The “Employee”/“Contractor” Conondrum
Whether to classify a worker as an “employee” or as an “independent contractor” (or “consultant”) is an important issue for any employer.  If the worker is an “employee,” you must ordinarily withhold from wages and pay taxes on the worker’s income, for Social Security and Medicare, and for the state’s unemployment arrangements.  If the worker is an “independent contractor,” such withholdings and payments are ordinarily not required.
The IRS in September 2011 launched a new policy that simplifies (sort of) the challenge of distinguishing “employees” from “independent contractors.”  Called the Voluntary Classification Settlement Program (VCSP), the new arrangement is supposed to reduce the possibility that employers will misclassify workers and thereby face sanctions.

Before VCSP, employers who misclassified an employee as an independent contractor without a reasonable basis for doing so might have been held liable for employment taxes for that worker and subject to penalties and interest.  Now, employers who incorrectly treat one or more of their workers as nonemployees or independent contractors can apply for the VCSP.  Employers accepted into the program will pay an amount effectively equaling just over one percent of the wages paid to the reclassified workers for the past year. No interest or penalties will be due, and the employers will not be audited on payroll taxes related to these workers for prior years.

To be eligible for the VCSP, an employer must: (1) consistently have treated the workers as nonemployees in the past; (2) have filed all required 1099 Forms for the workers for the previous three years; and (3) not currently be under audit by the IRS, the Department of Labor or a state agency concerning the classification of these workers.

Control is Key
The IRS analyzes the status of workers based on three factors:

  • Behavioral Control – A worker is likely an employee when the employer has the right to control the worker’s performance or determines the means used by the worker to achieve goals.  If the employer does not have control over the methods, the worker is probably an independent contractor

  • Financial Control – A worker is likely an independent contractor when they put money into the work performed, but are not reimbursed for expenses, have both the opportunity for economic gains and losses through employment, and who provides their services to the general public in addition to the employer.

  • Relationship – A worker is likely an employee when a worker receives employee benefits such as insurance, pensions, vacation pay or sick pay. A further indication that a worker is an employee is if there is an indefinite duration of the working relationship.   How the parties view the relationship is important, but the IRS does not have to follow any contract description of the relationship the parties may have used.

Federal and State Law(less)
Unlike employees, independent contractors are not protected by anti-discrimination laws, the Fair Labor Standards Act (which defines independent contractors differently than the IRS) or Employee Retirement Income Security Act.  Independent contractors in New York are not covered by the State’s anti-discrimination, worker’s compensation, and unemployment laws.  However, under certain circumstances, independent contractors are treated as employees under the New York City Human Rights Law (“NYCHRL”).
                                       
Pier 530 "IRS Safe Harbor"
Employers that misclassify workers sometimes have an out if they can prove they consistently treated their workers as independent contractors.  Employers must demonstrate that they (1) had a “reasonable basis” for classifying workers as independent contractors, (2) treated workers, and any similar workers, as independent contractors, and (3) filed all required federal tax returns consistent with their treatment of each worker as an independent contractor.  If an employer is able to prove safe-harbor status, then the employer may not have to reclassify workers.  An employer will need to thoughtfully consider whether to give up safe-harbor status and to reclassify workers under the VCSP, which will have costs accompanying the reclassification.   

Third Parties
Usually, when third parties suffer injuries at the hands of an employee while the employee is on the job, the employer may be held liable.  Not true when it comes to independent contractors.  Courts ordinarily hold employers liable for third party injuries only when an independent contractor is acting as an agent for the employer.  However, the NYCHRL goes so far as to impose liability on employers if an independent contractor’s discriminatory conduct it engages is “committed in the course of such employment and the employer had actual knowledge of and acquiesced in such conduct.
 

This Bulletin is for informational purposes only and does not constitute legal advice. Under the rules of some states, this Bulletin may be considered advertising.