The wrong answer could cost you
Pop Quiz: Which of these workers qualifies as an independent contractor?
If you're like many employers, you might think the answer is "all of the above." And there are many incentives to make that choice. When a company classifies a worker as a contractor rather than as an employee, it avoids paying unemployment, Social Security, and Medicare taxes. Contractors aren't entitled to overtime pay and aren't protected under antidiscrimination laws. A company may even be insulated from liability if, for instance, a delivery truck driver who is a contractor were to injure someone in an accident.
But many companies stretch the definition of a contractor a little too far. Indeed, each of the workers described in our quiz was labeled as a contractor by the company he or she worked for. But in the first two examples, courts ruled that the contractor in question was actually an employee. In the third case, the marketing firm voluntarily reclassified its part timer as an employee after concluding she had been labeled incorrectly.
It can be difficult to determine who is a contractor and who isn't. But making the wrong call is riskier than ever. At least eight states, including New York, New Jersey, Florida, and Kansas, have cracked down on companies that misclassify their employees. Some have deployed task forces to conduct random audits, especially in industries in which misclassification is common -- construction, for example. New York launched a task force in September 2007 to focus on the issue. Within three months, the task force identified more than 100 employers it suspected were misclassifying employees, and it assessed more than $1.4 million in unpaid taxes and penalties.
Because of a safe harbor provision in the tax code, the IRS forgives many employers that label their employees incorrectly. But when workers sue over labor issues -- discrimination, for example, or wrongful termination -- companies sometimes find that the contractor designation, which they thought would protect them from liability, doesn't hold up in court. And several government agencies besides the IRS, including state tax departments and even state insurance commissions, can dock employers for getting a worker's classification wrong. Even worse, those agencies don't all have the same definition of a contractor. "Someone could be classified as an employee under one law and a contractor under another," says Lawrence McGoldrick, a labor attorney with the Atlanta office of law firm Fisher & Phillips.
That's exactly what happened to Vector Marketing, an Olean, New York, company that sells Cutco cutlery in the U.S. and Canada. Vector hires college students as salespeople. After graduating, some of these students go on to become full-time district managers, responsible for renting their own offices and recruiting their own staff.
The IRS, in two separate audits, ruled that the district managers were independent contractors. New Hampshire's state tax department disagreed, however, and demanded that several years of back taxes be paid. Vector contested the decision, but the state Supreme Court upheld it in March, saying the district managers would have had to work for multiple employers in order to be classified as contractors. Vector has now paid the taxes, which amounted to "several thousand dollars," according to the company's president, John Whelpley.
How can you tell whether someone can be classified as a contractor? Start by reading the IRS guidelines, which cover much of the same ground as many state labor laws. (You can find the IRS publication on the topic at www.irs.gov/pub/irs-pdf/p15a.pdf.)
Contractors are supposed to be business owners with a certain degree of independence, so many of the guidelines revolve around one issue -- control. "Who controls the assignment of work -- where it's done, when it's done?" asks Joseph Ritok, a partner in the labor and employment group in the Detroit office of law firm Dykema Gossett. Contractors generally decide whom to hire and what equipment to use. A carpenter building a roof, for example, is probably a contractor. But that could change if someone else supplies the tools and tells the carpenter whom to hire. If you commission someone to complete a project -- say, hiring a designer to create a brochure -- then the contractor label is probably fine. But if you hire the designer to come in two days a week for an indefinite period, he or she probably will become an employee.
Where the work is done is not a litmus test, however. Even if your software developer works from home, he or she could be an employee. Contractors usually are free to seek out other business opportunities. And they generally have only short-term assignments; those working for you indefinitely are probably employees.
Courts are often inclined to find that low-wage workers are employees, even if they have some control. Late last year, the California State Compensation Insurance Fund, which provides workers' compensation coverage in the state, ordered Palmdale newspaper publisher Antelope Valley Press to buy insurance for its newspaper carriers. The company appealed, arguing that the deliverers were contractors. Indeed, the carriers were responsible for their own vehicles and were paid a negotiable rate for each paper delivered. But a judge decided the carriers were employees under workers' compensation law. He noted that there was "an extreme disparity in bargaining position" between the workers and Antelope Valley Press. The company has appealed to California's Supreme Court and would not comment for this article.
If you're still not sure whether your contractors are really contractors, compare them to your employees. Three years ago, Nikki Hickman, director of organizational development at the marketing agency nFusion, decided that two of nFusion's 65 staff members had been incorrectly classified as contractors. Both worked part time and received no benefits, which is probably why the mistake was made. But both had regular workspaces at nFusion, with the same nameplates as employees. One had the title "interactive product manager," the same as several other managers who were classified as employees. The other's title was "consultant," but a number of regular nFusion employees reported to her. Hickman quickly reclassified both workers and began paying the requisite employment taxes. "You never want to wait for an investigation," she says. "You want to do the right thing."