Business Law: Walking the Employee-Independent Contractor Tightrope

By Nina L. Kaufman, Esq

"Helen" needed someone to handle her bookkeeping and billing. It only took 1 or 2 days per week, but she didn't have the time. What she did have was an actor friend who would do the work for her. But the money he wanted, coupled with the cost of social security, worker's compensation, unemployment insurance, and other employee benefits was more than Helen could afford. Someone had told her that he could be a "1099 employee" and that she wouldn't have to pay all these extras or even withhold taxes for him. When I tried to explain that she was taking a great risk in possibly misclassifying her friend's employment status, she exclaimed, "But who is going to find out?" "I'm a lawyer, not a prophet," I replied.

There comes a time in the life of every small business when it outgrows the capacity of its owners and needs help from others. Whether this happens at the inception of the business or after some period of growth, the legal issues remain much the same. And thus, the age-old questions surface: "Should I hire a (full or part time) employee or outsource to an independent contractor in order to meet these needs?" And what really are the differences between the two?
The Employee-Independent Contractor Divide

The difference between employees and independent contractors that business owners tend to focus on is the difference in the taxes that need to be paid. Employees receive IRS Form W-2 , which reports their wages. The employer must withhold taxes and provide employee benefits such as the employer's portion of FICA and Medicaid taxes, unemployment insurance, and workers' compensation. No surprise, therefore, that the taxing authorities far prefer that people providing services be classified as employees: from their perspective, this means that more workers will be provided with employment benefits; fewer will require public assistance; and more taxes will be paid all around (independent contractors are notorious for not paying their taxes.). By contrast, a business simply pays independent contractors their gross fee. It need not withhold taxes on the worker's behalf, pay the employer's share of taxes (as they are not, technically, an "employer"), or provide benefits. For this reason, many business owners are tempted to classify employees as independent contractors.

How "Controlling" Are You?

However, the overriding difference - which is the difference that the law focuses on - is the degree of control you have over the worker. The more control you exert, the more likely the government will deem your worker to be an employee and not an independent contractor, regardless of the label you place on the working relationship or the title you have on any written agreement. The relevant factors that the courts (and the IRS) have considered fall into three main categories: behavioral control; financial control; and the relationship of the parties.
A business exhibits behavioral control over a worker when it has the right to direct or control how the worker performs the work. Do you give extensive instructions and training to the worker? Do you determine where the worker will perform the services? Do you decide what the worker will do and when? Do you provide the equipment, supplies, or other required materials to complete the work? Do you take care of staffing the work with assistants of your own choosing? The more of these to which you answer "yes," the more likely it is that you are hiring an employee.

Similarly, companies show their financial control over the situation when they have the right to direct or control the business part of the work. Courts will look to whether a worker has made her own financial investment in her business or whether she gets reimbursed for some or all business expenses, such as rent and utilities, licensing or professional dues, or advertising expenses. Particularly telling is whether the worker takes a risk on the transaction by either realizing a profit or incurring a loss. If the answer is "yes" to these criteria, the scales tip to the independent contractor side.

Finally, how do you truly perceive your relationship with the worker? Do you provide benefits such as insurance, pension, or paid vacation? Do you have a written agreement suggesting that the worker is an employee? Do you make payments for the worker's services to an individual instead of a corporation? Again, while these factors are not determinative in and of themselves, the more for which the answer is "yes" may tip the scales to "employee" if it is difficult to determine status based on other facts.

To return to Helen's situation, let's suppose that instead of an aspiring actor, the part-time worker will be a single-member LLC that provides bookkeeping and billing services. It has its own place of business, computers, and other equipment, and provides its services to two other companies. The LLC owner decides when to provide the service and can do so at her place of business, as well as yours. In this scenario, the LLC operates as a completely separate entity with its own overhead. Our actor, on the other hand, will work only for you at your place of business, will have no separate overhead, and no investment capital at risk. On these facts, the LLC would likely be considered an independent contractor but the actor must be treated as an employee.

The outcome can depend on very subtle differences. Especially in close cases, governmental entities will almost always deem the worker an employee unless you can show otherwise. To Helen's question - "Can I do this?" - the legal answer revolves not around whether Helen can, but whether she should classify her potential employee as an independent contractor. Although plenty of business owners claim to do it, the fact remains that improper classifications can result in expensive penalties. So be very wary of treating a worker as an independent contractor. And be sure to review your specific situation with legal counsel to ensure that you make the right choice.

© 2004-2009 The Legal Edge LLC. Nina L. Kaufman, Esq. is an award-winning business attorney, author, and speaker. Under her Ask The Business Lawyer umbrella, Nina offers easy-to-understand business law resources that protect small businesses and save them money. To learn more, and receive our FREE "LexAppeal" ezine, visit http://www.GreatBusinessLawTips.com  or contact Contact Us. This article is for your general information only. Be sure to consult with an attorney regarding your particular situation to make sure you get the specific advice you need.

Nina Kaufman, Esq. Award Winning Business Lawyer, Author & Speaker