Contractors: Some Tests for Determining Their Status

By Barrie Gross, Esq.

Many laws (federal and state) and the government enforcement agencies begin with the presumption that all workers are employees. But this is a rebuttable presumption, which means that if a contractor's

status is challenged, the company that engaged the worker has the chance to try to show that the person is a contractor, not an employee. Whether or not the person is a contractor or employee is based on weighing several different factors.

A good starting place is to apply the "economic realities" test. This is similar to the test used by the Internal Revenue Service in that the pivotal factor is whether the company that contracted for the services has control or the right to control the worker both as to the work done and the manner and means in which it is performed.

Under the "economic realities" test, there are several important factors to consider, each of which will carry different weight, depending on the circumstances. Some of the factors are:

• Whether the worker is engaged in an occupation distinct from the contracting company
• Whether the work is a part of the regular business of the contracting company
• Whether the worker supplies the facilities, instrumentalities, tools, and the place for doing the work
• The worker's investment in the equipment or materials
• Whether the service rendered requires a special skill
• Whether the kind of work is usually done under direction of the contracting company or by a specialist without supervision
• The worker's opportunity for profit or loss depending on his or her managerial skill
• The length of time for which the services are to be performed
• The degree of permanence of the working relationship
• The method of payment, whether by time or by the job; and
• Whether or not the parties believe they are creating an employer-employee relationship

The last point may or may not be relevant because courts and government agencies do not hesitate to reclassify a worker as an "employee" regardless of the type of relationship the parties thought they were creating or whether a independent contractor agreement exists. Also, keep in mind that the "economic realities" test is only one test that may be used for some purposes in some states, such as California. Washington, for example, also will inquire into factors such as whether the individual:

• has established an account with the Department of Revenue or any other state agency that collects taxes for the business operated
• is maintaining separate books and records of income and expenses; and
• is required to file a schedule of expenses with the IRS

The federal Department of Labor (DOL) also usually applies an "economic realities" test that is similar to California's, but is simplified. While this list is not exhaustive, the factors the DOL will consider include:

• The extent to which the services rendered are an integral part of the principal's business
• The permanency of the relationship
• The amount of the alleged contractor's investment in facilities and equipment
• The nature and degree of control by the principal
• The alleged contractor's opportunities for profit and loss
• The amount of initiative, judgment, or foresight in open market competition with others required for the success of the claimed independent contractor; and
• The degree of independent business organization and operation

The IRS used to use the "20 Factor Test" for determining whether a worker was an employee or independent contractor. But in 2006 the IRS "simplified" it and the test now focuses on three specific areas:

Behavioral control. The critical issue is whether the contracting company has retained the right to direct and control the worker. In assessing that fact, it does not matter if the right is not exercised. It only matters whether the right exists. Consideration will include, for example:

• the type and degree of instruction about doing the work; the tools and equipment to be used; who the worker hires; where supplies are purchased; what equipment and facilities are needed; and the sequence of the work. Also considered is whether the contracting company provides training to the worker.

Financial control. This is focused on facts that show whether the contracting company has the right to control various different business aspects of the worker's job, such as:

• whether there are unreimbursed expenses, and, if so, how much; whether the worker maintains the risk of making a profit or a loss; the worker's investment in facilities and equipment; whether the worker makes him/herself available to other clients; and how the worker is paid (hourly, monthly, by milestone, etc.).

Type of relationship. This looks at other indicia that tend to demonstrate the type of relationship, such as:

• if there is a contract that defines the relationship and, if so, how it is defined; whether the worker is being provided with any benefits associated with an employment relationship (group insurance, leaves of absences, etc.); expectations about the length of the relationship; the actual length of the relationship; and whether the worker's services are an integral aspect of the contracting company's business.

As you can see, even the IRS test is flexible enough to allow application of criteria that is specific to the facts of each relationship. That means that even if two workers are performing the same work under an independent contractor agreement, one or both of them could be misclassified. Remember, all of the issues for consideration are focused on the ability to direct and control the worker and the work performed, as opposed to the result of the work. And keep in mind that the IRS test of contractor status will be applied regardless of the state where the worker and the business are located.

If a worker is misclassified as a contractor, the liability to the contracting company can be substantial, including, for example, back overtime, health care coverage, bonuses, salary increases, stock plan rights, 401(k) or pension plan participation, back payroll taxes and social security payments, payment of the worker's income tax and the worker's contribution to social security, and a penalty equal to 100 percent of these taxes. Therefore, it is vitally important that you work with human resources or your legal counsel to make sure that you understand the type of relationships you are creating and how to maintain those relationships during the course of the contracts.

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Note: This article does not constitute legal advice and should not be relied upon as legal advice. If you have a legal issue or wish to obtain legal advice, you should consult an attorney in your area concerning your particular situation and facts. Nothing presented on this Web site or in this article establishes or should be construed as establishing an attorney-client or confidential relationship between you and Barrie Gross. This article is provided only as general information, which may or may not reflect the most current legal developments or be complete.