Employee or Independent Contractor? Tips for Making the Correct Classification

With the current economic difficulties, small and growing businesses have used the “lean and mean” staffing strategy – favoring the use of temporary consultants and independent contractors instead of permanent employees when possible – as a way to control labor costs. But this strategy can cause companies to run afoul of the Department of Labor’s rules on how workers are classified: as an employee or independent contractor.

The following provides an overview of the questions the Department of Labor asks in order to make its determination, and consequently, how small business owners need to make theirs.  At the initial investigatory level, Department of Labor investigators often ask themselves seven key questions in taking a very simplistic approach in deciding whether an individual should be classified as an employee or an independent contractor.

The first, and overwhelmingly most important, question investigators ask is if the independent contractor has multiple clients/customers or does he/she work exclusively for one company. If the individual is so exclusively engaged, it is very likely that the investigator will consider him/her as an employee.  Because of this exclusivity investigators generally do not consider these individuals as actually being in business for themselves, which is what an independent contractor is.

Consequently, investigations ask if the company arranged the independent contractor's work schedule so that he/she has some significant time during the regular workday, or workweek, to provide services for another client/customer. It is important for a company to arrange an independent contractor’s work schedule so that he/she can provide services for another client/customer. Even if the individual decides not to do so, it is still important for the company to give the individual the opportunity to have other clients/customers.

Similarly, investigators question whether the company asked the contractor to sign any form of non-compete provision. A non-compete requirement is a significant factor in finding that the individual is, in fact, an employee.

Another, closely related question is whether the individual was hired for a limited, definite period of time to perform a discreet service or to complete a particular project or task for the company, and whether these terms are stated in an Independent Contractor Agreement or Letter of Engagement. Having these terms set forth in such a document is particularly important if the company needs the contractor to work full-time during the term of his/her engagement.

That the individual has incorporated or created a limited liability company — and that the employer makes payments to this entity rather than the individual — is not at all a controlling factor in the Department of Labor’s determination of whether the individual is an employee or independent contractor. If the investigator finds that one employer is the only real client/customer of the entity which the individual has created, then, in making its determination, it is highly unlikely that the Department will give any weight to this entity’s existence or to the company’s payments to it, instead of directly to the individual.

Investigators also ask about how closely a contractor is managed. Are daily deadlines given? And does the company dictate the methods and means for completing the assigned project? A major factor in determining employee versus independent contractor status is the degree or extent to which the company establishes step-by-step tasks and goals and how closely it supervises/monitors the individual in completing them, and the entire project, for which the company has engaged him/her. In addition, the company should only set general time limits within which any interim tasks or goals must be completed, and then an ultimate deadline for the entire project. To be considered an independent contractor, the individual must be left to decide, independently, the methods and means, and the resources (e.g. personnel and otherwise), which he or she will use to complete these interim tasks/goals and ultimately the entire project. And the individual must be left to decide the pace at which the work will be performed; subject only to the general interim and final time limits the company has set.

In this same vein, determination of independent contractor versus employee hinge at least in part on whether the company establishes the work schedule for the individual, and require that he/she be at the company's facilities at certain times during the day for certain days? The company should not establish a work schedule for the individual, and should not require that he/she be at the company's facilities at certain times during the day for certain days. Rather, to maintain independent contractor status, the company should only schedule periodic meetings with the individual to report on progress; to have the work-to-date critiqued, and then, if necessary, to receive additional general directions for the remaining tasks/ goals to complete the project.

Another element here is whether the individual has any entrepreneurial risk, given that an independent contractor is in business for themselves. How is the contractor paid? By the hour, or by reaching specific milestones? For example, the individual should be paid by the company only when various interim steps/goals for the project are achieved up to certain, objective standards or quality of performance, as provided in the Independent Contractor Agreement. Also, a major portion of the individual’s compensation should not be paid until the project is completed; again subject to these same performance standards. With this payment structure the individual is more likely to be considered an independent contractor. This is because they have the risk of not being paid for substandard work, or having the payment reduced, or having to redo the work to an acceptable standard without additional compensation.

Conversely, if the individual routinely receives a pay check every two weeks from the employer, regardless of how much progress has been made in completing the project, then the individual is more likely to be considered an employee.

The final key question involves whether the individual is engaged in a trade, occupation profession, or business which is customarily considered as working independently. (The best example of this factor is the freelance journalist.)  A closely related element of this factor is whether the individual is providing a service for the company which is not at the core of the company's business; but rather, is outside of its normal course of business. (A good example is a company that is engaged solely in the manufacturing of tangible products which hires a computer consultant, as an independent contractor, to assist with upgrading the company's IT systems software.)

This article has very briefly addressed the key factors, and the various elements of each, which are considered in determining employee versus independent contractor status. In making this determination for tax purposes the IRS has a 20-factor test.  Consequently, this determination is often not as simple a matter as it may appear from this brief discussion.  Consequently, the advice of an experienced employment lawyer is a must BEFORE the individual is hired.

This guest post is courtesy of Dennis Alessi. He has over thirty-five years of experience in employment law and is Co-Chairman of the Employment Law Department at the law firm Mandelbaum Salsburg.  He can be reached at 973-736-4600, ext. 151, or at [email protected]

Guest Blogger

This post is courtesy of a guest post from a contributor to CEO Blog Nation. CEO Blog Nation is a community of niche blogs for entrepreneurs, startups and business owners. For more information on contributing a guest post read here:

Related Articles

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.

Back to top button