The Independent Counsel


Employees vs. Independent Contractors


Recent reductions in the number of available middle management jobs, downsizing and outsourcing have forced increasing numbers of workers into non-traditional positions as consultants and independent contractors. Jobs in the ’90s have become mere stopovers in an ever changing career landscape.

An employer may use independent contractors for any number of reasons, including to gain flexibility in hiring and firing workers as work needs change, and to reduce fixed overhead costs. Incentives also exist for an employer to avoid payroll taxes and sidestep benefits that would be payable in the case of regular employees.

Stepped up Enforcement

Abuses in this area have brought stepped up governmental enforcement, making misclassification of workers a dangerous game. One measure of this is that the IRS has found misclassified employees in 9 out of 10 audits, with average penalties exceeding $65,000 per audit. The IRS unfortunately has targeted small business for this type of enforcement.

Misclassification of workers violates both federal and state laws, and gives rise to private remedies as well. The IRS can demand a penalty of 20% of what ought to have been withheld, plus 1.5% of wages. Failure to submit Forms 1099 can mean doubled penalties, and without a reasonable basis to withhold, your company may face increased IRS penalties of up to 100%.

The Commonwealth of Massachusetts has also increased its scrutiny for the misclassification of employees. Through a recently enacted statute, the Commonwealth now creates the presumption that individual workers are employees. G.L. 149 § 148. The statute gives the attorney general the power to enforce violations through criminal as well as monetary penalties that may be levied against the company’s president, treasurer or any management officer personally.

Other Risks

Penalties may not be the only risk. If your company offers medical insurance to its employees, a worker misclassified as a contractor who suffers a catastrophic medical problem could hold your company responsible for staggeringly high medical expenses. Also, failure to include “employees” in your retirement plan can result in its being disqualified by the IRS.

Proper Classification

To understand the distinction between employees and independent contractors, look first to the criteria used by the IRS and the courts. There is no pass-fail or percentage measure to meet. Courts look to the “totality of the circumstances.”

Cases developed under the Fair Labor Standards Act have applied the following “economic realities” test:

  1. The degree of the employer’s right to control the manner in which the work is performed;
  2. The alleged employee’s opportunity for profit or loss depending upon his managerial skills;
  3. The alleged employee’s investment in equipment or materials required for his task or employment of helpers;
  4. Whether the services being rendered require a special skill;
  5. The degree of permanence of the working relationship; and
  6. Whether the service rendered is an integral part of the alleged employer’s business.

The Massachusetts Attorney General’s office has issued an Advisory clarifying the definition of “control” saying that it refers both to the results to be accomplished and to the methods used to accomplish the results. The Advisory states the following three-pronged test for an independent contractor:

  1. The individual is free from control and direction in performing his service
  2. Such service is outside the usual course of business for the service is rendered or done off premises
  3. The provider is customarily engaged in an independently established occupation, profession or business

The most comprehensive test is the list of twenty criteria published by the IRS (to obtain a copy, call 617-661-6565).

Practical Risk Management

What should your company do when employing independent contractors?

Comment: Have your company’s job descriptions audited regularly to ensure that employees are not misclassified as independent contractors. Do not be tempted to save money by misclassifying employees, as doing so may prove more costly in the long run.

© ASSOCIATION OF INDEPENDENT GENERAL COUNSEL 1996; (all rights reserved). This article is not intended as legal advice. Consult a qualified attorney for assistance concerning a specific issue or problem.