Independent Contractor or Employee — How do you tell the difference?

I recently had a client ask me whether he could avoid all the hassle of payroll taxes, withholding, unemployment insurance, workers’ comp, minimum wage, overtime, etc. — just by issuing 1099’s to all his staff and treating them as independent contractors.  The short answer?  No.  I mean, think about it.  If it were that easy, everyone would be doing it.

And in fact, many employers are doing this.  But they are also taking on a lot of risk.  Because if the government finds out — let’s say, because you try to fire the “contractor” and he seeks unemployment benefits through EDD, or he decides he really wants some overtime and files a complaint with the Department of Labor — you can be liable for very large penalties, plus interest on all the payments owed.  As anyone who has been through an employee audit will tell you — It’s generally not worth the risk.

So, how do you know whether a worker can legitimately be classified as a contractor vs. an employee?  Fortunately, the IRS and California provide lots and lots of guidance on this (though the federal and state tests are slightly different, if you follow California guidelines, you should be ok).

In essence, it all boils down to the extent to which you exercise direction and control over the means and method of performing the work.  The more discretion the worker has, the more likely he is to be considered a contractor.  The more control you have over the details of how your worker performs his job, the more likely he is to be considered an employee.

For example, when you hire someone to paint your office, you typically leave it up to him to determine what sort of brushes to use, how to tape up a room, where to start painting.  He generally supplies his own equipment, works for a number of office owners, and is paid at the end of the job, after submitting an invoice.

In contrast, let’s say you hire someone to perform secretarial services.  She comes into work every day, and sits at a desk and uses supplies that your provide.  You direct her as to what to say when answering the phone, how to handle the mail, where to file various documents, and how to deal with customers or clients.  It’s pretty clear that the first person is an independent contractor, while the second is an employee.

But let’s suppose you hire a bookkeeper.  She comes into your office twice a month, reconciles the books, writes checks, maybe even handles your payroll.  You give her general direction, but you don’t closely supervise what she does.  How do you know that it’s ok to issue her a 1099?  Here are some factors to consider, as suggested by the California Employment Development Department:

• Do you supervise the worker with manuals and specific instructions?
• Can the worker quit or be fired at any time, regardless of whether the job is completed?
• Is the work part of your regular business or is it a specific task done periodically that is not essential to the business?
• Does the worker have a separate business and/or work for other businesses besides yours?
• Can the worker make decisions that affect his or her ability to profit from the work (e.g., that affect the worker’s overhead costs or profit margin)?
• Does the worker have a substantial investment in his or her own business (e.g., tools, equipment, a separate business address)?
• Do you have other workers who do the same type of work but are treated as employees?
• Do you furnish tools, equipment, supplies used for the work?
• Is the work considered unskilled or semi-skilled labor?
• Do you provide training for the worker?
• Is the worker paid on a fixed salary, an hourly wage, or a piece rate basis?
• Did the worker perform the same or similar services for you as an employee?
• Does the worker believe that he or she is an employee?

In addition, here are some practical tips to help establish that your workers are contractors rather than employees:

• Have your lawyer prepare a written contractor agreement for the worker to sign.
• Make sure the worker has his or her own business cards, work address, letterhead, tools, supplies and equipment to perform the job, including cell phone and computer.
• Let the worker work from home, or at his or her own convenience, rather than requiring the worker to work set hours at your office location.
• Be careful with reimbursement of business expenses — keep them to a minimum or don’t agree to reimburse at all.  This is a sort of red flag for EDD, because it indicates the worker is not investing his or her own resources in the business.
• Check with your lawyer if in doubt!!!!!  There are certain workers who are classified by statute as employees, no matter what (including corporate officers and managing members of LLC’s) — better to have your lawyer ensure you are in compliance before you get a call from the DOL or EDD!