Legal Clinic

Classifying Employees

While there are substantial benefits derived by an employer when workers are independent contractors instead of employees, there are also substantial risks. And to make it more difficult, there is no easy way to determine which classification is the correct one.

Monday, June 4, 2012
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Question: I have read a lot about the differences between Form 1099 workers and Form W-2 employees, but still do not feel it is clear enough to make an informative decision as to what the drawbacks and benefits are of having each working with our company. Could you please explain?

Answer: On the surface, it appears that employers reap significant financial benefits from hiring a Form 1099 worker -- an independent contractor -- rather than a Form W-2 worker -- a statutory employee -- but employers also face risks if workers are misclassified.

Whether a worker is an independent contractor or an employee is determined under the common law test. 26 C.F.R. ยง 31.3401(c)1.

Independent Contractors vs. Employees

Financial incentives for hiring independent contractors are that employers have reduced overhead costs including expenses, payroll and benefits. Employers must withhold taxes from employees but not from independent contractors.

Additionally, employers must provide benefits to employees, whereas there is no such requirement with regard to independent contractors. Also, workers classified as contractors do not receive unemployment insurance if laid off or workers' compensation if injured.

Also, the laws governing employment discrimination typically do not apply to independent contractors. Therefore, the risk of discrimination lawsuits may be less when dealing with independent contractors.

Unlike independent contractors, employees are protected by a plethora of discrimination and harassment laws (including Title VII), and when disabled, are guaranteed reasonable accommodation at work.

Generally, independent contractors are subject to protection only when the contractor is harassed by an employee of the company on account of race. This is because Section 1981 of the Civil Rights Act of 1866 prohibits interference with minorities who enter into contracts and perform work under an independent contracting agreement for companies.

Employees often create a liability hazard for employers -- that can be held responsible for their acts of negligence. This liability hazard does not typically exist when dealing with independent contractors, who are generally considered to be in business for themselves.

A statement or agreement labeling an individual as an independent contractor, however, is not dispositive of that person's classification status. Accordingly, you may be liable for the acts and omissions of an individual who you classify as an independent contractor if, in fact, the person is found to be operating as an employee.

Courts employ various "tests" to determine if an individual is an employee or independent contractor in different contexts. These tests vary from jurisdiction to jurisdiction. The analysis in all of these tests is very fact-specific, and no single factor or group of factors conclusively defines the employee or independent-contractor relationship.

Generally, an employer will be liable for a worker if that worker is subject to the employer's right to control the manner and means of performing the work. Employers are not typically liable for individuals who obtain customers on their own to provide services (and who may have other employees working for them) and who are not subject to control over the manner by which they perform their services.

Accordingly, you still may be liable for a worker's acts or omissions even though you classified the worker as an independent contractor if a court finds that you exercised enough control over the individual's work and the manner in which it was done.

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The difficulty in predicting what courts will decide in these instances creates another risk associated with classifying an employee as an independent contractor. Moreover, a worker may be an independent contractor in one state but classified by the court as an employee in another.

Mischaracterizing a worker as an independent contractor creates significant legal and financial risks. The mischaracterization of workers as independent contractors rather than employees results in loss of federal, state and local revenue as well as that to Social Security, Medicare, the unemployment insurance trust funds and workers compensation funds.

Recently, enforcement authorities have intensified "crack-downs" on misclassification of employees. Employers who misclassify employees as independent contractors risk having to pay significant back wages, overtime pay, liquidated damages, tax payments, penalties and fines. This improper classification may also give rise to criminal liability to company executives.

Take-Away for Employers

Because it is often difficult to determine if a worker will be deemed to be functioning as an independent contractor instead of an employee, it is important that you evaluate the classification status of your workers carefully at the outset of the work relationship to determine whether a worker is, in fact, an independent contractor or an employee.

If you are employing independent contactors, it is always a good idea to review the arrangement, agreement and work duties with legal counsel regularly to ensure that your classification remains correct.

Keisha-Ann G. Gray is senior counsel in the Labor & Employment Law Department of Proskauer in New York and co-chair of the Department's Employment Litigation and Arbitration Practice Group.

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