9th Circuit case that came down in October 1996. The case was: Microsoft hired a bunch of independent contractor software engineers. The company had a lot of these people-there are many folks out there who are software engineers who don't want to be anybody's employee. So they were very happy to be independent contractors. They signed independent contract agreements stating they weren't entitled to employee benefits, and they got more money per hour than an equivalent employee would get, because they weren't getting any benefits. Microsoft called them independent contractors, and they had written agreements and everyone was fine with it. Well, the IRS audited and determined-rightly probably-that these weren't truly independent contractors, these were employees. It assessed Microsoft lots of these back taxes. That's well and good. That happens all the time. Microsoft then ran some of them through temporary service agencies, let some go and put some on the payroll as employees.

So what makes this case stand out?
Some enterprising woman said, "Wait a minute. If I was an employee, I should've been eligible for stock options and eligible to participate in a 401(k) plan." So she sued under ERISA for inclusion in Microsoft's benefits plans. Microsoft defended by saying [the employees] knew what they were getting into. They got more money because they weren't eligible for these things. The trial court agreed but the 9th Circuit reversed the decision, [because] the definition of employee for eligibility for the 401(k) plan was anybody who had common-law employee status and is paid on U.S. payroll. Microsoft lost that. As for being paid on U.S. payroll, Microsoft said, "These people submit invoices that get paid out of accounts payable, so they're not on payroll." The judge [ruled] that "payroll" means being paid out of U.S. funds, not out of the payroll department. So they're being paid out of payroll and they're common-law employees. Therefore, they're eligible to participate in benefits plans, including receiving stock options.

What does this mean to employers?
The implication of the case is really serious because Microsoft now has to go back from the time these folks started and allow them to participate in the 401(k) plan. So if they want to put a bunch of money in the plan, and if Microsoft has a matching [fund program], Microsoft has to do all that.

There's more to it, isn't there?
Here's where it gets really creepy, at least in theory. We don't know how this will play out yet. These folks are all highly compensated. When you set up a benefits plan, the rules are that you're not allowed to give an unfair advantage to people who are highly compensated by letting them contribute proportionally more than people who aren't highly compensated. So you have discrimination tests to make sure you're not being unfair. You base discrimination testing on who your eligible employees are in any given year. Well, now Microsoft has got a whole bunch of people who, it has just found out, have been employees for purposes of the plan, and who the company never included in its discrimination testing.

What will Microsoft have to do?
In theory, the company has got to go back and redo all its discrimination testing. Because Microsoft has to add all these highly compensated people into the plan, it may no longer pass the discrimination test. Which means for the plan years when these people get added, the plan theoretically could be disqualified. That means the IRS says it's not a tax-exempt plan so all the money Microsoft puts into the plan gets taxed, and every employee who contributed in the 401(k) has that money treated as taxable income. It's sort of a nightmare scenario. Now, it probably isn't going to happen that way because the IRS isn't going to let tens of thousands of Microsoft employees take the hit for Microsoft's screwing up. The IRS probably will let Microsoft participate in a correction program that will cost the company a lot of money. This is a new wrinkle on the independent contractor thing. I think this is the class-action lawsuit of the '90s, with every major company that uses a lot of contractors tremendously vulnerable. There's this nuclear scenario of disqualification of your plan, which is like a nuclear bomb in your office. So Vizcaino is a sleeping giant.
The 9th Circuit will rehear the case, and the opinion might be changed. Certainly if Microsoft loses at the 9th Circuit, it will take this to the Supreme Court. It has no choice; this case is a big deal.

Any final advice?
Do a self-audit. Bring in someone who knows this area. Bring someone in under the attorney-client privilege and do an internal audit of your independent-contractor practices so you can fix [any problem] before you get audited. The IRS will look very favorably on a company that, without an IRS audit or a complaint, looks at itself and says, "We screwed up, we're going to fix it."

Workforce, September 1997, Vol. 76, No. 9, pp. 125-130.