Service Providers: Employees or Independent Contractors?
When your business uses a service provider, like a bookkeeper or consultant, you need to determine whether to classify them as an independent contractor or employee. While classifying a service provider as an independent contractor has many advantages, the costs of misclassification can be high.
Benefits of Classifying Service Providers as Independent Contractors
Classifying a service provider as an independent contractor instead of an employee offers a number of benefits.
The cost savings for your business can be significant. With an independent contractor, your business is not responsible for payroll taxes, unemployment compensation, or workers' compensation. In addition, you don’t have to provide independent contractors with employee benefits, such as health insurance and paid time off.
An independent contractor arrangement also offers your business increased flexibility and reduced legal obligations. For example, let’s say you need a website designer for a specific project. If the designer is an employee, when the project is over and you need to either reduce their hours or let them go, they may be entitled to unemployment compensation. As an independent contractor, you can bring the designer on as needed without having to worry about unemployment compensation or other costs and legal requirements associated with reducing an employee’s hours or laying them off.
When is a Service Provider an Independent Contractor?
As with many other legal questions, the answer to whether a service provider can be classified as an independent contractor is not straightforward as there is no single standard for making that determination. Instead, there are multiple standards and the applicable one depends on the purpose of the classification. For example:
For federal tax purposes, the Internal Revenue Service (IRS) uses the right-to-control test. A worker is considered an independent contractor if the company has the right to control or direct only the result of the work and not what will be done and how it will be done.
For purposes of the Fair Labor Standards Act (FLSA), the Department of Labor (DOL) uses the economic realities test. A worker is considered an employee if the worker is economically dependent on the employer for work.
Every situation is unique. Regardless of which standard applies, an individualized assessment of relevant factors is required to determine whether a service provider is an independent contractor. Examples of relevant factors include:
Degree of Instruction - When you give a service provider detailed instructions on how to work that indicates that they are an employee. Whereas, less detailed instructions indicate less control over the service provider and that they are more likely an independent contractor.
Method of Payment - If you pay the service provider on a hourly basis, that usually indicates that they are an employee. Independent contractors are usually paid on a project basis.
Permanency of the Relationship - When your arrangement with the service provider has a fixed ending date or involves regularly occurring fixed periods of work, that supports them being an independent contractor. If there is no fixed ending date, the service provider is likely an employee.
Risks of Misclassifying Service Providers as Independent Contractors
Deciding whether a service provider is an independent contractor or an employee is more than just a choice of words. Misclassification can result in significant legal and financial consequences, including fines and tax obligations.
Minimizing the Risks of Misclassification
Fortunately, there are proactive steps that your business can take to reduce the risks of misclassification. These include:
Evaluating all current and future classifications to determine whether they comply with federal and state law.
Drafting a detailed independent contractor agreement that sets forth the terms of the relationship.
The decision to classify a service provider as an independent contractor cannot be a choice of convenience dictated by financial and logistical benefits. Rather, it is a determination that requires a careful and individualized assessment in order to minimize the risk of misclassification and the potential liability it entails. Taking proactive steps now can save your business from significant legal and financial consequences in the future.
Levene Legal can help you take these steps. We can evaluate your current classifications as well as draft and review independent contractor agreements.
