Sometimes, businesses may find it necessary to outsource certain activities. Even if a business does not intend on hiring employees, it may still find itself in need of recurring services by some individual. Especially in the realm of e-commerce, where cloud computing and some recent software applications have given rise to numerous solely-owned businesses. The global interaction between individuals and service providers through the internet has made the use of independent contractors and freelancers explode. But, what are the pitfalls your business should avoid if you enter these recurring types of relationships?
The answer depends upon your objectives, but most small or solely owned businesses will want to avoid withholding federal and state payroll taxes, which is required for any employee. In addition, having employees will obligate the employer to comply with minimum wage, overtime and employee benefits laws. Additionally, employees may be able to make claims for unemployment under State law.
In order to avoid the legal and tax liability that goes along with having employees, every business must understand the basic factors the Courts and the IRS have used to differentiate employees from independent contractors. In general, to determine if workers are independent contractors or employees by law, the degree of control and independence are the primary factors evaluated. The examination is often referred to as an “economic-realities test” or “right-to-control test”.
According to the IRS, three distinct categories of control have been generally identified and evaluated under common law principles to determine whether an employment relationship exists. The first category, “behavioral control,” evaluates if the employer controls the means and methods and the outcome of the work. In other words, does the employer control how, when and where the work is performed? The second, “financial control”, evaluates who controls how the individual is paid and other financial items.
For instance, the IRS sets forth the following items that have been traditionally considered under this category:
- The extent to which the worker has not been reimbursed for business expenses;
- The extent of the worker’s investment in the facilities used in performing services;
- The extent to which the worker makes his or her services available to the relevant market;
- How the business pays the worker; and
- The extent to which the worker can realize a profit or incur a loss
The last category, “Type of Relationship,” evaluates how the employer and the individual see the relationship. The examples set forth by the IRS include:
- Written contracts describing the relationship the parties intended to create;
- The extent to which the worker is available to perform services for other, similar, businesses;
- Whether the business provides the worker with employee-type benefits, such as insurance, a pension plan, vacation pay, or sick pay;
- The permanency of the relationship; and
- The extent to which services performed by the worker are a key aspect of the regular business of the company.
Since agencies and the courts consider the whole picture, a single factor usually will not determine whether someone is an independent contractor or employee by law. If the factor is extreme enough, however, it could be enough by itself. But, in general, the more an employer attempts to exert control over the worker’s means and manner of production, the more likely the worker will be categorized as an employee. Simply stated, independence and control are the core factors that will be evaluated.
Also, when practical, it’s a good idea to deal with independent contractors that are organized business entities as opposed to sole proprietors. Obviously, requiring that each independent subcontractor organize into a business entity is simply impractical. Fortunately, requiring incorporation is not required, only the most conservative approach I have recommended to my clients. But, your business can and should utilize an independent contractor agreement drafted to specifically address the qualifications used to determine an employment relationship under Federal and any applicable state law.