Some of the small business clients I work with often want to hire an independent contractor versus bringing on a permanent employee. The use of independent contractors is very attractive to businesses because it can reduce the business’s exposure to employment-related lawsuits and reduce the business’s tax burden (i.e., no income tax withholding, Social Security taxes, Medicare taxes). While it can make sense in many cases to bring on an independent contractor, it is very important that the business discern from the outset whether it is truly seeking an individual that would be better classified as an employee because the risk of misclassifying the independent contractor can bring about serious legal consequences.
Classifying: Independent Contractor vs. Employee
To be clear, an independent contractor is an individual (or business) that provides services or goods as and when required to another business. Independent contractors are usually paid on a freelance basis. Whereas, an employee is hired and compensated to perform specific tasks at the direction of a business on a regular basis. Businesses withhold taxes for employees. Businesses to not withhold taxes for independent contractors, but are required to report to the IRS when it pays more than $600 per calendar year to a specific contractor.
There are a few different tests to determine whether an individual is a contractor or an employee. Minnesota courts tend to use “The Common Law Test”. Under this test, the main consideration is the amount of control and direction a company exercises over an individual. In general, if a business controls only the end result, the individual is likely considered a contractor. On the other hand, if a business controls the means of achieving the end result, then the individual is most likely an employee.
Another test, “The Economic Realities Test”, looks at whether the individual is dependent on the business for his or her economic opportunities. Some of the factors include:
- The permanency and duration of the relationship
- The method of payment, whether by time or by job
- The degree of specialized skill required by the individual
- The individual’s investment in equipment, materials, or facilities to accomplish the task
Besides the aforementioned two tests, the IRS developed its own 20-factor test to determine when an individual is an employee. The 20 factors have been divided among three categories: 1) behavioral control, 2) financial control) and 3) the relationship of the parties. Behavioral control refers to whether the business has the right to control how an individual performs a specific task. Financial control means whether there is a right to direct or control how the business aspects of the individual’s activities are conducted. Finally, the relationship of the parties pertains to how the individual and business perceive their relationship to each other.
If an individual is misclassified as a contractor, when the individual should be considered an employee, a business exposes itself to:
- Wage and Hour litigation
- Liquidated Damages
- Civil Penalties
- Punitive Damages/Attorneys’ Fees
Given all of the above, it is important for businesses to understand whether they are in need of a contractor or an employee because the consequences of misclassification can be very expensive. Be sure to consult a business attorney or CPA to assist with the proper classification.