(December 2011)

INTRODUCTION

Business owners or managers are constantly challenged by having to control operating expenses and still provide quality products and timely service. At first glance, it seems like using independent contractors for some operations reduces expenses. However, this approach should be examined carefully because the disadvantages and possible penalties may more than offset any perceived savings. Qualified legal counsel should review using independent contractors and the decision to do so should be made with full knowledge of the potential legal, financial, and practical consequences.

POTENTIAL ADVANTAGES

Insurance Premium Reductions

Using independent contractors may result in premium savings in two areas.

•Workers compensation premiums may be reduced because they are based on remuneration or payroll. Payments made to independent contractors are not payroll and are not used to calculate workers compensation premiums. These savings can be significant in cases that have classifications with high rates.

•Commercial general liability coverage premiums may be reduced. Subcontractor classification rates are usually significantly lower than the corresponding rate for the related classification used when employees do the work. Similarly, the rate for subcontractor classes for products or completed operations/work is usually judgment or "A" rated. In these cases, the insurance company determines the rate to use but it is usually only a fraction of the rate that applies if the named insured's employees do the work. While there are premium savings in this line of business, they are usually not as large as those for workers compensation.

Social Security Withholding

Social Security withholding is required when the named insured uses its own employees but not when it uses subcontractors. This is another area of potentially significant savings.

Unemployment Taxes, State Disability Income (SDI), or FICA Taxes

Similar to Social Security withholding, this is another area that has potentially large savings because the named insured does not pay any of these taxes on subcontractors.

Company-Provided Benefits

Many businesses provide a number of important benefits to their employees, including all or part of the costs of:

•Health or medical insurance

•Life insurance

•Retirement or 401(k) plans

•Paid vacations, sick days, and holidays

Independent contractors are not eligible for and do not receive such benefits. As a result, this is yet another area of potentially significant savings.

Tools, Equipment, and Supplies

Independent contractors usually provide and maintain their own tools, supplies, and equipment (including vehicles). Depending on the details of particular operations, using independent contractors to perform certain work could be a very important way to reduce expenses.

Example: General Novelties, Inc. sells its products through independent salespersons paid on a commission basis instead of through employees. Each sales representative owns, uses, and maintains his or her own vehicle. This saves General Novelties the expense of purchasing or leasing and maintaining a fleet of motor vehicles for its own sales representatives.

 

POTENTIAL DISADVANTAGES

Insurance Premiums on Audit

Business owners must pay additional premiums when a misclassified independent contractor is actually an employee. The amount of premium involved with workers compensation and commercial general liability coverages in such cases can be significant. In addition, the insurance company has the right to go back several years, perform revised audits, and charge additional premiums for previous policy periods.

Social Security Withholding

If it is determined that a worker is an employee and not an independent contractor, Social Security tax that was not withheld is due and payable immediately. This includes additional percentage penalties and possible fines that could be significant.

Unemployment Taxes, State Disability Income (SDI), or FICA Taxes

Similar to Social Security withholding, FICA Tax withholding on employee compensation is due and payable immediately after it is determined that an employee was misclassified as an independent contractor. In such cases, fines and penalties from 20% to 40% of the employee's portion of the tax are assessed.

Loss of Workers Compensation Protection

Business owners and their employees are eligible for workers compensation coverage. Workers compensation coverage and benefits may not available to them if they use independent contractors to perform all business operations.

Quality and Continuity

Employees have a vested interest in the quality of the employer's product and the timeliness of their employer's service. There is also a continuity of operations as one employee trains newly hired employee. The company's culture can be passed on through the employed staff. Independent contractors are interested in their short term maximizing of profits from the specific contract, not in whether or not the business continues to operate.

Cost

Independent contractors are paid based on projects completed. Their cost structure must include many of the same factors any employer must consider. The initial cost may appear lower but cost overruns, poor quality, do-overs, and other factors may result in higher ultimate costs.

REVENUE RULING 87-41–FACTORS FOR DETERMINING IF INDEPENDENT CONTRACTOR STATUS APPLIES

Government agencies usually have the last word and determine worker status to establish responsibility for Social Security withholding, Income Taxes, and FICA Taxes. To assist in these efforts, the Internal Revenue Service (IRS) provides Revenue Ruling Number 87-41. It lists 20 criteria to evaluate and determine who is an independent contractor versus who is an employee. The recurring theme throughout the list is "control" of the work performed. This ruling also explains that the way the relationship or the compensation is labeled, described, or designated is irrelevant to determine a worker's actual status. A recap of this ruling with the 20 criteria follows.

The entity that controls the worker's activities is the ultimate determining factor. The worker that has more control over the work is more likely to be an independent contractor. On the other hand, if the employer has more control over the work, it is more likely that the worker is an employee. Keep in mind that no single factor is used to make this determination. The entire test should be applied to the situation and the individual responses summarized to arrive at the final determination. The 20 factors are as follows:

1. Instructions

A worker who must comply with the compensating entity's instructions with respect to when, where, and how to perform work is probably an employee. A worker who establishes when, where, and how to perform the work is probably an independent contractor.

2. Training

A worker who must be trained or is required to have training to perform the compensating entity's work is probably an employee. Clients do not usually train (and are not usually required to train) independent contractors.

3. Integration

Workers whose services are integrated into and become part of the employer's business operation are probably under the compensating entity's direction and control and are probably employees. Independent contractors do not normally integrate their services into the workflow this way.

4. Services Rendered Personally

The entity for whom a worker personally performs services is usually interested in the methods used and the results attained. This suggests exercising control and that worker is probably an employee. Workers who are not required to personally perform the needed services are probably independent contractors.

5. Hiring, Supervising and Paying Assistants

The entity that controls hiring, supervising, and paying assistants or helpers usually determines who controls the relationship. If the entity that compensates a worker performs these functions with respect to that worker's helpers or assistants, it is probably an employer and employee relationship. On the other hand, workers who hire, supervise, and pay their assistants are probably independent contractors.

6. Continuing Relationship

Even irregular relationships that recur suggest that it is an employer and employee relationship. Such relationships do not usually occur with independent contractors.

7. Set Hours of Work

The worker is probably an employee if the compensating entity establishes and controls the hours of work. Independent contractors usually control and set their own hours.

8. Full-Time Required

If the compensating entity controls the amount of time a worker spends on the job (which serves to restrict that worker from other contracts or employment), that worker is probably an employee. The opposite applies with independent contractors who normally control their own hours and when they work.

9. Doing Work on Employer's Premises

The worker is probably an employee if the compensating entity exercises control over the location of the work, routes traveled, or the territory canvassed. Independent contractors usually work from their own locations and control their own routes and territories but not always.

10. Order or Sequence Set

The worker is probably an employee if the compensating entity controls, sets, or has the right to establish the schedules and routines to be followed. Independent contractors establish their own schedules, routines, and patterns of operation and work.

11. Oral or Written Reports

The worker who must submit either oral or written reports at specified intervals is probably an employee. Independent contractors may occasionally submit periodic reports but do not necessarily do so.

12. Payment by the Hour, Week or Month

Payments made to workers based on commission or by the job usually suggest an independent contractor relationship. Conversely, payments made to workers by the hour, week, or month usually suggest an employer and employee relationship.

13. Payment of Business and Travel Expenses

An employer and employee relationship is usually characterized by the compensating entity controlling, paying, or otherwise regulating business and travel expenses.

14. Furnishing Tools and Materials

If the compensating entity provides tools and materials to workers, they are probably employees. However, workers who provide the tools and materials are probably independent contractors.

15. Significant Investment

Workers who invest money into facilities in order to perform a service are probably independent contractors, if the facilities are not the kind an employee usually provides, such as an office or building. However, cases where employees have offices in their homes to the extent that the employer furnishes those offices must be considered.

16. Realization of Profit or Loss

Workers subject to the risk of (or who sustain) real economic loss from investments, expenses, and salaries of assistants or hires are probably independent contractors. Employees are not usually exposed to these elements and receive an established specific compensation instead.

17. Working for More Than One Firm at a Time

Workers who control their own circumstances and can or do work for more than one unrelated entity at a time are probably independent contractors. Employees usually work for one specific employer.

18. Making Service Available to the General Public

Independent contractors usually have the ability to make their services available to the general public. Employees usually serve only one employer at a time.

19. Right to Discharge

Independent contractors have contractual agreements that guarantee compensation for the contract period, as long as they meet the contract's terms and conditions. The compensating entity's right or ability to discharge a person usually suggests an employer and employee relationship.

20. Right to Terminate

Independent contractors cannot be terminated at will. They must comply with the contract's terms and conditions. On the other hand, employees can be terminated at will.