Using Independent Contractors Using Independent Contractors

UsingIndependentContractorsLegal Safeguards& Compliance TipsBusinessManagementDAILYBUIC

UsingIndependentContractorsLegal Safeguards& Compliance TipsBUIC

About the AuthorsRichard Brann is former chair of the Labor and Employment Law Practice at Baker BottsL.L.P., where for 39 years he specialized in representing management in all aspects oflabor and employment law. Mr. Brann is Board Certified in Labor & Employment Law bythe Texas Board of Legal Specialization. For over 25 years he was included in The BestLawyers in America in the field of labor and employment law. Mr. Brann is a Fellow of theCollege of Labor & Employment Lawyers and is the past Chair of the Labor & EmploymentLaw Section of the Houston Bar Association and the Houston Management Lawyers’Forum. He can be reached at Richard.Brann@bakerbotts.com.Greg Guidry is a shareholder in the Lafayette, La., office of Onebane Law Firm, wherehe heads the labor and employment law practice group and is chairman of the firm. Heis licensed in Louisiana and Texas and has successfully represented management on allaspects of labor and employment law for over 35 years. His practice includes advising,training and defending employers on issues and claims related to misclassification. Mr.Guidry is past Chair of the Louisiana State Bar Association Section of Labor & EmploymentLaw, is a Fellow in the College of Labor and Employment Lawyers, and is listed in BestLawyers in America and Louisiana Super Lawyers. He is also President of the ManagementLabor & Employment Roundtable. He can be reached at guidryg@onebane.com.Authors: Richard Brann, Esq.; Greg Guidry, Esq.Past Contributors:Editor:Editorial Director:Associate Publisher:Publisher:Anniken Davenport, Esq.; Morey StettnerKathy A. ShippPatrick DiDomenicoAdam GoldsteinPhillip A. Ash© 2013, 2006, 2001, 1998, Business Management Daily, a division of Capitol Information Group, Inc.,7600A Leesburg Pike, West Building, Suite 300, Falls Church, VA 22043-2004. Phone: (800) 543-2055;www.BusinessManagementDaily.com. All rights reserved. No part of this report may be reproducedin any form or by any means without written permission from the publisher. Printed in U.S.A.ISBN 1-880024-22-5This publication is designed to provide accurate and authoritative information in regard to the subject mattercovered. It is sold with the understanding that the publisher is not engaged in rendering legal service. If legaladvice is required, please seek the services of an attorney.

ContentsExecutive Summary 1Beware Agents Bearing Compliance Checks 2Out of Harm’s Way 3A Tricky Balancing Act 4Courting Disaster 4You and the IRS 5Risky Business? 5A Fuzzy Definition 620-Factor Test Revised 6The IRS’ 20-Factor Test 7On the Plus Side 9Quiz Yourself on Some Common Scenarios 10Contractors and Hostile Work Environments 12Watch State Laws 13The IRS’ New Attitude 13Section 530 Relief 14Voluntary Classification Settlement Program 14Form SS-8: Inviting a Ruling 14The IRS on Patrol 15Compliance Check or Audit? 15Form 1099: Handle With Care 16Congress Hands You Another Weapon 17An Ounce of Prevention 19Avoid Being a Control Freak 20Converting Employees to Contractors 20Liability Insurance 21Contracts: Essential Part of Your Protection 21Courts May Overlook the Contract 22Terminating Contracts 23Sample Contractor’s Agreement 24

Overseeing the Work of Contractors 27Establish a Talent Pool 27How to Negotiate Price 28Managerial Challenges 29Protect Confidential Information 29Don’t Overlook Your Staff’s Morale 30Who Pays When a Contractor Fails? 31Related Court Rulings 33Circuits of the U.S. Court of Appeals 33Retaliation 34Mixing the Workforce: Employees and Contractors 34Employee Benefits 35Union Organizing and Entrepreneurialism 35Civil Rights Issues 36Reclassification 36Employment Discrimination 37Hostile Work Environment 37Overtime Under the FLSA 38

Executive SummaryOne misstep and you could be liablefor misclassifying workers.For employers, the practice of using independent contractors carriesobvious appeal. Contractors can accomplish much of the same workas employees while sparing employers a lot of expense and hassle.Not so obvious: Many businesses have opted to use independent contractorsonly to discover a new set of problems: lack of control, unreliableworkers and, in some cases, legal claims. And in the worst-casescenario, the IRS or another government agency may audit an employerand end up reclassifying its independent contractors as employees.From large corporations to small family-owned businesses, legal hazards linethis road to perceived efficiency. Employers that use independent contractorsmust structure their contracts to comply with the rules of several governmententities, including the IRS, the U.S. Department of Labor (DOL) and variousstate agencies. To complicate matters, each entity has its own set of rules aboutdetermining whether a worker is an employee or an independent contractor.Thus, an employer could be told by one agency that its workers are properlyclassified as independent contractors, but be informed by another agency thatits workers are misclassified.For many years, the IRS used a 20-factor test to help decide the contractor vs.employee question. In 1997, the agency revised the test to focus on three categoriesof analysis. By submitting Form SS-8 to the IRS, you may obtain a ruling onthe question. Keep in mind, however, that your contractors can request their ownrulings without you ever knowing about it.Additionally, employers must worry about regulations set forth by the DOL.For example, if a worker has been misclassified, there is a risk of an audit by theDOL’s Wage and Hour Division, and a request for payment of unpaid minimumwage or overtime under the Fair Labor Standards Act. The more workers classifiedas independent contractors, the more potential exposure for the employer.The Wage and Hour Division has a relatively simple, broad definition ofemployment: i.e., an employer “suffers or permits” someone to work. The departmentpresumes an employer-employee relationship and applies a seven-factortest to determine whether someone is an independent contractor or employee.Some employers have also run afoul of the National Labor Relations Act. Ifemployers interfere with contractors’ attempts to unionize, they may trigger aruling that the contractors are employees. Or, the employer could have its independentcontractors reclassified as employees by the National Labor RelationsBoard, and thus found subject to organizing by a labor union.1

2 / Using Independent ContractorsAnother headache: Employers that extend benefits to contractors may inadvertentlychange their status. The Employee Retirement Income Security Act, whichregulates benefit plans, has its own definition of employees as well. Also, failingto provide coverage to contractors under a benefits plan that does not clearlyexclude those specific contractors could wind up resulting in a determinationthat they should have been covered under the plan as “employees.”Employer concerns don’t end at the federal level. State government agenciesor courts, through their administration or interpretation of workers’ compensationand unemployment compensation programs, as well as other state laws,have their own definitions of employment relationships. Crossing the linebetween contractor and employee in any one of these areas can translate intoproblems all around.In this special report we’ll show you how to make your best effort to keepyour contractors truly independent. You’ll learn how to:• Follow IRS guidelines to avoid unwanted scrutiny.• Structure contracts to help your chances of successfully entering into a defensibleindependent contractor relationship.• Avoid falling into the “union trap.”• Provide benefits without inadvertently changing contractors’ status or erroneouslyexcluding covered workers.• Navigate the laws in your state.Important note: The law changes frequently in some of the areas discussed inthis report, and courts in some jurisdictions will reach different legal conclusionson what appear to be the same facts or job positions. You should always consultwith legal counsel before undertaking a course of action that might be discussedin this report, to ensure that it complies with current law in your jurisdiction.Beware Agents Bearing Compliance ChecksThe IRS has taken a great interest in employers that use independent contractors,and is committed to ending misclassification in the workplace. Nevertheless, youdo have rights.First, the IRS has the burden of proof when parsing the factors surrounding anindependent contractor’s work. If you designate someone as an independent contractor,the IRS must prove, by a preponderance of evidence, that the person is anemployee. Otherwise, your assessment stands.Second, if the IRS does reclassify your contractors as employees, it’s not the endof the world. Under Section 530 of the IRS code, you’re entitled to tax relief forprevious taxes on those workers as long as you had classified them in good faithand met other requirements. Note that there have been several bills introduced inCongress in recent years that would remove this “safe harbor.”Third, disputes over worker classification are resolved in the Tax Court, andemployers don’t have to pay taxes on those workers until their cases are decided.

Executive Summary / 3Out of Harm’s WayHow can you take steps to maximize the chance that the government won’tswoop down and change your contractor’s status? And how can you avoid beingsuccessfully sued by a contractor who claims he’s an employee entitled to overtimeor other benefits?Some preventive steps you can take:■ Enforce the worker-status rules uniformly. Be consistent in how you categorizeeveryone within the same class of workers, and send 1099s to all contractorsto whom you paid more than $600 in the tax year.■ Re-examine your benefits policy. Many companies are rewriting their benefitsplans so that the plans explicitly exclude contingent workers.They’re reacting, in part, to a 9th Circuit ruling that went against Microsoft Corp.,which was ordered to include a group of contingent workers in its 401(k) plan,which was open to all employees. Even though the computer programmers hadsigned documents stating they were independent contractors, the court orderedthat they be reclassified as Microsoft employees. (See details on page 5.)■ Have an accountant or lawyer certify your worker classifications. Obtain aletter from your accountant or lawyer affirming your workers’ status. This documentwill help demonstrate that you made a good-faith effort to comply with thelaw, even if the IRS or a court later determines that there was a violation.■ Sign a contract. Although formal contracts with freelancers or contractorswon’t offer total protection, they can reduce the odds that you’ll face tax penaltieswhen the IRS comes calling.The contract should include a description of the work to be performed, howmuch you will pay, the project’s deadlines, a statement that no benefits will beprovided and, if necessary, a confidentiality clause to protect proprietary information.(See discussion of other important points to include in your contract laterin this report.)■ Keep your distance. Don’t try to control how and when contractors carry outtheir tasks. The more control you exert, the more likely it is that they will bereclassified as your employees. You should be concerned only with the end result,not with the means and methods used by your contractors.The IRS scrutinizes employers through compliance checks and audits. It’simportant for you to know the difference. Less formal than full audits, compliancechecks are a quick perusal of payroll records and working conditions toensure that you’re properly classifying workers. Audits, by contrast, are farmore in-depth.

4 / Using Independent ContractorsYou have the right to know which type of check the agent is performing, aswell as your rights in each situation.Caution: One sure way to get audited is to file 1099-MISC forms late or haphazardly.A well-organized, clear 1099 file will attract less attention from eitherIRS agents or the courts reviewing classification issues.A Tricky Balancing ActIn the world of independent contracting, balance is the name of the game. Youmust balance federal and state requirements to keep contractors truly independentwhile meeting your labor needs. One misstep and your contractorsbecome employees entitled to everything you provide for employees: such asminimum wage, overtime and FMLA leave. The hottest flashpoint: Managerswho control and micromanage contractors’ actions too much may end up turningthem into employees.Finally, remember, there’s no “one size fits all” solution. Some jobs are suitablefor contractors; others aren’t. It’s better to allow your employees to performjobs requiring specific expertise that you already have in-house or jobs that youmust tightly monitor. Look at all the factors and choose the right approach foreach project.Courting DisasterIf the government doesn’t challenge you, the workers may. Disgruntled contractorsmay look for a way to settle the score, such as proving that they are youremployees. Then they can sue you for overtime, workers’ compensation benefitsor damages for discrimination under various federal and state laws that protect“employees” but not independent contractors.In these cases, all employment practices come under the court’s scrutiny. Themajor court cases cited at the end of this special report will give you a generalsense of how and why judges are ruling on independent-contractor law and howtheir decisions affect you.

You and the IRSThe agency claims that 80%of contractors are misclassified.Did you ever write a check for $96.9 million? Microsoft did whenthe IRS reclassified 12,000 independent contractors as its employees.The 9th Circuit Court of Appeals sided with the workersagainst some of the best legal talent money could buy. When the U.S.Supreme Court refused to hear the case, Microsoft opened its checkbook.It’s tempting to outsource work to freelancers. No employment taxes, no workers’compensation, just pay for the project. But the contractor to whom you shiftthat responsibility may not fully understand the situation. If you mislead himor make promises you can’t keep without turning him into an employee, you’reheaded down a dangerous path.Further, you should view your relationship with independent contractors inthe context of your total business operation. Microsoft lost because it could showno real difference between its employees’ and the freelancers’ situations. As aresult, the court concluded they all were entitled to the same benefits.Risky Business?More than half of all businesses use independent contractors, according to aBureau of National Affairs study. It’s easy to see why freelancers are popular.According to a U.S. Chamber of Commerce study, for each full-time employee’ssalary, employers pay an additional 9% in Social Security, workers’ comp,unemployment and disability insurance; another 19.9% in vacation time, sickleave and paid breaks; and a whopping 35.6% in pensions, health insurance andother benefits.Another plus for compliance-conscious employers: Many statutes, such as TitleVII of the Civil Rights Act, the Americans with Disabilities Act and the Familyand Medical Leave Act, don’t apply to freelancers.But the IRS knows this all too well. In fact, the agency claims that 80% of workerscurrently classified as independent contractors are really employees. Thatmeans IRS auditors believe that you’ve probably misclassified your workerswhen they walk in the door. You have to change their minds.The IRS is charged by Congress to collect the nation’s taxes. Everyone knowsthat some taxes aren’t collected or are collected late. The difference between whatthe IRS should collect and what it doesn’t is called the tax gap. For 2006, the latestyear available, the IRS calculated the tax gap as $385 billion. With skyrocketing5

6 / Using Independent Contractorsdeficits, the pressure is on to collect it. Unfortunately, it all rolls downhill and isheaded toward you if you hire independent contractors.Remember, it’s far easier for the IRS to audit you than your contractors.Your books lead to them anyway, which makes you No. 1 on the IRS hit list.Employers that use independent contractors have also become the target ofstate taxing and other agencies, which are also fighting declining revenues andsee misclassification enforcement as another source of revenue for state coffers.At the time of publication, at least 14 states had entered into Memoranda ofUnderstandings with the IRS and federal Department of Labor to collaborateon enforcement efforts directed at misclassification. That’s why you better haveeverything in order.A Fuzzy Definition“The big question in deciding who’s an employee or an independent contractordepends on whether the employer can control the employee,” says William R.Rodgers, partner with the Boston law firm Tarlow Breed Hart & Rodgers. “Thewhole issue turns on the matter of control.”Sounds simple enough. But as Rodgers and otherlawyers have found, there’s no concrete way to measure“The whole issueturns on the matterof control.”the extent to which an employer exercises control over aworker.In recent years, the “best” tool to help employers figurethis out had been the IRS’ notorious 20-factor test (see box,page 7). When answered in the affirmative, these 20 questionsmade it more likely that the IRS would classify anindividual as an employee, not as a contractor. Yet this20-point test is about as clear as mud. Because the test is subjective and no singlefactor on its own conclusively proves anything, this definition created frustrationand uncertainty for employers, workers and tax collectors. “It’s a very contentiousarea, and it always has been,” Rodgers says.20-Factor Test RevisedOver the years, the 20-factor test steadily lost ground in the courts and inCongress. Recognizing this, the IRS announced in 1997 that it would begininstructing its auditors to apply a somewhat simpler set of standards. The IRSwants to make more worker-status determinations that will stick.The latest guidelines set forth three main categories of evidence that the agencythinks are most important in making the determination. Within those main categoriesare 10 questions that IRS auditors now focus on to determine status.The list includes eight factors from the old test (Nos. 1–8 in the 20-factor test onpage 7), plus two new ones:• Does a written contract exist that describes the relationship the parties intend to create?• Does the business provide the worker with employee-type benefits?

You and the IRS / 7The IRS’ 20-Factor TestFor years, the IRS had relied on this 20-factor test to determine whether a workeris considered an employee or an independent contractor. Although the IRS hasmoved to a different analysis, as discussed previously, this checklist can still beuseful in analyzing your contractor relationships.The more questions you answer “no,” the easier it is to prove that the worker isa bona fide contractor.1. Did you train the worker to perform the services for you?2. Did you give the worker instructions on where, when and how the work isto be performed?3. Is the worker protected from losing money as a result of providing servicesto your company?4. Is the worker prohibited from providing services to the public at large?5. Do you pay for the worker’s business expenses?6. Does the worker provide services to your company on an ongoing basis?7. Do you pay the worker by the week, month or hour?8. Are the services the worker provides essential to running the company?9. Do you establish work hours for the worker?10. Does the worker provide services on a full-time basis for your company?11. Does the worker provide services at your company’s facility?12. Do you provide equipment, tools or other supplies to the worker?13. Have you purchased equipment, tools or other supplies for the worker?14. Is the worker responsible for completing progress reports to your company?15. Do you prohibit the worker from delegating tasks to others?16. Is the worker prohibited from hiring assistants?17. Does the worker provide services exclusively for your company?18. Can the worker terminate the relationship with your company withoutpenalty?19. Is your company able to fire the worker at will?20. Does your company control the order and the way in which the work isdone by the worker?Following is an abbreviated synopsis of each factor, as summarized with permissionby Vern Hoven, CPA, of The California Enrolled Agent magazine:

8 / Using Independent ContractorsI. Does behavioral control over the worker exist?Behavioral control focuses on how the worker receives instructions for performingthe work. Factors include:1. To what extent are instructions given and taken? Generally, an employeeis subject to the business’s instructions about when, where and how to work; anindependent contractor isn’t. Even if no instructions are given, sufficient behavioralcontrol may exist if the employer has the right to control how work results areachieved. Pertinent evidence includes: (1) needing prior approval before proceedingwith the work, (2) rendering services personally and (3) hiring, supervisingand paying assistants.2. What training does the business provide to the worker? Employees may betrained to perform services in a particular manner. Independent contractors ordinarilyuse their own methods. The company’s orientation course, safety seminarsand voluntary unpaid educational programs are to be disregarded.II. Do financial controls over the worker exist?These factors illustrate whether there’s a right to control how the business aspectsof the worker’s activities are conducted:3. Can the worker realize a profit or incur a loss? A contractor can make aprofit or loss, whereas an employee can make only a profit. The IRS discloses thatthe worker’s dependence on the job isn’t a factor.4. Is the worker’s investment significant? An independent contractor oftenhas a significant investment in the equipment or facilities he uses in performingservices for someone else. However, a significant investment isn’t required.Pertinent evidence would include: (1) amount of unreimbursed expenses,(2) payment of business and/or travel expenses, (3) furnishing of tools andmaterials and (4) analysis of lease arrangements between the worker and thebusiness. The IRS has listed expenses expected to be found on the taxpayer’sbusiness return.5. To what extent does the worker make services available to the public?Pertinent evidence includes: (1) Yellow Pages advertising, (2) working for morethan one firm and (3) identifying cases in which advertising isn’t required, e.g.,word-of-mouth advertising.6. How does the business pay the worker? An employee is generally paidby the hour, week or month. An independent contractor is generally paid a flatfee or on a per-job basis, even though it’s common in some professions, such aslaw and accounting, to pay hourly. The payment of commissions indicates bothare possible.III. What type of relationship exists between the parties?These factors illustrate how the worker and the business perceive their type ofrelationship:7. Does a written contract exist that describes the relationship the partiesintend to create? This is a new factor generally considered of lesser importance

You and the IRS / 9On the Plus SideThe primary reason most employers use contractors is their desire to keep personnelcosts down. There are other reasons as well:■ You don’t normally pay for downtime. When a full-time employee showsup for work, you pay him whether he’s busy or not. But a contractor typicallygets paid only for the time he spends working. Many firms pay contractors bythe job rather than by the hour, so it’s in the contractor’s best interest to finish aproject as quickly as possible. Inevitably, an independent contractor’s rate willreflect some of his overhead expenses, including downtime. However, assumingyou use an established contractor with a broad client base, those costs will bespread out among several customers.By contrast, with a full-time employee, you bear all the overhead expenses.■ Supervisors don’t spend as much time on training. Although managers stillhave an important role in selecting contractors and overseeing their work, theirinvolvement is usually far less intense than with a full-time employee.■ You save what you’d otherwise spend on office space, electricity, equipmentand phone lines because contractors usually work out of their own facilities. Insome businesses, such as travel agencies and real estate firms, contractors evenrent space from the company that hired them.■ You can shrink or expand your labor force to match the work at hand insteadof maintaining a permanent staff that may, at regular intervals, be underutilized.■ You can “audition” potential employees. Find an independent contractor youwould like to add to your full-time staff and you’ve spared yourself the expenseof recruiting and advertising for job candidates, as well as interviewing and testing.For example, the cost of filling a job opening the traditional way can runas high as $4,900 for a technical position, such as an engineer, according to aJournal of Accountancy study.by the IRS (but more important by the courts!) as the substance, not the label, governsthe worker’s status. A written contract contains other evidence: for example,the method of compensation, which expenses are reimbursed and how the workis to be performed.8. Does the business provide the worker with employee-type benefits, suchas insurance, a pension plan, vacation pay and sick pay? Employee benefits arepaid only to employees. The IRS surprisingly discloses that W-2s don’t necessarilyindicate employee status; incorporated workers generally won’t be recharacterizedas the business’s employees; and state law determination (or someother government or industry-imposed regulation) isn’t a relevant indicator ofemployer-employee status.(Continued on page 11)

10 / Using Independent ContractorsQuiz Yourself on Some Common ScenariosThe following situations typically arise when firms use contractors. Often, thefirms don’t think twice about the arrangement—until the IRS or other governmentagency challenges how they classified the workers. Test your knowledge of theworker’s status in these scenarios:1. A company purchases supplies for the contractor to use in his work for thecompany. Let’s say the company hires a contractor to landscape its grounds.The company is able to purchase sod at a lower rate than the contractor anddoes so as a favor. The contractor provides all the labor and submits an invoicewhen the project is completed. Further, the contractor (not the company) determineshow to undertake and complete the project. Will this scenario raise anyred flags with the IRS?Answer: The IRS will most likely cite the purchase of the sod as an exampleof the company’s interfering with the contractor’s purchasing prerogatives andtherefore a factor supporting employee status.➤ Recommendation: Don’t purchase or provide any supplies or equipmentfor contractors. This includes items you no longer use and outdated or surplusequipment. You can, however, sell or rent these items to the contractor.2. A company lends equipment or personnel to the contractor. The companyhires an independent contractor to reprogram all its computers. It suggests thatthe contractor work with the on-staff computer “guru” so that the contractor cansave time and focus on the more difficult aspects of the reprogramming. Willthis affect the contractor’s status?Answer: The IRS may conclude that the contractor is an employee if the companyis continually involved with the project and controls how it is done.➤ Recommendation: Once you hire a contractor and give him or her the assignment,your involvement should be minimal until the project is completed. It’sfine to establish an early due date during the course of the project to make surethat the goods are delivered as you specified. (Remember that you do have controlover accepting or rejecting the finished result.)3. A company provides ongoing supervision of a contractor’s performance. Thecompany hires a painter to do the walls in a suite of offices. The office administratorchecks on the painter’s work every hour, telling him that the trim is thewrong color or pointing out when he’s missed a spot. Is the employer paintinghimself into a corner?Answer: The IRS could use the administrator’s close supervision as evidence ofan employer-employee relationship.

You and the IRS / 11➤ Recommendation: You must trust your contractors to supervise their ownwork until the initial due date. If the work is below expectations (or the contractorfails to meet the deadline) at that point, you can criticize it or terminate thecontract.4. A company requests that, for the duration of the contract, a contractor workonly for its company. After hiring an independent contractor to build additionaloffices, the company asks him not to take on any additional work until the officesare completed. Is that a good idea?Answer: The company is limiting the contractor’s ability to offer his services onthe open market—this is a factor supporting employee status.➤ Recommendation: Before you hire the contractor, determine how much timethe project will take, and set realistic deadlines. If the contractor has other clientswhose demands conflict with yours, it’s up to him to balance his workload. Hemay very well choose to subcontract out part of the job. If your goal is to keepthe contractor from revealing a trade secret, you can require him to sign a confidentialitypact as part of the contract.5. A company provides continuous, ongoing work for a contractor. A freelancearchitect is hired by a company to do some planning for future building sites.The architect’s work is so good that the company asks her to stay on indefinitelyas an independent contractor to handle additional design duties. Is she still afreelancer?Answer: Again, the IRS might find that the independent contractor has beenconverted to an employee under these facts.➤ Recommendation: Work assignments with contractors must be on a per projectbasis, with all subsequent work assigned in that manner. Ideally, each assignmentshould be a separate relationship between the contractor and the hiringcompany.(Continued from page 9)9. How permanent and ongoing is this relationship? Permanent and indefiniterelationships indicate an employer-employee relationship, whereas, the IRSreveals, long-term and temporary relationships aren’t important evidence (that is,contractors can have long-lasting relationships).10. To what extent are the services performed by the worker a key aspect ofthe regular business of the company? Is the success of the business dependent,to an appreciable degree, on the worker’s performance? If so, that’s an employeremployeerelationship. For example, restaurants need cooks and cashiers and lawfirms need lawyers, so these workers are generally employees. By contrast, eventhough it’s essential for an appliance store to retain good accountants, bookkeepingcan be done equally well by independent contractors or employees.

12 / Using Independent ContractorsContractors and Hostile Work EnvironmentsEmployers are ultimately responsible for hostile work environments. This applieswhether the independent contractor is the perpetrator or the victim of a hostileenvironment. For example:A Mexican-American owner of a company hired to clean parking lots atWalmart complained of several racially motivated incidents, including someonepainting the words “White Supremacy” on the parking lot. He sued under Section1981 of the Civil Rights Act of 1866, which bars racial discrimination incontracting, and he was awarded $300,000. Danco Inc. v. Wal-Mart Stores Inc.,Nos. 98-2101 and 98-2269 (1st Cir. 1999)Note: The U.S. Supreme Court has limited the rights of agents and corporationsto sue under Section 1981, which it said protects only the rights of individuals.Domino’s Pizza Inc. et al. v. McDonald, No. 04-593 (2006 U.S. Lexis 1821)Conversely, a female nurse at a small hospital complained of harassment by adoctor whom the hospital engaged as an independent contractor. The hospitalmaintained it wasn’t responsible for his harassing behavior because he was acontractor. A federal appeals court disagreed, stating, “The employer’s responsibilityis to provide its employees with nondiscriminatory working conditions.”Dunn v. Washington County Hospital and Coy, No. 05-1277, 429 F. 3d. 689(7th Cir. 2005)Factors now considered less importantThe IRS de-emphasized its focus on several other factors that were previouslyused in the 20-factor test, including:1. Does the client/customer have the right to discharge the worker?2. Does the worker have the right to terminate the relationship?3. Can the person work part time or is full time required?4. Must the worker perform the work on the employer’s premises?5. Who sets the hours to be worked?6. Must the worker perform the work in an order or a sequence?7. Does the person work for only one business?The IRS has completely eliminated one factor from the old test: “Are interimoral or written reports required?”

You and the IRS / 13Watch State LawsDon’t overlook state laws that may provide even more stringent definitionsof independent-contractor status. It’s not unusual for a state unemploymentor workers’ compensation board and the IRS to disagree on a worker’s classification.Also, be aware that as part of the focus on attacking misclassification, numerousstates have recently enacted laws imposing new and more onerous penaltieson violations, including criminal sanctions. For example, in 2012, Louisianaamended a section of its unemployment compensation statute to provide forfines, debarment from state contracts and even imprisonment for multiple violationsinvolving misclassification of workers. The same law requires all employersto display a poster on employee bulletin boards, advising workers that it is aviolation of the law to be improperly classified as an independent contractor, andproviding workers with information on whom to contact if they feel they havebeen misclassified as contractors.In some states, companies must prove that their contractors (1) are free fromany control exercised over their work by the companies that hire their services;(2) have an off-site place of business or office; and (3) have an independentlyestablished business. Although these criteria seem remarkably simple comparedwith the IRS’ common-law test, the states with this test require that all three conditionsbe fully satisfied. Also, keep in mind that the IRS is often prompted toinvestigate an employer after the state classifies its contractors as employees.When hiring a contractor, you’re less likely to be entangled in the federalanti-discrimination laws, such as Title VII, the Civil Rights Act of 1991, the AgeDiscrimination in Employment Act, the Pregnancy Discrimination Act and theAmericans with Disabilities Act. However, state laws in your area may supersedethe federal statutes and extend discrimination protection to contractors.Check with your state labor office or local legal counsel for the provisions in yourarea. In addition, if your company is a federal contractor or subcontractor, additionalobligations may apply to your business.The IRS’ New AttitudeWhile no sweeping laws have solved the problem, some positive developmentshave made it possible for employers at least to proceed on more solid ground.Besides shifting gears on the 20-factor test discussed earlier, the IRS now has theburden of proof when it interrogates an employer about its worker classifications.Before the Small Business Job Protection Act of 1996, the onus was on theemployer to prove that the individual didn’t qualify as an employee. But the lawdoes prohibit employers from relying on a prior audit to validate the classificationunless the audit specifically examined the worker’s status.

14 / Using Independent ContractorsSection 530 reliefUnder revised IRS training manual guidelines, its agents must inform you ofyour right to so-called Section 530 relief. The law provides you with immunityfrom back taxes if the IRS reclassifies your contractors as employees. However,employment law experts say many employers miss out on the tax break becauseagents fail to explain it fully. If an agent doesn’t provide you with a copy of IRSPublication 1976 (Rev. 05-07), he or she is breaking the rules.While Section 530 does provide for back tax relief, the IRS will still require youto convert those workers to employees and begin paying payroll taxes. To be eligiblefor Section 530 relief, employers must prove that they:• Had a “reasonable basis” for treating the workers as independent contractors.“Reasonable basis” is further defined in IRS Publication 1976.• Regularly filed a Form 1099 for each worker.• Consistently classified all workers with similar jobs as independent contractors—neveras employees.To obtain a copy of Publication 1976, contact your local IRS office or go onlineto www.irs.gov/pub/irs-pdf/p1976.pdf.Voluntary Classification Settlement ProgramAlso, the IRS recently launched an initiative to allow employers to pay greatlyreduced back taxes if they agree to reclassify their workers prospectively. Theprogram, called the Voluntary Classification Settlement Program (VCSP), waslaunched in 2011, and currently at least 1,000 employers have decided to participatein this tax “amnesty” program.The employer must meet several tests to qualify for the program (see details atwww.irs.gov/form8952). Employers are advised to consult with experienced taxand labor professionals about the advisability of participating in this program,since there could be several unintended consequences resulting from your misclassificationagreement with the IRS, including claims or investigations by laboragencies or your reclassified workers.Form SS-8: Inviting a rulingDespite these steps to simplify the process, many employers still find it dauntingto classify their workers. Employers can ask the IRS to make a determinationabout their classification decisions by using Form SS-8, “Determination ofEmployee Work Status for Purposes of Federal Employment Taxes and IncomeTax Withholding.”Employers that submit this completed four-page form receive a written rulingfrom the IRS on whether an individual qualifies as an independent contractor.The form was revised in 2011, and among other things, it asks questions relatedto the new IRS three-factor analysis (see page 6). “The form isn’t well knownbecause a lot of employers don’t want to draw attention to their situation,” says

You and the IRS / 15attorney William Rodgers. “Essentially, it’s a request for an IRS ruling, and someemployers would rather not go through all that trouble just to tell the IRS somuch about their business.”In some cases, angry workers who think they’ve been misclassified by theiremployers as independent contractors will file Form SS-8 to clarify their status.Although the individuals will receive an IRS ruling, they will also probably irritatetheir employer for attracting the IRS’ attention. Nevertheless, about 95% ofthe Forms SS-8 filed are from individuals, according to the IRS. (To access theform, go to www.irs.gov/pub/irs-pdf/fss8.pdf.)The IRS on PatrolVirtually every taxpayer dreads an IRS audit. For employers, it’s even worse. IRSagents can scrutinize your company’s books for days, demand reams of documentationand even interview dozens of individuals before making a ruling.The IRS has only one chance to audit the same workers. That’s because the socalledprior-audit rule prohibits the feds from coming back and challenging thestatus of the same people again. But beware: Because the prior-audit rule (alongwith provisions in the Small Business Job Protection Act) makes it harder for theIRS to prove that workers are employees, tax investigators have designed a procedurethat legally gives them another shot at your firm. Called a “compliancecheck,” it’s not officially an audit, so you’re not facing as much potential liability.But business owners and managers alike should know the difference.Compliance check or audit?When the IRS contacts you to inspect your employment records on worker classification,your first question should be: Is this a compliance check or an audit?Here’s how to tell the difference:■ Compliance checks. Basically, a compliance check is just a pop quiz on howyou keep your payroll records. Under this procedure the IRS can:• Check your math on certain IRS forms you’ve completed (Form 1099 for contractorsand Forms W-2, 940 and 941 for employees).• Ask you to correct errors.• Determine if the forms are completed and filed properly.• Ask if you understand the payroll record-keeping rules and provide furtherinformation.During a compliance check the IRS can impose penalties for misfiled records,but this isn’t likely to happen.■ Audits. The stakes get higher when the IRS launches a full-scale investigationof how you use and classify workers. During an audit the agent can:• Examine all your books and records.

16 / Using Independent ContractorsForm 1099: Handle With CareThe information you record on Form 1099 is a top audit target. Be sure yourrecords are in order when the IRS comes to call.You must file Form 1099 for every independent contractor to whom you’ve paidmore than $600 a year. The form must also be mailed to each contractor the followingyear, postmarked by Jan. 31.If you mailed your 1099s on time and filed them properly in house, you have agood chance of avoiding retroactive payroll taxes even if an auditor reclassifiesyour freelancers as employees. What’s the auditor looking for?Here’s a checklist of common slip-ups:✔ The number of 1099s on file doesn’t match the number of contractors whowork for your firm.✔ You have certified mail receipts to show that you mailed the forms on time, butyou don’t have copies of all the forms on file.✔ You have all the forms on file, but you’re not able to show that you mailedthem on time.✔ The payments recorded on your 1099s don’t match your accounting records.Of course, the IRS reviews other criteria. But if your 1099s are misfiled, youmight be ineligible for other exclusions, and if so, you might get hit with threeyears’ worth of back payroll taxes. Even if the IRS approves the status of yourworkers, misfiled 1099s will cost you up to $50 per form.➤ Recommendation: When you mail your Forms 1099, be sure to include thephone number of someone in your organization who can answer questions fromcontractors. If you forget to include the phone number, you’ll pay a penalty ofup to $50 per form.• Interrogate you in detail about the relationship between your freelancers andyour full-time staff.• Suggest which staffers should be treated as contractors and which should beconsidered full-time employees.• Determine whether you’ve calculated all your tax liabilities correctly.• Determine whether employee reimbursements or fringe benefits you’ve paid aretaxable.In some cases, a compliance examiner might slip into an audit withoutwarning. If you notice the IRS agent crossing the line into audit territory, takethese steps:

You and the IRS / 17• Inform the agent that he or she is now conducting an audit, not a compliancecheck.• State that you intend to claim your prior-audit right if you are audited inthe future.• Demand a full audit report so that your contractors are shielded under the priorauditrule.If you’re audited a second time within a few years, the IRS is allowed to examineworkers who perform jobs different from those who were investigated duringthe prior audit. But if certain workers were deemed contractors during the firstaudit, the IRS can’t change its mind this time and reclassify them as employees.Congress Hands You Another WeaponFighting an IRS audit’s reclassification of your independent contractors wasmade easier via a small provision buried in the Taxpayer Relief Act of 1997,which allows you to take your classification disputes to U.S. Tax Court. Why isthis important? Previously, to fight an IRS reclassification, you had to pay all or aportion of the tax due, then sue the IRS for a refund in a federal district court orthe U.S. Court of Federal Claims.Now, if the IRS reclassifies your freelancers as employees, you don’t have topay any of the assessed tax upfront. Instead, collection of any taxes or penaltiesis suspended pending a decision from the Tax Court—a big benefit if your cashflow is tight.Other benefits of going to Tax Court:• Save time. Previously, you would find yourself in two separate courts if therewas a related retirement plan conflict. Now, the Tax Court can settle both issues.• Lower your legal fees. You can be reimbursed for professional fees (accountant,attorney and so forth) if you prevail in Tax Court. Also, if the payroll tax disputeis $10,000 or less for each quarter, you can use the Tax Court’s less formal smallcaseprocedure. This way, you can argue your own case without incurring legalfees. The downside: Small-case decisions can’t be appealed.➤ Recommendation: IRS Publication 15-A, Employer’s Supplemental Tax Guide,includes a section on deciding independent-contractor status. You can access theguide at www.irs.gov/pub/irs-pdf/p15a.pdf.

An Ounce of PreventionTo avoid government scrutiny, keepyour contractors truly independent.As previously mentioned, your problems with independent contractorsdon’t end with the IRS. A host of other agencies, state aswell as federal, weigh in. For example, the Department of Laborhas been known to sue on behalf of employees whose employers claimthey’re independent contractors.The law books are full of recent decisions involving enforcement lawsuits filedby the DOL against employers that misclassified their workers. The settlementsand awards have involved huge numbers, often in the six or seven figures. Keepin mind, if you are successfully sued under the Fair Labor Standards Act, youcan be liable for unpaid overtime for up to three years, liquidated damages (doublethe back pay) and attorneys’ fees in private litigation lodged by employeesand their attorneys.Also, pay attention to these issues to avoid messy lawsuits later:■ Communicate your benefits policy. When distributing your benefits planinformation, have independent contractors and leased employees acknowledgein writing that they aren’t covered, and ensure that your benefits plan clearlyexcludes this category of worker.■ Have an accountant or an attorney certify your workerclassifications. For extra protection, ask your accountantand/or lawyer to provide a letter rendering an opinionabout your workers’ status. You can use this document asevidence that you relied on professional advice. While itmay not free you from liability, it will demonstrate thatyou made a good-faith effort to comply with the law.Contracts reducethe odds of facingtax penalties.■ Compose a contract. While formal contracts with independentcontractors don’t offer total protection, they can help reduce the oddsthat you’ll face tax penalties when the IRS comes calling, and they can help createevidence supporting contractor status. The contract should describe the work to beperformed, the duration of the agreement and the amounts paid to the contractor.It should also state that no benefits will be provided and that the contractor isresponsible for paying federal and state taxes.In addition, have contractors sign an acknowledgment that they have compliedwith applicable business licensing requirements and maintain their ownemployment records.19

20 / Using Independent ContractorsAvoid Being a Control FreakIndependent contractors are viewed as small businesses that just happen to bedoing work for your company: for example, construction workers, janitorialservices, software designers and independent sales reps. If they choose to dothe same kind of work for your fiercest competitor, that’s none of your business(unless company secrets are at risk).The more you control how and when the contractors carry out their tasks andwhether they may work for a competitor, the more likely they will be seen asemployees.Example: Suppose your company hires two college students who have advertisedtheir services to paint your offices over the summer. You want to classifythem as independent contractors to avoid having to pay employment taxes orprovide benefits and to avoid risking liability under civil rights laws. Besidesinforming them of the arrangement and having them sign a statement to thateffect, take the following steps:• Require them to provide their own equipment and supplies. Don’t give theman expense account.• Allow them to choose their own work schedules within a general time frame(say, tied to your office hours or to your deadline for completing the project).Don’t say, “You’re allowed only an hour for lunch.”• Don’t supervise their work beyond expected standards of quality.• Don’t have them perform the same jobs as your employees.• Let the contractors decide whether to hire assistants.• Don’t withhold taxes or provide benefits.You’ll be on even safer ground if the contractor has several clients—or is biddingfor work from other customers—while he or she is working for you. “Askthem if they’re doing work for several other companies, have their own officeand so on,” says Michael Avakian, general counsel for the National Center onLabor Policy. “It’s the employer’s neck that’s on the line.”Converting Employees to ContractorsSome employers, so enamored with independent contractors, are replacing theiremployees with them. But unions, courts and the DOL haven’t looked kindly onthe practice.In a case that has resonated through the courier business, in 2005 a Californiajudge ordered FedEx to pay $5.3 million to California drivers whom the companyhad terminated and then hired back as independent contractors. The drivers then

An Ounce of Prevention / 21became responsible for fuel, oil, tires, repairs and liability insurance. The driversfiled a class-action suit, and the judge found in their favor.Clearly, converting employees to independent contractors is a risky move. Youmust carefully map out the process and take into consideration:• The IRS’ rules• Your company’s union situation• Regulations in the Fair Labor Standards Act• Your state labor department• State unemployment and workers’ compensation rulesMake surecontractors carrytheir own insurance.Liability InsuranceA contractor who carries his own insurance, is bonded or is otherwise licensedheightens his credibility as an independent vendor of services. Because mostindependent contractors work off site and carry their own liability insurance,including workers’ compensation coverage, there’s little or no risk to your firmof employment-related liability. But there’s always the potential that you will beheld responsible for someone’s injury, especially if a contractor works on site as,for example, a painter or an electrician.Liability can still be altered by agreement, according to Ronald Goldfarb ofGoldfarb & Graybill Associates. “There are no fast answers because this is a complicatedarea,” he says. And even if a contract assigns liability to the contractor,an employer that knowingly acts in a negligent manner could still be heldaccountable.➤ Recommendation: Hire only contractors who can prove they carry all applicableinsurance themselves (including workers’ compensation coverage), especiallyfor jobs where hazards are involved. Consult your company’s legal adviserfor assistance in tailoring all contracts with independents specifically to protectyour company from potential liability.Contracts: Essential Part of Your ProtectionYour contract with an independent contractor establishes payment rates andmethods, the nature of the work to be completed, the deadline for completing thejob and performance standards. No matter how casual the relationship or howwell you know the contractor, you should always have a signed contract describingthe work to be done. Here’s why:• It helps establish that your intent was to hire the individual as a contractor,not as an employee. The contract won’t prove a bona fide contractor relationshipexisted, but the lack of a contract makes it extremely difficult to prove sucha relationship existed.

22 / Using Independent Contractors• It offers you protection should the contractor’s work be unacceptable in someway. If a disgruntled contractor sues you and there’s nothing in writing, it’s upto the court to decide whether the terms of the contract were met.• Most reliable contractors will insist on a contract. After all, the contract representsthe contractor’s best protection as well.Some contracts include clauses that allow either the contractor or the contractingfirm to cancel the arrangement with a penalty. For example, contracts withwriters often include “kill fees,” which stipulate that if the publisher decides notto run an article, the writer will be paid only a percentage of his or her fee. Otherclauses include confidentiality pacts, whereby contractors agree not to revealdetails of their work for a company.Remember: Although the contract affirms your intent to hire the individualas a contractor and not as an employee, an IRS inquiry would focus on how thecontractor performed the work. Thus, the safest course is to ensure that yourcompany’s supervisors understand that they must produce a quality end productwith only minimum involvement with contractors.Labor and employment attorneys Richard Brann, of Baker Botts L.L.P., andGreg Guidry, of Onebane Law Firm, suggest the following checklist of items toinclude in your written independent contractor agreement:1. State specifically that the parties all agree that the contractor is indeed an independentcontractor, agent or consultant, and that he or she is not an “employee”for any purposes.2. Describe the services to be provided.3. Limit “control” provisions, particularly over manner and means of per formance.4. Emphasize the authority of the contractor.5. Describe the method of payment.6. Set out the contractor’s responsibility for taxes.7. Describe the term of the contract and circumstances for early termination, withthe best term being on a project basis.8. Set out the contractor’s responsibility for equipment and benefits.9. No exclusivity—make it clear that the contractor is free to perform workfor others.10. Require the contractor to have the required licenses and proper insurancecoverage.Courts May Overlook the ContractContracts are your first line of defense, but they may just be a paper wall. Morethan likely, any court or agency case is going to focus on the particulars of thework relationship, not on the contract.

An Ounce of Prevention / 23For example:■ Microsoft had contracts with all its freelancers, but ultimately they didn’t helpits defense. A court concluded that the contractors were performing the sametasks as employees and ordered them to be reclassified. This entitled Microsoft’s12,000 freelancers to participate in its lucrative 401(k) plan. Vizcaino v. MicrosoftCorp., 97 F. 3d. 1187 (9th Cir. 1996)■ The DOL sued Time Warner for not making temporary workers permanentafter they had worked for the company for six months. Although it was TimeWarner’s stated policy to do so, it failed to follow the policy and the DOL intervened.While the company denied any wrongdoing, it did pay $5.5 million to themisclassified workers.Similarly, if you provide benefits to independent contractors, you may riskmisclassification as well.Example: A brokerage house offered disability insurance to its independentcontractorfloor traders. When one of them filed for benefits, the insurer deniedthe claim because the policy covered only employees who worked 30 or morehours per week. The man sued, and the court ruled that independent contractorscan be beneficiaries of ERISA benefit plans. According to the court, thecompany erred when adopting the policy because it had been purchased forthe purpose of insuring independent contractors.Terminating ContractsIn theory, any person may enter into a contract with anyone and terminate thecontract in accordance with its provisions.But as recent court cases have shown, terminating contracts with contractorsexposes employers to some of the same risks as firing employees, depending onthe law in your jurisdiction.Case in point: A director of a state hospital refused to renew the contract of apsychiatrist who had criticized the hospital administration. The psychiatrist sued,arguing he was singled out because of his comments. Since the employer was agovernmental entity, he argued that it had violated his First Amendment rights.In addition, he claimed that he was disparately treated because of his criticism.The court agreed. Springer v. Henry et al., No. 04-4124, 2006 U.S. App. Lexis 1346(3rd Cir. 2006)Private employers may not terminate or refuse to renew contracts of “troublemakers”if they don’t treat other contractors the same way. Since disparate treatmentis a civil rights issue, you should never terminate a contract based on theperson belonging to a protected class (e.g., race, gender, religion, age, nationalorigin or, in some jurisdictions, sexual orientation).Finally, keep in mind that employer liability for the actions of independentcontractors is an extremely fluid area of the law. Employers should structure contractsto limit liability for their contractors’ actions and require them to carry theirown appropriate insurance. Consult with legal counsel on these issues.

24 / Using Independent ContractorsSample Contractor’s AgreementAgreementI. Services to Be PerformedThis agreement between [your company name] and [contractor’s name] representsa binding contract for the Contractor to perform the following services:[Describe services and any specific performance standards.]It is agreed between the Contractor and this Company that the above-namedproject will be completed on or before [date]. Failure to meet this date willresult in a reduction of payment.II. PaymentIn exchange for providing the aforementioned services, the Contractor will bepaid a fee of [list fee here; if the contractor is being paid an hourly rate, you maywant to include a maximum amount: for example,“$20 per hour, not to exceed$600”]. This payment will be made within 30 days of completion and acceptanceof the Contractor’s work.The Contractor will be responsible for submitting invoices for all services provided.III. Cancellation of Contract[Your company name] reserves the right to cancel the contract for any reason.If the contract is canceled before completion of the project, the Contractor willbe paid a fee of not less than 50% of the agreed-upon fee.IV. Nature of RelationshipBoth the Contractor and this Company agree that the Contractor is an independentcontractor, and thus the Company relinquishes any control over the executionof the above-described assignment.The Contractor agrees to carry his or her own insurance, including workers’compensation insurance.The Contractor agrees that he or she will abide by all applicable labor laws,including paying any employees he or she may use on the project in accordancewith state and federal labor standards.In addition, the Contractor agrees to indemnify and hold harmless [your companyname] for any violations of state or federal law that may occur during theexecution of this contract.

An Ounce of Prevention / 25The Contractor will provide all equipment and supplies needed for this assignmentand will pay for them at his or her own expense.Client: _____________________________________________Contractor: _________________________________________Date: _________________

Overseeing the Workof ContractorsStay in charge, but keep your distance.Unlike at-will employees whom you can fire for any reason or noreason, contractors have specific rights agreed upon in the contract.To maintain control, you should craft contracts that containspecific, measurable standards for the work they’ll perform. Use thoseagreements to hold all your contractors accountable.At the same time, a contractor must be free from meddling by an employer’smanagers; otherwise, the IRS could decide that the contractor is an employee.Also, make sure that your contracts are written to limit potential areas of dispute.Should conflicts arise, have a mechanism in place that allows you to resolve disputesquickly. After all, time is money.Establish a Talent PoolIf you plan to use freelancers on an ongoing basis, it’s important not to rely onusing just one or two. Using the same contractor too often, without a break, couldraise the IRS’ suspicion. Plus, if he or she is suddenly not available, you’ll be backto square one on a project that may already be behind schedule. Using severalcontractors also gives you more leverage and control over setting prices becausethe contractors know they’re competing for the work.Another important issue is quality control. “Wheneverwe had a request for a funding proposal to get out, we’dalways hire the same typist,” says an engineer at a firmthat does business with the government. “The problemwas, she wasn’t very good. She made lots of errors andsometimes missed entire paragraphs. One afternoon, afterspending hours correcting her mistakes, I told a colleagueI thought the typist’s work was really subpar. ‘Yes,’ hesaid, ‘but she’s the only one we know who’s willing towork for our rates.’ It reminded me of the old joke: The food is lousy, but theportions are so generous! The woman isn’t a good typist, so what difference doesit make what her prices are?”Had the firm developed a pool of contractors, it would not have had to settlefor second-rate work.Using severalgives you more controlover setting prices.27

28 / Using Independent ContractorsHow to Negotiate PriceNegotiating pay with a contractor is similar to the process involved with a fulltimeworker. Chances are, each of you has a figure in mind. If you’re lucky,you will be in the same ballpark; if not, it’s up to each of you to determine howmuch you’re willing to bend on price. Keep several factors in mind when younegotiate a fee:■ Will you pay by the hour or by the job? Contractors generally charge clientsby the project or by the hour. When you pay per project, you can count on thepredetermined price no matter how many hours it takes the contractor to finish.For example, a contractor may agree to rewrite your company’s employeehandbook for $2,000. As long as you don’t change the specifications, you cancount on paying that amount. But if you do change the specs (you decide to addtraining materials to the manual, for example), you will have to renegotiate thecontractor’s fee.The downside: It’s in the contractor’s best interest to complete the job as soonas possible. That means she may not sweat the details, especially if she knowsyou’re unlikely to require her services again in the near future.If the project you have in mind is relatively small, or if you want the contractorto work on several projects, you should pay by the hour. The downside to payingby the hour is higher overall costs.■ How much expertise is necessary to do the job? As with regular employees,the amount you pay a contractor is usually commensurate with the difficulty ofthe task and the number of workers qualified to complete it.■ Will the contractor use special equipment or supplies to complete the job? Ingeneral, contractors’ rates should take into account the expenses they incur. Thegreater those expenses, the higher their rate for doing the job.■ How quickly does the job need to be completed? A rush job will likely carrya premium price—usually twice the regular rate.■ What’s the going rate for similar services? You get what you pay for. If youhire a contractor who charges you 50% less than everyone else does for the samework, chances are the result will be only half as good.■ Where’s the contractor based? With email, faxes and overnight mail delivery,it’s not always necessary for the contractor to be local. If you live in a majorcity, where contractors’ rates reflect the higher cost of living, you could probablyreduce your expenses by contracting with an out-of-towner.■ How quickly will you pay them? If you customarily make your contractorswait to get paid longer than 30 days after completing the job, expect to payhigher rates.If you’re having difficulty establishing a price range, take a look at what you’dexpect to pay an employee doing that job full time, then add the approximate40% in taxes and benefits you won’t have to pay the contractor. When you setrates, keep in mind that a contractor’s take-home pay is significantly less than the

Overseeing the Work of Contractors / 29fee you pay him or her. It’s not unusual for a contractor who’s paid $20 per hourto net only $12 per hour or less after paying insurance, expenses and taxes.Some employers motivate contractors by offering bonuses if their work iscompleted by a certain date or meets a predetermined performance standard.Similarly, the promise of additional assignments if the worker delivers qualitywork in a timely fashion serves as a good motivator.Managerial ChallengesHow can you ensure that a contractor will do the work he or she is hired to do toyour satisfaction—without having the IRS swoop down and change the contractor’sstatus? Clearly, the key is to select a contractor whose ability you can trust.Assessing skill means more than reviewing résumés. Chances are, the contractoris self-employed, and when Bill Smith lists Bill Smith Enterprises as hisemployer, he’s free to describe his professional experiences however he sees fit.There’s no boss or personnel office with whom you can verify details. That’swhy it’s important to request a list of the contractor’s past clients and ask forreferences you can contact. Also, if practical, ask a potential contractor to providesamples of his work.Once the contractor begins work, you should set and enforce regular deadlines.Break one large project into several smaller ones, so you’ll have the opportunityto review the work at regular intervals. This allows the contractor to adjusthis work to your standards as the project progresses, not after it’s completedand time is short. You should also provide the contractor with a list of those hecan contact if questions arise. Answering a question initiated by the contractordoesn’t violate the IRS’ guidelines.➤Recommendation: Recognize that you can never exert as much managerialcontrol over a contractor as you can over an employee. In fact, in many casesemployers turn to contractors because they want to be freed of the burdens ofsupervising a large staff. You should, however, determine whether a project isappropriate for an autonomous contractor before you assign it. If you need to exerta lot of control, you’d be better off keeping the work in house.Protect Confidential InformationDetermine what information you’re willing to release before you bring in contractors.Too many outsiders working in your company could cause a leak ofconfidential information and trade secrets. That’s what a New England-basedelectronics firm learned the hard way. The company hired several contractorswho specialized in engineering. After the work was completed, one of the firm’scompetitors hired the same contractors. Soon after, the rival began offering similarproducts at lower prices.The lesson is clear: Don’t take any chances with confidentiality. Limit contractors’access only to documents that pertain to their assignments. If necessary,make them sign confidentiality agreements. Keep in mind, however, that you can

30 / Using Independent Contractorscontrol contractors only as long as they work for you. Once the contract expires,so does their relationship with you unless you include in your contract a clausethat prohibits the contractor from revealing any information about the projectwithout authorization. Note: Chances are that such a clause will cause the contractorto hike his or her fee.Similarly, your contract should stipulate that the assignment, once completed,belongs solely to your company as the one that commissioned it. You wouldn’twant a computer programmer who developed a program for you to turn aroundand sell it to your rivals. Again, expect to pay a premium for exclusivity rights.Don’t Overlook Your Staff’s MoraleOutsourcing work to independent contractors can adversely affect staff morale.Employees may seem to feel little loyalty to an employer that outsources theirjobs.Case in point: A lab technician who was replaced by an independent contractorfiled suit. He claimed whistle-blower status after alleging that the hospitalordered its technicians to falsify medication records so it could overchargeMedicaid. U.S. Ex Rel. Schell v. Battle Creek Health System, No. 04-1418, 419 F. 3d.535 (6th Cir. 2005)When outsourcing work, look at the big picture. Ask yourself:1. Will it always be feasible to have a contractor perform this work?By outsourcing jobs, you’re shipping expertise to another company. In thefuture you may need those skills and not have them.2. Are you training a future competitor?The small independent contractor performing your work today could becomeyour smaller, nimbler competitor tomorrow. Contractors gain valuable knowledgeof company methods while performing outsourced work. They may alsoidentify flaws in your procedures that they could exploit. Several years down theroad, they could be your competitors and you financed it.3. Are the economies of scale permanent or temporary?It may be cheaper to outsource today but perhaps not tomorrow. Examine costtrends and market forecasts before jumping to the conclusion that outsourcing isthe best choice.4. Have you done the “make-buy” analysis on your workflow?Manufacturing firms often do a make-buy analysis to determine whether it’sbetter to make a product needed for production or buy it from someone else.Deciding whether to outsource work to an independent contractor is similar:You’re either making services (paying an employee) or buying them (using anindependent contractor).Whatever decision you reach, communicate the reasons to your staff. You maywant to assure them that their jobs won’t be affected, but be careful not to promisethem too much. Offhand promises have been interpreted as creating contractsbetween employers and employees. Don’t fall into this trap.

Overseeing the Work of Contractors / 31Who Pays When a Contractor Fails?The best-laid plans of businesses often go awry, so you need to make contingencyplans. Your protection starts with the contract.If your contract covers all the following points, you’re off to a good start:1. Are performance standards clear and concise?2. Does it contain a mechanism for resolving disputes quickly?3. Does the contractor have a contact within your company who has theauthority to solve problems?A tightly constructed contract will give you an out if a contractor isn’t performing.In effect, a good contract preserves your right to “fire” the independentcontractor by terminating the contract.Short of terminating the contract, you both should have the right to modify thecontract to deal with situations that may arise. For instance, suppose a contractoris a sole proprietorship or small company and the principal of the firm becomesseriously ill. If you’re able to shift some of the work to another contractor temporarily,the job gets done while you’ve preserved the working relationship.If things really go downhill, you should have the flexibility to:• Adjust payments based on the amount of work satisfactorily completed.• Adjust his or her fee by the amount you must pay someone else to finish the job.• Refuse to pay anything at all.Before pursuing the last option, consult with your attorney. This draconianmove carries some inherent risks.

Related Court RulingsWhich decisions affect your company?This section describes several independent-contractor cases decidedby the federal courts and gives you a general sense of how judgesare interpreting the issue of worker classification. Keep in mindthat only those appellate court decisions in your jurisdiction, as well asthose by the U.S. Supreme Court, are binding on you. (See circuit mapbelow.)Nevertheless, courts often look to other jurisdictions for guidance whenaddressing issues for the first time. As a result, rulings from other jurisdictionscan be insightful when making your own decisions about a worker’s classification.Circuits of the U.S. Court of Appeals1991085761134212D.C.33

34 / Using Independent ContractorsRetaliationYou can’t terminate a contract just because the contractor has criticized youroperation. In the following case, a federal appeals court ruled that a state hospitalwas guilty of disparate treatment and in violation of the First Amendment of theU.S. Constitution.A psychiatrist criticized a state hospital for some administrative deficiencies.Following the criticism, the hospital refused to renew the doctor’s annual contract,as it had done for the previous nine years. He sued, and the court foundthat the hospital violated his First Amendment rights and, in the process, treatedhim differently than other independent contractors. Springer v. Henry et al., No.04-4124, 2006 U.S. App. Lexis 1346 (3rd Cir. 2006)Although private employers need not worry about First Amendment issues,they can’t retaliate against employees who complain about working conditions;that would violate the National Labor Relations Act (NLRA). The courts willhave to decide on a case-by-case basis whether this protection applies to workersclassified as independent contractors.Mixing the Workforce: Employees and ContractorsThe NLRA protects employees, but not independent contractors. When contractorslook to union organizing, however, it puts the entire relationship undergreater scrutiny. This can lead to the NLRB classifying contractors as employees.A trucking firm used both employees and independent contractors to delivergoods. It differentiated between employees and contractors by requiring only itsemployees to wear uniforms and take predetermined routes, but allowing contractorsto load their freight and deliver as they wished. Employees drove companyvehicles; contractors provided their own. But when the contractors startedto discuss unionizing, a manager terminated two of their contracts in retaliation.The contractors appealed to the NLRB, which ruled that the contractors wereemployees because their contracts failed to allow “significant entrepreneurialopportunity.” In other words, the company’s requirements were so demandingthat it would have been nearly impossible for the contractors to perform servicesfor other firms. The trucking firm appealed the ruling, but the federal appealscourt sided with the NLRB. Corporate Express Delivery Systems v. NLRB, 352 U.S.App. D.C. 73 (D.C. Cir. 2002)A unionized trucking firm that supplemented its workforce with nonunionindependent contractors was expelled from the Teamsters’ pension fund.The fund argued that using contractors deprived the fund of new hires’ contributions,thereby activating a clause in the fund’s trust agreement allowing itto expel companies engaging in “adverse selection” that hurts the fund’s viability.The trucking firm challenged the expulsion on a variety of grounds.

Related Court Rulings / 35The trial court ruled in favor of the pension fund. On appeal, the Court ofAppeals held that the pension fund, under the adverse selection rule, had theauthority to expel employers that shift work to bona fide independent contractorswho don’t make contributions to the pension fund rather than hire newemployees who do make contributions to it.The lesson for employers is clear. When outsourcing work previously performedby employees to independent contractors, look carefully at the big picture.Make sure the decision does not have an unintended, adverse consequenceas it did in this case. Borntrager et al. v. Central States, Southeast and Southwest AreasPension Fund, 577 F. 3d. 913 (8th Cir. 2009)Employee BenefitsIn the category of “no good deed goes unpunished,” employers that makeERISA benefits available to independent contractors risk having them reclassifiedas employees.A brokerage firm provided disability insurance for its commodity trader contractors.When one of them tried to collect from the policy, the insurance companydenied his claim, arguing that the plan covered only full-time employeeswho work more than 30 hours per week. Obviously, because he was an independentcontractor, the brokerage firm never tracked the trader’s hours.While not ruling on whether the trader was an employee, a federal appealscourt decided that he could be a plan beneficiary under ERISA without being anemployee. It noted, however, that the employer and insurer erred when draftingthe plan’s language. Ruttenberg v. U.S. Life, 413 F. 3d. 652 (7th Cir. 2005)Union Organizing and EntrepreneurialismAs stated above, the National Labor Relations Act protects employees, butnot independent contractors. FedEx Home Delivery v. NLRB, 563 F.3d 492 (D.C.Cir. 2009) grew out of a Teamsters’ effort to organize FedEx Home Deliverydrivers at two Massachusetts locations. The NLRB conducted an election amongworkers, who the union claimed were employees. The union won the election,but FedEx refused to bargain with the union, claiming the drivers were independentcontractors, not employees.The NLRB found that the drivers were employees, and FedEx Home Deliveryappealed to the Court of Appeals for the District of Columbia. The appellatecourt disagreed with NLRB and found that the drivers were independent contractorswho could not unionize because they were contractors—not employees.In concluding that the workers were independent contractors, the Court ofAppeals applied the common law test, but said that prior court rulings hadoften incorrectly stressed one factor in the common law test: the employer’sright to exercise control. The court held that while all of the common law factors“remain in play,” the analysis should not focus just on control, but rather on the

36 / Using Independent Contractorsbroader concept of “the opportunities and risks inherent in entrepreneurialism.”Remember that concept.Using this concept, the court found that the drivers were “entrepreneurs” andthus independent contractors because (1) the drivers could incorporate; (2) theyserved multiple routes; (3) the drivers could (and sometimes did) hire otherworkers to drive their routes for them; (4) they could use their vehicles—withcertain limitations—for purposes other than servicing FedEx Home Deliveryroutes; and (5) the drivers could sell, create and even bequeath their routes toothers—all without permission from FedEx Home Delivery.The Court of Appeals focused more on the financial relationship between thedrivers and the company, rather than just on the extent to which the workers’day-to-day tasks are overseen by FedEx Home Delivery.Civil Rights IssuesTitle I of the Americans with Disabilities Act doesn’t apply to independent contractors,only to employees. However, a suit questioning whether Title III of theADA applies to independent contractors met with a mixed result.The estate of an HIV-positive carpet installer sought injunctive relief underTitle III of the ADA, arguing that the company that hired him as a contractorhad discriminated against him because of his medical condition. Because theman had since died, the estate asked that the court award monetary damages tocompensate for the injunctive relief that should have been enforced during theman’s lifetime.The court ruled that Title III provided for no monetary benefits, but it didn’trule on whether Title III injunctive relief applies to independent contractors.Bottom line: Companies that refuse to contract with individuals because of theirdisabilities could possibly be sued under the ADA to force them to accommodatedisabled contractors. Goodwin, executrix of the estate of Lunnin v. C.N.J. Inc., F. 3d.No. 04-2050 (1st Cir. 2006)ReclassificationIf one of your workers is reclassified, you could end up paying a bundle for yearsto come, as the following case illustrates.A group of computer programmers who had signed a contract with Microsoftstating that they were independent contractors sued the company, claimingthey were really employees entitled to benefits. They had worked full time for18 months in Microsoft’s offices alongside full-timers doing similar work. TheU.S. Court of Appeals for the 9th Circuit ruled in their favor, saying they hadbeen misclassified and were entitled to participate in Microsoft’s 401(k) plan andstock purchase plan. Vizcaino v. Microsoft Corp., 97 F. 3d 1187 (9th Cir. 1996)

Related Court Rulings / 37The U.S. Supreme Court refused to hear Microsoft’s appeal of this 9th Circuitruling, which expanded to up to 15,000 the number of workers who could participatein the class-action suit.Employment DiscriminationA woman who operated a cleaning service and did all the work herselfcleaned a company’s offices three days a week. The woman had providedcleaning services to the company for 12 years. She sued the company, claimingshe had been subjected to gender discrimination and sexual harassment atits offices. A district court in Missouri found that no reasonable jury could findthat the woman was an employee of this client company. Rather, the court concludedthe woman was an independent contractor, observing that the plaintiffnever received a W-2 form from the company, the company never withheld anyamount for taxes or Social Security from the payments made to her over 12 years,and that she was never entitled to any employee benefits.The court stressed that the woman’s cleaning service had its own tax identificationnumber and she filed tax returns as a sole proprietor, reporting the paymentsshe received from this company, and others, as business income. Finally,the fact that the cleaning services were unrelated to the company’s core businessalso weighed in favor of finding that she was an independent contractorand not an employee. Zahner v. Tower Rock Stone Co., 115 BNA FEP Cases 1125(E.D. MO 2012)Another woman working with a company appeared to be an independentcontractor. She was paid by commission, had no taxes withheld and had signedan agreement stating she was an independent sales representative. But the perceptionof her status changed overnight as a result of a sexual harassment complaintshe filed with the EEOC.While the EEOC noted that independent contractors can’t file suits under TitleVII, it also pointed out that this woman seemed to be an employee because heremployer exercised a great deal of control over her work. A Texas district courtagreed with the EEOC and reclassified the woman as an employee. As a result,the woman was free to submit her sexual harassment claim, and the companyhad to provide her with benefits and pay higher payroll taxes. EEOC v. FawnVendors, 965 F. Supp. 909 (S.D. Tex. 1997)Hostile Work EnvironmentA Mexican-American owner of a company hired to clean parking lots atWalmart claimed that several racially tinged incidents (such as the words “whitesupremacy” painted on the lot) created a hostile work environment.In 2000, the U.S. Supreme Court let stand a lower court’s $300,000 award underSection 1981 of the Civil Rights Act of 1866, which bars racial discrimination in

38 / Using Independent Contractorsmaking and enforcing contracts. Congress had broadened the racial bias law in1991, and some courts say the new language protects independent contractors.Walmart had argued the ruling would make a company responsible for protectingall its contractors, but the 1st Circuit said only on-site workers would likely beaffected. Danco Inc. v. Wal-Mart Stores Inc., Nos. 98-2101 and 98-2269 (1st Cir. 1999)A 2006 Supreme Court decision limits Section 1981 suits to individuals. WereDanco Inc. to file this suit today, the corporation would have no standing, norwould its owner as agent for the corporation. Each affected individual wouldhave to file suit. Consequently, companies that fail to protect contractors fromhostile environments will face multiple suits instead of one. Domino’s Pizza Inc. etal. v. McDonald, No. 04-593 (2006 U.S. Lexis 1821)A nurse filed harassment charges against the hospital where she worked,claiming she was harassed by a doctor who was an independent contractor. Thehospital claimed it wasn’t responsible for the doctor’s actions because he wasn’tan employee of the hospital. But a federal appeals court disabused the hospitalof that notion when it ruled, “The employer’s responsibility is to provide itsemployees with nondiscriminatory working conditions.” Dunn v. WashingtonCounty Hospital and Coy, 429 F. 3d. 689 (7th Cir. 2005)Overtime Under the FLSAIn 2009 and 2010, the 5th Circuit Court of Appeals decided three cases dealing withan employer’s compliance with the overtime provisions of the Fair Labor Stand -ards Act. Employees are protected by the FLSA; independent contractors are not.In the first case, Cromwell & Bankston v. Driftwood Electrical Contractors et al.,348 Fed. Appx. 57 (5th Cir. 2009), two splicers who worked on telecommunicationline repair following Hurricane Katrina sued for unpaid overtime. The factsrevealed that the defendants checked the progress of the splicers’ work, but didnot train or control the details of how they did their jobs. The splicers providedtheir own trucks, testing equipment, connection to the insulation equipment andhand tools. One splicer had a $16,000 investment in tools and materials; the othersplicer had a $50,000 investment in tools and materials.The Court of Appeals agreed that while many of the common law factorspointed to an independent contractor relationship, those factors were not enoughto establish, as a matter of “economic reality,” that these workers were in businessfor themselves during the relevant time period. Since the splicers workedon a “steady and reliable basis” over a “substantial period of time” (11 months)exclusively for their purported employer, that relationship severely limited anyopportunity for profit or loss by either worker. Accordingly, the court found theywere employees, not independent contractors.In a similar case a year later, Thibault v. BellSouth Telecommunications et al.,612 F.3d 843 (5th Cir. 2010) the same Court of Appeals found that another splicerwho worked on telecommunication line repair after Hurricane Katrina was anindependent contractor, not an employee. Applying the same “economic reality”

Related Court Rulings / 39standard as in Cromwell, the court reached an opposite conclusion. The relationshipin Thibault was only three months, rather than 11. Based on a variety ofother factors, the splicer appeared to truly be in business for himself rather than acaptive employee of this three-month project.In Thibault the court found that the relevant question is whether the allegedemployee so “economically depends upon the business to which he renders hisservices, such that the individual, as a matter of economic reality, is not in businessfor himself.” In analyzing the permanency of the relationship, the courtfound that this splicer did not work exclusively for the defendant. Rather, he hadhis own business selling picnic tables, storage facilities and customized golf cartsin his home state of Delaware.The court explained that the splicers in Cromwell (who were found to beemployees) did not have the same temporary, project-by-project, on-again-offagainrelationship with their purported employers that the splicer in Thibaulthad. While the splicers in Cromwell were economically dependent on the allegedemployers, the circumstances of Thibault’s employment reflected that he was not.In the third case, Lindsley v. BellSouth Telecommunications et al., 401 Fed. Appx.944 (5th Cir. 2010), another splicer sued for unpaid overtime. As in the two priorcases, this splicer also worked on telecommunication line repair after HurricaneKatrina. Again applying the same “economic reality” test as in Cromwell andThibault, the court found that the plaintiff in Lindsley was an independent contractor,not an employee. Lindsley, for example, had decades of experience as asplicer; held himself out as “self-employed” and paid self-employment taxes; and(perhaps most importantly) had a working relationship with the defendants on aproject that lasted only three months.Recently, in Scantland et al. v. Jeffry Knight Inc. et al., 721 F.3d 1308 (11th Cir.2013), the 11th Circuit Court of Appeals reviewed an FLSA overtime lawsuitagainst an Internet and cable installer. It ruled that the trial court dropped theball when it decided the workers did not fall within the scope of the FLSA’s protectionsof employees.The plaintiffs had argued that they were misclassified as independent contractorsand, consequently, were denied numerous benefits and protections theywould have otherwise enjoyed, including overtime pay. The Court of Appealsapplied the generally accepted six-factor test in assessing whether the workerswere employees or independent contractors. It concluded that four of the sixfactors weighed heavily in favor of employee status, while the other two factorsweighed “very slightly” in favor of independent contractor status. Accordingto the Court of Appeals, the lower court applied the same “economic reality”standard, but did so in a way that lost sight of the key question of whether theworkers were in business for themselves or depended on the alleged employerfor their livelihood.Note: As can be seen by careful analysis of these four FLSA cases, all of whichhave similar fact patterns, the question of whether a worker is determined by thecourts to be an independent contractor or employee can turn on very subtle factsand fine distinctions.

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