(Originally published in Fall 2017)
“I’m an independent contractor, but without the independence.”
“My independent contractors have all signed a non-compete agreement.”
“They’re not employees because they choose their own hours.”
These statements misconstrue the distinction between employees and independent contractors. An employee cannot agree to be treated as an independent contractor, and employers can be harshly penalized for misclassifying their workers. (1,2) The overlapping and synonymous titles used for different types of workers further confuses this issue.
“Which designation is better?”
The distinction between an employee and an independent contractor is not arbitrary, so employers who miscategorize their employees as such may be severely penalized for violating state and federal employment and taxation laws. (2) To understand the distinction between the two categories, consider the worker’s level of independence. While employees are employed by the workplace, an independent contractor is typically self-employed.
Employers typically prefer to classify their workers as independent contractors while workers typically prefer to be treated as employees. In an employer-employee relationship, the employer withholds a portion of an employee’s wages for income, Medicare, Social Security, and unemployment taxes. An employee enjoys greater rights under federal and state labor laws, and the employer is liable for an employee’s on-the-job negligence.
In contrast, in an employee-independent contractor relationship, the independent contractor is personally responsible for tax withholdings and typically pays self-employment taxes. Independent contractors enjoy fewer rights under labor laws and are typically liable for their own on-the-job negligence.
To further illustrate the advantages and disadvantages, consider the following example:
Phyllis the physical therapist wants to begin offering massage therapy at her clinic. A massage therapist, Maddy, is interested in working together, and Phyllis is considering whether to hire Maddy as an employee or work with her as an independent contractor. She wants to understand the pros and cons of each classification.
Option One: Work with Maddy as an independent contractor.
If Maddy enters into an agreement with Phyllis as an independent contractor, Maddy will retain maximum control over her work. She will bring her own treatment table, sheets, and business cards (which will feature her own business name, Maddy Massage LLC). Maddy will maintain her own records, pay self-employment taxes, and procure her own health and liability insurance. Phyllis will not pay employment taxes on Maddy’s behalf and will not compensate her for sick or maternity leave. Under this arrangement, Phyllis will have less responsibility for Maddy’s on-the-job negligence, and either party can also terminate the agreement at any time.
Phyllis will not be able to control Maddy’s hours, modalities, work attire, or billing, and Maddy is probably free to provide the same services to Phyllis’ competitors. Further, Maddy will keep the money she earns from her massages. For example, if Maddy charges $100 per hour, Maddy will keep $100 per hour.
Option Two: Hire Maddy as an employee.
If Phyllis hires Maddy as an employee, then Maddy joins her staff in her individual capacity (not through Maddy Massage LLC). Phyllis will control Maddy’s hours, modalities, work attire, and billing. Phyllis can even control details like the timing of Maddy’s lunch break and the design of her business cards (which will display Phyllis’ business name). As her employee, Phyllis can require Maddy to sign a non-competition agreement, which will bar Maddy from working for Phyllis’ competitors, even after Maddy stops working for Phyllis. Phyllis will also keep the $100 fee that she will charge clients for Maddy’s massages while paying Maddy as little as minimum wage.
However, if Maddy is Phyllis’ employee, then Phyllis must provide or pay for Maddy’s work equipment like a treatment table, sheets, and business cards. Phyllis will maintain Maddy’s records and pay employment taxes from her paychecks. Phyllis may be required to provide Maddy with health or liability insurance and pay her for sick leave. Under this arrangement, Phyllis will bear more responsibility for Maddy’s on-the-job negligence, and Phyllis may not be permitted to terminate Maddy’s employment without paying a severance package or giving a good reason for firing her. Further, regardless of Maddy’s client load, Phyllis must pay Maddy’s wages (at least minimum wage).
Advance planning and careful contracting between an employer and a new worker are crucial to help avoid missteps that could incur costly penalties later. Both arrangements have positive and negative aspects that will impact Maddy’s legal rights and Phyllis’ responsibilities to her.
“Where is the line between an employee and independent contractor?”
Despite a surplus of literature on the topic, the distinction between employees and independent contractors confounds both lawyers and employers. Unfortunately, no uniform definition exists for either classification. Instead, the courts and government agencies evaluate numerous factors to make this determination. They might reach seemingly-contradictory conclusions in different contexts, too. For example, a worker may be classified differently under tax, labor, or anti-discrimination laws.
For federal tax purposes, the Internal Revenue Service (IRS) considers the amount of control exercised by the employer, the parties’ financial arrangement, and the existence of other agreements (like a written contact or a vacation policy). (3) But in considering these factors, the IRS cautions that: “There is no ‘magic’ or set number of factors that ‘makes’ the worker an employee or an independent contractor, and no one factor stands alone in making this determination.” (4)
If an employer cannot determine how to classify a worker, they can ask the IRS to determine the worker’s status.3 However, such requests can take months to process and may have unforeseen consequences, so it is best to consult with an accountant and attorney before filing. Notably, the IRS’ determination is only relevant for tax purposes, and other government agencies may – and do – classify a working relationship differently.
For purposes of federal labor laws, (4) there is a multi-factor framework for classifying a worker. These factors include details like: how much control the employer has over the worker’s tasks; who pays for the work-related equipment (like a treatment table); how the worker’s skills impact her income; and the duration or permanency of the parties’ relationship. (5) In the aggregate, these factors essentially weigh the degree to which the worker is financially dependent upon and controlled by the employer.
Finally, many states have adopted their own classification framework for purposes of state labor, contract, and tort laws. For example, to determine whether a business must pay a worker minimum wage, it is state law – and not the IRS’ determination – that is dispositive. (6) This means that a worker can be an independent contractor for federal tax purposes but an employee for state minimum wage purposes.
In summary: Carefully consider the purpose of the classification to ensure that it complies with the relevant test and consult with an attorney if you are unsure. The checklists on the previous pages can help steer your thinking.
“What questions should I ask?”
It is crucial that business owners maintain written workplace policies and procedures that standardize and articulate protocols to facilitate appropriate worker classification. Any employment contracts or independent contractor agreements should be drafted by an attorney, ideally after consulting with an attorney about the legal implications and risks of using employees versus independent contractors.
Payroll should be established by an accountant familiar with the tax implications of both arrangements. Most issues can be avoided (along with punitive fines or oversight) with careful planning and detailed business management. Importantly, the personalized service of attorneys and accountants can be a critical tool in growing your business. For that reason, the charts and guidance included here is no substitute for the advice of such professionals and should not alone be relied upon when making business decisions.
Erin Jackson is a health and wellness attorney in the Chicago area at Jackson LLP. She also co-founded Jackson Compliance, a healthcare consulting company which specializes in practice start-up and compliance. Through this work, Erin collaborates with providers to make their practices friendlier and more approachable for a diverse patient population.
Erin serves as the President of the nonprofit organization Inspire Santé, which she founded after recovering from debilitating chronic pain. She is writing a memoir about how she conquered her pelvic pain, which she hopes will help other women discuss these issues without embarrassment or shame.
You can follow her on Twitter: @healthy_lawyer, and contact her at firstname.lastname@example.org
1. # Baker v. Barnard Construction Co., 860 F.Supp. 766, 772 (D.N.M. 1994).
2. Internal Revenue Service, Independent Contractor (Self-Employed) or Employee? (last updated Apr. 18, 2017)
3. IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.
4. Fair Labor Standards Act of 1938, (FLSA), 29 U.S.C. § 201, et seq
5. Secretary of Labor, United States Department of Labor v. Lauritzen, 835 F.2d 1529, 1533 (7th Cir. 1987).
6. Washington State Department of Labor & Industries, Independent Contractor or Covered Worker? (last updated Sept. 2016)