There are potential advantages and disadvantages to employers using independent contractors instead of employees. Many 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 independent contractors and employees. 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 federal and state laws and regulations. Thus, it is extremely difficult for an employer to determine whether an individual is properly labeled as an independent contractor.
Adding to this confusion is a definite trend for courts as well as federal and state agencies to classify individuals who are arguably 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.
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. The IRS uses a three-part test comprised of multiple factors to determine whether an individual is an employee or independent contractor.
The IRS uses the common law “right to control” test in determining whether an individual is correctly classified as an independent contractor. The IRS examines a number of factors 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 that an individual is 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.
In close cases, an employer may want to consider consulting a 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. 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 or she is hired include:
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.
Facts that show whether an employer has a right to control the economic and financial elements of the worker’s job include:
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:
Some workers who are independent contractors under the common law rules are deemed employees by federal tax statute for certain purposes. 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 may consist of any one of the following four categories:
If workers fall into one of these 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 these conditions are met. Additionally, services performed by statutory employees under the first or fourth categories listed (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 nonemployee, the worker must fall into at least one of the following classifications:
Direct sellers and licensed real estate agents are treated as self-employed for federal tax purposes, including income and employment taxes, if they meet both of the following requirements:
Direct sellers include persons 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:
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.
The Illinois Employee Classification Act is aimed at addressing the practice of misclassifying employees as independent contractors, generally in construction-related companies. The term “construction-related” is very liberally defined. It includes taking the following actions to any building, structure, highway, roadway, bridge, alley, sewer, ditch, sewage disposal plant, water works, parking facility, railroad, excavation site, real property, development or improvement:
It also includes doing any related work, whether or not the performance of the work involves the addition to, or fabrication into, any structure, project, development, real property or improvement of any material or article of merchandise. Construction shall also include moving construction related materials on the job site to or from the job site. To determine applicability, there is a three-part test that, if not met, leads to a fourth part.
The three-part test states that an individual performing services for a contractor is considered to be an employee of the contractor, unless it can be shown that all of the following conditions have been met:
In the event that one of these qualifications is not met, the fourth prong of the test and its 12 qualifications, are invoked. The fourth prong seeks to determine whether or not the individual in question is deemed a legitimate sole proprietor or partnership. In other words, if an employer does not meet all three qualifications in the three-part test, the employer must meet all 12 parts in the fourth prong of the test. Due to the fact that most subcontractors in the construction sector will not meet the second prong of the three-part test, almost all construction-related entities will need to meet the 12-part test. The sole proprietor or partnership performing services for a contractor as a subcontractor is deemed legitimate if it is shown that all of the following are true:
Subcontractors or lower tiered contractors are subject to all provisions of the act, but a contractor shall not be liable under the act for any subcontractor’s failure to properly classify persons performing services as employees, nor shall a subcontractor be liable for any lower tiered subcontractor’s failure to properly classify persons performing services as employees.
An employee aggrieved by a violation of this law may file suit in circuit court, in the county where the alleged offense occurred, or where any person who is party to the action resides, without regard to exhaustion of any alternative administrative remedies. This law also provides for a private right of action for retaliation if an employer discharges an individual for exercising rights under this law.
An employer or entity that violates any of the provisions of this law may be subject to a civil penalty not to exceed $1,500 for each violation found in the first audit. Following a first audit, an employer or entity shall be subject to a civil penalty not to exceed $2,500 for each repeat violation found within a five-year period.
When the Illinois Department of Employment Security (IDES) conducts an audit of payroll and income tax records for the purpose of determining whether the classification of certain individuals as independent contractors complies with Illinois law, they generally presume an individual is an employee. Employers should understand that the IDES does not necessarily follow determinations of other agencies that an independent contractor relationship exists.
The IDES defines covered “employees” broadly. The IDES generally scrutinizes the actual work done by the individual to determine their status, not what the parties call themselves. The Agency will often disregard an independent contractor agreement agreed to by the parties. In addition, the IDES does not recognize a waiver of rights to unemployment compensation benefits.
Employer liability for contributions under the Illinois Unemployment Insurance act is dependent, in part, on the existence of an “employment” relationship. “Employment” is defined as any service performed by an individual for an employing unit. Therefore, all individuals performing services for an employer are deemed to be employees unless there are specific facts that indicate that conclusion is incorrect. In other words, any person performing services for another is presumed to be an employee unless proven otherwise. Section 212 of the act carves out an exemption (known as the “ABC test”) for services performed by independent contractors. According to the Act, a worker is considered an employee, unless the worker is both:
And the service is either:
A strict burden of proof is placed upon anyone seeking exemption from unemployment contributions under Section 212, and all three conditions must be established before an exemption is allowed.
When interpreting the term “independent contractor” under Section 212, the IDES inquiry is directed to the actual rather than the alleged relationship of the parties. The designations and terminology used in any agreements or contracts between them are not controlling. Also, the fact that an individual is compensated by commission or any payment other than wages does not preclude a determination that the individual is an employee under the Act.
IDES regulations clarify each of the components of the ABC test as follows:
For purposes of the first element of the ABC test, “control” or “direction” means that an employer has the right to control and direct the worker, not only as to the work to be done, but also as to how it should be done, regardless of whether that control is actually exercised. While this determination must be made based on the particular facts of each case, the regulations identify that all of the following relevant factors to be considered:
The second requirement of the ABC test is satisfied if the service is either outside the usual course of business of the employing unit or performed outside its place of business. The regulations provide the following guidelines:
For purposes of the third element of the ABC test, “engaged in an independently established trade, occupation or business” is interpreted to mean the individual has a proprietary interest in the business that he or she can sell, give away or operate without hindrance from any other party.
While no one factor will determine if an individual is engaged in an independently established trade, occupation, profession or business, the business reality or “totality of the circumstances” will determine the presence of this condition. According to the regulations, the following types of factors are viewed to determine whether the individual is engaged in an independently established trade, occupation, profession or business:
If the IDES determines an individual is an employee rather than an independent contractor, back taxes with interest may be imposed (which could go back four years), among other penalties. In addition, the IDES may report the violation to the Internal Revenue Service, which may conduct an audit for federal income tax purposes.
Bona fide independent contractors are not covered as employees under the Illinois Workers’ Compensation Act (although they may be covered under their own company’s workers’ compensation policy). However, in Illinois, independent contractors (or subcontractors) who do not have their own workers’ compensation coverage are usually treated the same as direct employees. If an employer uses workers who are independent contractors and they do not have their own workers’ compensation coverage, they can and more than likely will, be treated as regular employees if they are injured in the course of their work.
In Illinois, the Workers’ Compensation Commission generally begins its analysis with a common law “direction and control” test. If a worker is designated as an independent contractor but is substantially “controlled” in the conduct of work duties, than the worker is more likely to be determined to be an employee.
Example - The Illinois Supreme Court decided a case in March of 2007 that supports this proposition. In Roberson v. The Industrial Commission (P.I. & I. Motor Express, Inc., the court noted that an employment relationship is a prerequisite for an award of benefits under the act. The question of whether a person is an employee remains “one of the most vexatious in the law of compensation.” The court confirmed no hard and fast rule governs all cases, but instead listed various factors to help determine when a person is an employee. These factors include whether the employer:
Other factors may also be considered, and the determination rests on the totality of the circumstances. The right to control the manner of the work is often called the most important consideration. Control issues involve a person’s work schedule, whether or not the individual is trained for job tasks by the employer, and whether or not the performance of the individual’s job duties is largely dependent on resources made available by the employer.
If the individual is largely dependent on the employer in order for work duties to be obtained, assigned, and accomplished, the individual is probably an employee even if paper designates him or her an independent contractor. That is to say, if a worker is designated as an independent contractor but is substantially “controlled” in the conduct of work duties, than the worker is more likely to be determined to be an employee.
If individuals who are labeled “independent contractors” are later found to be employees, an employer may be found liable for their workers’ compensation claims, which could include liability for medial payments, lost time and any permanency awarded. In addition, employers may be penalized for any unreasonable or vexatious denial of a claim of benefits. Employers may also be charged premiums by their workers’ compensation insurer for any uninsured independent contractors that are being utilized.
Federal and Illinois courts and agencies typically apply the common law test to determine entitlement to minimum wage or overtime benefits and applicable Illinois wage and hour laws. Specifically, they discuss an economic realities test to determine whether individuals are economically dependent on the business for which they render service.
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 or 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. In applying the economic realities test, the following factors have been considered:
the nature and degree of the employer’s control - Who decides the number and type of hours to be worked? Who is responsible for quality control? Does the worker perform services for another party? Who determines the rate and schedule of pay? Does the employer have the right to hire, discharge, and discipline?
The worker’s opportunity for profit or loss - Is there any investment made in the form of insurance or bonding? Is profit margin based on whether the work is performed more efficiently or through the exercise of managerial control?
The degree of permanency and duration of worker/employer relationship
The level of skill required for work and the amount of initiative and judgment necessary
As part of the economic realities test, the courts look to the circumstances of the whole activity and no single factor determines the status of the worker.
Employers may be liable for payments to employees to compensate them for the minimum wage, as well as being liable for overtime pay. In addition, employers may be liable for penalties and attorneys’ fees relating to wage and hour litigation.
In contrast, the Illinois Wage Payment and Collection Act adopts the “ABC test” (which is described above) to determine whether workers are covered.
The Employee Retirement Income Security Act (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. In one case, the Supreme Court set forth standards to be used to determine whether a person is an employee for purposes of ERISA. The Supreme Court 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 (Title VII), only apply to employees. Unless there is a definition of employee in the specific act prohibiting a specific form of discrimination, federal courts in the Seventh Circuit will typically use the “common law agency test” to decide this issue. Effectively, it means that the employer is not going to know for certain the answer to the question – employee or independent contractor – until a court decides.
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. The First Circuit has allowed an independent contractor to sue under Section 1981 because it applies to all contracts. As such, employers should be aware that they will not necessarily prevail on race discrimination 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.
Recent trends both on a federal level and within the state of Illinois are encouraging greater transparency of worker classification and reveal a familiar inclination to find workers to be employees, rather than independent contractors. President Obama’s administration has implemented several initiatives to deter misclassification of employees as independent contractors, including such statutory changes as:
Increased federal and state awareness and action demand even greater attention by employers to ensure compliance with applicable statutes to avoid the consequences of worker misclassification.