How (and why) to distinguish independent contractors from employees

Ryan Kutter, 

Esq., Relationship Manager

When it’s time to bring on the first non-founder to a startup’s team, it’s an exciting moment for the company. The startup’s product development or business needs have grown beyond the capabilities of the founders, and the project is validated well enough that it makes sense to invest in additional talent. However, founders should proceed with caution in how they are choosing to bring on that new worker.

Startup companies need to be concerned about how they are classifying their new workers—they can be either employees or independent contractors. Typically, startups would prefer to label new workers as independent contractors: independent contractors are generally cheaper and don’t require the company to start complying with various employment laws and regulations. Additionally, this new hire might not necessarily be needed full time, so the founders might not want to go through the hassle to make these hires employees.

Frankly, this area of running a startup is the most misunderstood and frequently violated. There is a lot of confusion in the ecosystem about how to engage talent without having to hire them as employees. Unfortunately for founders that follow incorrect hiring advice, the consequences for getting this distinction wrong are risky and a founder should be sure before they hire a worker as an independent contractor that the company is complying with the law.

What is an independent contractor?

Not surprisingly, it depends on who you ask. It is more complicated than just designating the new worker as an independent contractor, having them sign an independent contractor agreement, and providing them with a 1099. What matters is how the relevant statute or regulation would designate the worker's services to the company. Below are some examples of some of the federal and state agency tests founders will have to consider.

Internal Revenue Service test for worker status

The IRS uses a three-category approach to determine whether the worker is an independent contractor or employee. No single fact is determinative; the IRS still considers the worker’s status based on the totality of the facts.

The three main considerations are:

Behavioral Controls: facts that show whether the business has a right to direct and control how the worker does the task for which the worker is hired. This includes:

  • The types of instructions that the business gives the worker. If the employer controls the when/where to work, the specific equipment that the worker has to use, the what/where to purchase supplies and services, whether work must be performed by a specific individual, or exercises similar kinds of control over the worker, the worker is more likely to be considered an employee.
  • The type of training the business gives the worker. Generally an independent contractor should already be able to perform the service and can use their own methods to perform the service.

Financial Controls: facts that show whether the company has a right to control the business aspects of the worker’s job.

  • Independent contractors have ongoing expenses as part of their trade or business that would occur whether or not they were working for your business (i.e internet, web services, etc.).
  • Does the contractor perform similar services for others? If you are the only client of the contractor, that may weigh heavier on the side of an employee relationship rather than as an independent contractor, However, this fact is not necessarily controlling.
  • How is the worker paid? Independent contractors are generally paid on a flat fee or a per project basis (according to the specific contract). Employees generally get regular recurring wages over a period of time.

Type of Relationship: facts that show what kind of relationship the worker has to the business.

  • Is there a contract describing the type of relationship? If there is a contract that covers the relationship, the worker is more likely to be an independent contractor.
  • Does the worker get benefits that employees get at the company? If yes, they are more than likely an employee.
  • How long will the relationship last? If there is no specific duration, the worker is more likely an employee.
  • To what extent are the worker’s services a key component of the ordinary business of the company? If the business relies on the worker’s services to provide their offering on a basic level, the worker is more likely to be an employee.

If the company is still unsure about how to classify the work after going through that exercise, you can submit a form to the IRS for them to make a determination. However, this process can take several months to get a response.

Jucidiary economic realities test for worker status

The economic realities test is used by the judiciary to interpret if there is an employment relationship under several federal employment law statutes including the Fair Labor Standards Act and the Family and Medical Leave Act. This test is similar to the IRS test in that the level of control the business has over the worker is very heavily weighted. The economic realities test is also a multifactor test with no individual factor being determinative. However, there are several differences.

The US Department of Labor outlines the six general factors that are generally considered to determine the worker classification under the Fair Labor Standards Act:

  1. The extent that the work performed is an integral part of the employer's business
  2. If the worker is a key part of the business, they are more likely to be dependent on the employer. This can be perceived as more like an employment relationship than an independent contractor relationship.
  3. Whether the worker’s managerial skills affect his or her opportunity for profit or loss
  4. Does the worker's exercise of managerial skills affect the worker’s opportunity for profit and loss? In other words, do hiring or management of employees change the amount of compensation the worker keeps, by allowing them to perform their services more or less efficiently? If yes, this suggests that they do not receive the set wages typical of an employee.
  5. The relative investment in facilities and equipment by the worker and the employer
  6. The worker has to make some investment into the work required to be considered an independent contractor. Does the worker provide their own tools and equipment?
  7. The worker’s skill and initiative
  8. Does the worker exercise independent business judgement? Is the worker in open market competition with other contractors? If the answer is no, they are likely an employee.
  9. The permanency of the worker’s relationship with the employer
  10. If the worker’s role is permanent or indefinite, that tends to indicate that they are an employee.
  11. The nature and degree of control by the employer
  12. Is the worker free to work and hire others without oversight? Does the business control the methods that the worker uses to perform services? Does the worker control their work hours? If not, it may suggest that the worker is an employee. However, this test is complex and depends on the specific facts of the case.

While both the economic realities test and the IRS test focus largely on the amount of control that the business has over the worker, it is important to realize that a designation under one test does not guarantee the same under the other. All tests are equally important and have their own serious consequences for noncompliance. While there are ways to dispute noncompliance claims either through the courts or regulatory process, these methods will be expensive and time consuming for a startup–possibly more expensive than the penalty.

Other Tests

There are several other statutory and regulatory bodies that make a distinction between an employee and an independent contract. State worker’s compensation boards, state departments of labor, and state departments of revenues also have their own tests and interpretations.

Further, civil anti-discrimination statutes at both the federal and state level also have tests to determine if there is an employment relationship. All these tests largely focus on the same things, but the statutory authority and the relevant enforcement agency might not follow the same procedures.

Consequences of noncompliance

The consequences for misclassifying a worker, especially for doing so deliberately, can be substantial. Additionally, since there are multiple agencies at both the state and federal level that are responsible for enforcing these laws, the fines from misclassification can add up.

Here are some examples of possible consequences to which agencies can subject businesses for worker misclassification.

  • Federal income tax: 1.5% tax placed on the the wages paid to the misclassified worker, possibly 3% if the business also failed to file the appropriate forms.
  • FICA (Social Security and Medicare): The worker’s share of the tax with an additional 20% tax levied on the worker’s share. The additional tax increases to 40% if the IRS determines the worker misclassification to be intentional.
  • Unemployment tax and workers compensation insurance: These consequences vary state to state.
  • Payroll taxes: the IRS maintains the right to hold not only the business but also the owners, chief executive officer, and the individuals responsible for paying the taxes personally liable to pay the taxes. This is one of the examples where an agency can “pierce the corporate veil” to collect tax payments and levy additional penalties.

One of the ways misclassification is detected is when a former worker classified as an independent contractor files for unemployment or a worker’s compensation claim, believing they are entitled to these benefits. The agency will then notice the discrepancy and will trigger an investigation to see if worker was misclassified. Further, 37 states have entered into information sharing agreements with both the US Department of Labor and the IRS to coordinate enforcement. This means that an investigation by one agency can trigger follow-on investigations from other state and federal agencies. There are a number of other situations that can trigger investigations, including a worker reporting the business’s misclassification to the IRS directly.

Why workers should be classified correctly

Worker misclassification is a 50 billion dollar problem for the US and one that the IRS takes very seriously. Payroll taxes alone account for a third of the tax revenues that the government collects each year. It makes sense that the IRS is very diligent and concerned about the possibility of these tax payments not being paid by the employer or misreported as W-2 income by individuals with 1099 income.

Additionally, public policy over time has increased the protections given to employees. State and federal agencies with a responsibility to enforce these laws and regulations are serious about making sure that all workers that should be classified as employees under the law receive the protections and benefits they deserve.

Finally, startups have enormous financial pressures to conserve resources and capital wherever they can. Bringing on employees is expensive and complicated. However, that is not a sufficient reason to shift the employer’s tax burden to a worker by paying them 1099 income when they are legally an employee. Rather, in the interest of treating your workers right and to avoid potentially hefty penalties, founders should take every precaution to ensure that they bring on independent contractors in a way that comports with the law.

Overall, here's what a startup founder needs to remember:

  1. Be careful when you are bringing on your first paid worker (and any paid workers after that, too)
  2. If they are an independent contractor, treat them like a independent contractor
  3. If they are an employee, treat them like an employee
  4. If you are unsure, talk to an attorney.

This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.