There are advantages and disadvantages to employers using independent contractors instead of or in addition to employees. Most labor and employment laws only regulate the employer-employee relationship and therefore do not apply to independent contractors. Similarly, other laws, such as tax laws and social security laws, also make distinctions between employees and independent contractors. Because employers are required to pay certain federal, state, and local taxes on behalf of their employees, the financial benefits of having a large independent contractor workforce may be significant. This financial incentive, however, is mired by the inconsistent and seemingly unpredictable classifications of independent contractors by numerous state and federal laws and regulations. Because of this, it can be extremely burdensome for employers to keep on top of exactly what qualifies someone as an independent contractor, and the penalties for misclassification can be costly.
Adding to the confusion is a definite trend for the courts as well as federal and state agencies to classify independent contractors as employees. In these situations, employers become exposed to unanticipated liabilities and penalties. For those employers who use large numbers of independent contractors, it has become increasingly important to consider the potential ramifications of misclassifying employees as independent contractors. This chapter discusses the different tests used to classify workers as independent contractors and the agencies and regulations associated with each method.
Colorado state laws regarding independent contractors continue to evolve. Effective as of August 2018, Colorado passed a law establishing the requirements for designating volunteer coaches as independent contractors. The law established the criteria by which a nonprofit youth sports organization may designate coaches as independent contractors instead of employees. To make the designation, the parties must enter into a written agreement that includes:
Two sets of law operate to govern whether an employer has properly classified its workers as employees or independent contractors – federal law and state law. Federal law involves three distinct, but overlapping, tests for distinguishing employees from independent contractors:
The State of Colorado employs a separate evaluation, which is similar, though not identical, to the tests utilized under federal law. Depending on the exact circumstance an employer faces, one or all of these tests may be applicable. Regardless, each test consists of multiple factors, all of which must be closely analyzed in order to correctly make the ultimate determination. By correctly employing these tests, the employer should be able to decide with much more certainty whether an individual should be considered an employee or independent contractor. These tests are discussed below.
Employees’ wages are subject to federal and state withholdings and deductions for taxes. Social security and Medicare are also withheld for employees only – not independent contractors. Accordingly, the Internal Revenue Service (IRS) has a strong interest in whether employees are legitimately characterized as independent contractors. To this end, the IRS uses the common law “right to control” test in determining whether an individual is correctly classified as an independent contractor.
To determine whether an employer-employee relationship exists, the IRS looks at a number of factors that have been incorporated from the common law. The general rule is that the more control an employer has over a worker, particularly with regard to how the work is performed, the more likely it is that the worker is an employee rather than an independent contractor. The IRS examines a number of factors, which are organized into three groups:
The IRS works through these factors before concluding whether the business has “the right to direct and control the means and details of the work.” Employers should similarly work through the same exercise before attempting to claim an individual as an independent contractor. The employer should keep in mind that the importance of each factor will vary depending on the type of work being done and the circumstances of the particular case. No one particular factor is conclusive to the ultimate determination.
In close cases, an employer may want to consider consulting an attorney or tax professional, or requesting an IRS determination of the worker’s status. For an official determination, the employer or worker may submit IRS Form SS-8. Once submitted, the IRS will generally render its decision as to the worker’s status within six months. If this is done, however, a formal determination is binding on the IRS with respect to the worker or class of workers submitted. Bearing this in mind, the following factors are considered by the IRS in the right to control test.
This subset of factors analyzes the employer’s right to control the worker but not necessarily whether the employer has asserted such control over the worker. Facts that show whether the employer has a right to direct and control how the worker does the task for which he/she is hired include:
Instructions - If the person for whom the services are performed has the right to require compliance with instructions, this indicates employee status. An employee is generally subject to the employer’s instructions about when, where, and how to perform work. All of the following are examples of types of instructions considered by the IRS:
The amount of instruction needed varies among different jobs. Even if no instructions are given, sufficient behavioral control may exist if the employer has the right to control how the work results are achieved. A business may lack the knowledge to instruct some highly specialized professionals, but may exert control over those workers in terms of where, when, and in what manner the work is completed. In other cases, a worker’s task may require little or no instruction. As a result, this test alone does not indicate that a worker is an employee or independent contractor.
The IRS also assesses the degree of instructions involved. An employer-employee relationship is more likely to be found in situations involving more detailed instructions demonstrating the employer’s control over the worker. The key consideration is whether the business has retained the right to control the details of a worker’s performance or instead has given up that right.
In this regard, employer evaluations play an important role, as the subject matter of worker evaluations may be indicative of whether the worker is an employee or an independent contractor. When the evaluation focuses on how the work is to be completed as opposed to the final product of the work, the IRS is more likely to find an employer-employee relationship.
Training - Training a worker, such as by requiring attendance at training sessions, indicates that the employer wants the services performed in a particular manner, which in turn indicates employee status. When the employer makes training available, especially when the training is periodic or ongoing, this provides evidence that the employer wants to control the manner in which the work is performed. This factor is often indicative of the true nature of a worker, and may be sufficient to find an employer-employee relationship because independent contractors ordinarily use their own methods.
Integration - Integration of the worker’s business operations into the business operations of the employer is an indication of employee status.
Services rendered personally - If the services must be performed in person, this indicates that the worker is likely an employee.
Hiring, supervising, and paying assistants - If the employer hires, supervises, or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others while working under a contract to provide material and labor and is only responsible for the result, this indicates independent contractor status.
Continuing relationship - A continuing relationship between the worker and the employer indicates that an employer-employee relationship exists. A continuing relationship may exist where work is performed at frequently recurring although irregular intervals.
Set hours of work - The establishment of set hours of work by the employer indicates employee status.
Full time required - If the worker must work full time for the business of the employer, this indicates employee status. An independent contractor is free to work when and for whom he/she chooses.
Work on employer’s premises - If the work is performed on the premises of the employer, this indicates employee status, especially if the work could be done elsewhere.
Order or sequence - If a worker must perform services in the order or sequence set by the employer, that shows the worker is not free to follow his/her own pattern of work and indicates employee status.
Reports - A requirement that the worker submit regular oral or written reports indicates employee status.
Facts that show whether an employer has a right to control the economic and financial elements of the worker’s job include:
Payment of expenses - The extent to which the worker has unreimbursed business expenses is another factor in his/her status. If the employer pays expenses, this indicates employee status. An employer generally retains the right to direct the worker in order to control expenses. Independent contractors, on the other hand, are more likely to have unreimbursed expenses.
Fixed ongoing costs that are incurred, whether or not the work is currently being performed, are especially significant to a finding of independent contractor status. It is possible, however, that employees may incur unreimbursed expenses in connection with the services they perform. Payment of operating expenses, such as insurance and rent, would be examples of ongoing costs incurred by a worker regardless of whether he/she is currently performing work.
Significant investment - The worker’s level of investment is the next factor considered under the financial control element. An employee usually has no investment in the work other than his/her own time. Conversely, an independent contractor often has a significant investment in the facilities or equipment he/she uses in performing services for someone else.
Furnishing tools and materials - Closely related to the investment prong above, is who furnishes the tools and materials used to complete the work. An employer who provides significant tools and materials to the worker indicates employee status, whereas independent contractors generally provide their own tools and materials.
Services available to relevant market and general public - Whether the worker makes services available to the relevant market and other individuals and entities is one of the most important factors considered. An independent contractor is generally free to seek out other business opportunities. Independent contractors often advertise, maintain a visible business location, and are available to work in the relevant market. If a worker performs more than very minimal services for multiple firms at the same time, then that generally indicates independent contractor status. Employees on the other hand, are more likely to be bound by non-compete and non-solicitation provisions.
Compensation - Payment by the hour, week, month, or other period of time usually indicates employee status, even when a commission supplements the wage or salary. Independent contractors are usually paid on a flat fee basis, and payment by the job or commission indicates independent contractor status.
Realization of profit or loss - A worker who can realize a profit or suffer a loss as a result of the services is generally an independent contractor (because of his/her investment and unreimbursed expenses). Because an employer usually provides its employees with the necessary workplace, tools, materials, equipment, and supplies, and generally pays the costs of doing business, employees do not make a profit or suffer a direct loss.
Here, the IRS considers the type of the relationship between the parties. Facts considered include:
The written contract - Written contracts describing the relationship that the parties intended to create can be indicative of the relationship. Without more facts, this may be the least important factor because the IRS’s overall focus is on the nature of the underlying work relationship, not what the parties call the relationship. While a contract may state that the worker is an employee or an independent contractor, this alone is insufficient to determine the worker’s status. The IRS is not required to honor the title given to the relationship by the parties; however, in close cases, the written contract may make a difference.
Employee benefits - Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, or vacation, disability, or sick pay also plays a role. The power to grant benefits carries with it the power to take them away, which is a power generally exercised by employers over employees. An independent contractor will generally finance his/her own benefits out of the overall profits of his/her business. The lack of benefits alone, however, is not sufficient to render a worker an independent contractor. This analysis puts the cart before the horse, however, as the purpose of this analysis is often made to determine whether these types of benefits are appropriate.
The permanency of the relationship - If a worker’s engagement with his/her employer is indefinite, rather than limited to specific project or period, this is generally considered evidence that the intent was to create an employer-employee relationship.
The means of ending that relationship are also considered. The right to discharge a worker, for instance, is a factor indicating that the worker is an employee. Likewise, if a worker has the right to terminate the relationship at any time he/she wishes, without incurring liability, this indicates employee status.
Service is a key aspect of the business - When a worker provides services related to a key aspect of the employer’s regular business activities, the employer will likely have the right to direct and control the worker’s activities. In such cases, the facts may indicate an employer-employee relationship. For instance, if a law firm hires an attorney, it is likely that the firm will present the attorneys’ work as its own and would have the right to control or direct the work. This would be more indicative of an employer-employee relationship.
Because this test focuses on the totality of the circumstances, no single factor or circumstance is absolutely clear in determining an independent contractor status or employee status. Where the determination of a worker’s status involves a balancing of all relevant factors, employers must remember to weigh and consider all facts and circumstances involving the worker’s engagement.
In Nationwide Mutual Insurance Company v. Darden, the U.S. Supreme Court articulated a similar, fact-based test to determine whether an employment relationship exists. Just like the IRS’s 20‑factor test, the crucial question under Darden is whether the hiring party has the control over the way the work is done. Accordingly, the Court considers all of the following factors:
Because of the similarities between the common law agency test and the IRS right-to-control test, it is likely that a worker would fall under the same classification regardless of which test is applied. Nevertheless, because of the potential severity of penalties for misclassification, employers should engage in a thorough analysis of both tests before classifying a worker as an independent contractor. Ultimately, under either test, the focus is on control. The more control an employer exercises over the relationship, the more likely it will be that the individual will be found to be an employee.
The FLSA regulates federal wage and overtime requirements for employees, defining “employee” very broadly as “any individual employed by an employer.” Given this vague definition, state and federal courts have typically applied the “economic realities” test in determining a worker’s status under the FLSA. The focal point of this test is whether the individual is economically dependent on the business to which he/she renders service or is, as a matter of economic fact, in business for himself/herself.
The economic realities test generally revolves around the amount of monetary risk the worker has in the job (in other words, if the worker can finish the job with a monetary loss, then he/she will typically be considered an independent contractor). Although the economic realities test focuses on the worker’s monetary risk, the courts also look to whether the employee has the right to control how the work is performed. As a consequence, both economic realities and the right to control tests are relevant. Used in various combinations, courts consider the following factors to weigh the economic reality of a worker-business relationship:
As part of the economic realities test, the courts look to the circumstances of the whole activity, and no one factor determines the status of the worker.
Some workers who are independent contractors under the common law rules are deemed employees by federal tax statute for certain purposes – see:
For these “statutory employees,” federal and state income taxes do not need to be withheld but social security and Medicare taxes need to be paid by both the worker and the employer. These statutory employees consist of all of the following four categories:
If workers fall into one of the prior categories, they will be considered a statutory employee if all three of the following conditions are met:
Again, employers need not withhold federal income tax from a statutory employee’s wages, but must withhold social security and Medicare if all three of the prior conditions are met. Additionally, services performed by statutory employees under the first or fourth categories listed previously (a driver or traveling salesperson) are subject to FUTA tax.
The tax code exempts certain occupations from FICA, FUTA, and employee tax withholding requirements, regardless of any contract involved or the labels attached by the parties. For an occupation to fall within the category of statutory non-employee, the worker must be one of the following:
Direct sellers are treated as self-employed for all federal tax purposes, including income and employment taxes, if both:
Direct sellers include persons falling within any one of the following three groups:
Direct selling includes activities of individuals who attempt to increase direct sales activities of their direct sellers and who earn income based on the productivity of their direct sellers. Such activities include:
Licensed real estate agents are treated as self-employed for all federal tax purposes, including income and employment taxes, if both:
This category includes individuals engaged in appraisal activities for real estate sales if they earn income based on sales or other output.
Companion sitters are individuals who provide personal attendance, companionship, or household care services to children or to elderly or disabled individuals. Companion sitters who are not employees of a companion sitting placement service are generally treated as self-employed for all federal tax purposes.
Note: A person engaged in the trade or business of putting the sitters in touch with individuals who wish to employ them (such as a placement service) will not be treated as the employer of a sitter if that person or placement service does not receive or pay the salary or wages of the sitters and is compensated by the sitters or the persons who employ them on a fee basis.
Congress has enacted a “safe harbor” rule that can minimize some employers’ uncertainty when it comes to the proper treatment of workers for purposes of employment taxes. This rule provides that an employer cannot be penalized for its characterization of particular workers as independent contractors if three requirements are met:
The voluntary classification settlement program (VCSP) allows employers to voluntarily reclassify employees and pay greatly reduced penalties. Under the terms of the program, to be eligible to participate in the VCSP, the employer must:
In exchange for agreeing to re-classify its workers, the employer will:
Employers are not required to reclassify all workers and may choose which to reclassify under the program.
Employers who wish to participate in the program must submit a VCSP application at least 60 days before it reclassifies the workers. The IRS will then review the application and determine whether to accept the employer into the VCSP.
While the program could be beneficial for some employers, employers should also exercise caution before participating in the program. First, participation in the VCSP does not shield the employer from potential liability under the Fair Labor Standards Act (FLSA). In addition, employers who participate will, for the first three years in the VCSP, also be subject to a special six-year statute of limitations (instead of the three-year limitations period that normally applies to assessment of employment taxes). It appears that the three-year extension of the statute of limitations period applies not just to the misclassification of workers, but to all payroll taxes. Finally, the VCSP application provides the IRS with information regarding an employer’s misclassification, and it is unclear whether the IRS can use this information in a later audit if it rejects the employer’s application to participate in the VCSP. Consultation with a labor and employment attorney is best before agreeing to enter VCSP.
The treatment of independent contractors for unemployment compensation, workers’ compensation, and wage and hour benefits is determined by Colorado law. As always, employers must first figure out if a worker is an employee or an independent contractor.
The term “employee” is defined in numerous Colorado statutes. For instance, the Colorado Anti-Discrimination Act defines an employee as “any person employed by an employer, except a person in the domestic service of any person.” These definitions, however, are not particularly helpful in distinguishing an employee from an independent contractor.
Nevertheless, in Colorado, the exception establishes the rule. The Colorado laws governing workers' compensation, unemployment, and wages contain an important “exception” to the definition of “employee.” Without expressly saying so, the exception provides a definition of an independent contractor. According to the statute that governs workers’ compensation, any individual who performs services for pay for another shall be deemed to be an employee, irrespective of whether the common-law relationship of master and servant exists. This is true unless the individual is free from control and direction in the performance of the work or the individual is customarily engaged in an independent trade, occupation, profession, or business related to the service performed.
This definition is also used in Colorado Overtime and Minimum Pay Standards Order 36, which defines an “employee” as: "any person, including a migratory laborer, performing labor or services for the benefit of an employer.” For the purpose of the this Order, it explains: “relevant factors in determining whether a person is an employee include the degree of control the employer may or does exercise over the person and the degree to which the person performs work that is the primary work of the employer; except that an individual primarily free from control and direction in the performance of the service, both under his or her contract for the performance of service and in fact, and who is customarily engaged in an independent trade, occupation, profession or business related to the service performed is not an 'employee'.”
Luckily, the statute also provides a list of conditions that must exist in order for the individual to prove independence. Therefore, for the worker to be considered an independent contractor for purposes of workers’ compensation, unemployment compensation, and wage and hour issues, the employer must not:
Accordingly, employers in Colorado should be wary of classifying anyone as an independent contractor who does not have a distinct and independent business.
Employers wishing to establish an independent contractor relationship should execute an agreement stating the individual is an independent contractor, as well as a disclosure in large font stating that the independent contractor is not entitled to unemployment insurance benefits unless unemployment compensation coverage is provided by the independent contractor or some other entity, and that the independent contractor is obligated to pay federal and state income tax on any monies paid pursuant to the contract relationship.
The Employee Retirement Income Security Act of 1974 (ERISA) was enacted to safeguard employee benefit plans, such as pension plans, profit-sharing plans, and health insurance plans. The classification of a worker as an independent contractor or employee determines that individual’s coverage under ERISA.
Independent contractors are not permitted to participate in an employer’s ERISA-covered employee benefit plan, but employees are. ERISA uses the common law agency approach, to determine whether an individual is an employee. Applying this test (with no one factor being determinative), the Supreme Court has held that the underlying consideration when determining the type of relationship that exists in the ERISA context is the right to control the manner and means by which the work is accomplished. The Supreme Court then set forth the following additional factors to be evaluated in applying the common-law test in the ERISA context (with no one factor being determinative):
Federal anti-discrimination laws, such as the Age Discrimination in Employment Act (ADEA), the Americans with Disabilities Act (ADA), and Title VII of the Civil Rights Act of 1964 (Title VII), only apply to employees. The analysis herein explains how it is determined whether a worker is an “employee,” as opposed to an independent contractor for the purposes of unemployment compensation, workers’ compensation, and wage and hour benefits also applies for protection under Colorado discrimination statutes. If a worker is considered an employee, then the Colorado Anti-Discrimination Act provides a number of very important protections for employees. These are described further in Chapter 12: Discrimination.
Employers should be aware that although independent contractors are not protected under the anti-discrimination laws set forth previously, they may be protected under Section 1981 of the Civil Rights Act of 1866, as amended by the Civil Rights Act of 1991. Section 1981 provides that everyone – regardless of whether they are employee or independent contractor – is protected from racial discrimination.
This prohibition on racial discrimination applies to all types of employment-related decisions, including hiring, pay, promotions, demotions, discipline, and termination. A number of courts have allowed an independent contractor to sue under Section 1981. As such, employers should be aware that they will not necessarily prevail on race discrimination, hostile work environment, or harassment cases just because they can successfully argue that the worker at issue was an independent contractor.
The National Labor Relations Act (NLRA) protects workers against unfair labor practices and allows them to organize or support labor organizations without fear of reprimand by the employer. However, the NLRA specifically excludes from its definition “any individual having the status of independent contractor.” The National Labor Relations Board (NLRB) applies a familiar common law agency test to analyze and determine whether an individual is an employee and subject to the NLRA. Although there is no shorthand formula associated with the test, the NLRB looks to the following factors:
The NLRB also notes that these factors are not exclusive or exhaustive, and should not be applied uniformly. Instead, the NLRB balances all facts surrounding the relationship to determine the worker’s status.
Misclassifying an employee as an independent contractor can have expensive consequences for an employer under federal law.
If the employer has no reasonable basis for the misclassification, the employer can be liable for years of unpaid federal, state, and local income tax withholdings, social security and Medicare contributions, unpaid workers’ compensation and unemployment insurance premiums, unpaid work-related expenses, and overtime compensation. Specifically, the employer will be liable for:
The employer will also be liable for interest and penalties and will face potential disqualification of employee benefit plans. If the employer had a reasonable basis for the classification, it may qualify for relief from paying employment taxes if certain requirements are met.
To assert an ERISA claim, the plaintiff must be either a participant or beneficiary of an ERISA plan. An employer’s obligations to a benefit plan rely not only on legal classification of a worker, but also plan documents (including summary plan descriptions) and collective bargaining and contribution agreements. Where the plan itself does not designate the definition of an “employee,” a court will invoke the common law agency test. Thus, employers need to define clearly in their plans:
Clear drafting allows employers to limit their liability to certain groups and prevent those groups from later claiming benefits. Failure to do so may constitute a waiver of this issue, and courts will defer to common law definitions, which may be at the expense of employers. Under ERISA, the benefits owed to such misclassified employees will be those that they would have received had the workers not been improperly excluded from participation.
Misclassification of employees as independent contractors can have expensive retroactive effects under various employment laws that require an employer to ensure specific employment conditions. A few examples of potential exposure follow.
An employer may be required to cover employees and certain non-employees under workers’ compensation insurance. While independent contractors are generally exempt from worker compensation requirements, they retain the right to sue in tort for work-related injuries.
Employees may have a retroactive right to unionize under the NLRA. Persons that enjoy protection under NLRA include all employees, regardless of the type of industry, but exclude independent contractors. Courts will utilize the common law agency test to determine whether a party is an employee or independent contractor.
Employee analysis under the FLSA is determined by the economic realities test. An employer is defined as “any person acting directly or indirectly in the interest of an employer in relation to an employee.” Independent contractors reside outside the scope of FLSA protections, and therefore whether a worker qualifies as an employee under FLSA is a frequently litigated issue.
Just like under federal law, an employer who misclassifies an employee as an independent contractor under Colorado law will be liable for payment of unpaid state taxes and employer contributions. This payment may be abated if the employer had a reasonable basis for the misclassification. However, liability for unemployment tax cannot be abated. Current Colorado law provides for fines of up to $5,000 per misclassified employee if an employer willfully disregarded the law. Subsequent offenses can result in fines of up to $25,000 per employee and a two-year ban on state contracts. The employer may also face additional liability under discrimination and wage laws.
About the Author
About the Contributors
About the Firm
Appendix A: Recordkeeping requirements
Appendix B: Posting requirements
Background checks — Colorado
Benefits — Colorado
Celebrating in the workplace — Colorado
Child labor — Colorado
Compliance thresholds — Colorado
Disabilities and reasonable accommodation — Colorado
Disaster planning — Colorado
Discipline — Colorado
Discrimination — Colorado
Diversity, equity and inclusion in the workplace — Colorado
Family and medical leave — Colorado
Features of the HR Library
Federal contractors and affirmative action — Colorado
Health insurance continuation coverage — Colorado
Health insurance portability and privacy — Colorado
Health insurance reform — Colorado
Immigration — Colorado
Independent contractors — Colorado
Marijuana — Colorado
Military leave — Colorado
Other types of leave — Colorado
Pandemic Preparedness — Colorado
Performance evaluations — Colorado
Personnel files — Colorado
Plant closings and mass layoffs — Colorado
Policies and procedures manuals — Colorado
Politics in the workplace — Colorado
Privacy rights — Colorado
Public Employers — Colorado
Recruiting and hiring — Colorado
Restrictive covenants and trade secrets — Colorado
Safety and health — Colorado
Snapshot – An HR audit — Colorado
Social media — Colorado
Technology and the Internet — Colorado
Telecommuting — Colorado
Temporary, leased and franchise employees — Colorado
Termination — Colorado
Unemployment insurance — Colorado
Unions — Colorado
Wages and hours — Colorado
Whistleblower protections — Colorado
Workers' compensation — Colorado
Workplace harassment — Colorado
Workplace investigations — Colorado
Workplace violence — Colorado