Independent Contractor or Employee?

Just because a company calls a worker an independent contractor does not make him or her so. For clarification purposes, I’m using “independent contractor” as a synonym for the terms “consultant”, “contractor” and any individual your company retains whom you don’t consider an employee.

If your company classifies a worker as an independent contractor, the company does not have to withhold or pay state or federal payroll taxes such as including Social Security, Medicare, disability, unemployment, and income taxes.

However, if that person is an employee, the company must withhold and pay these taxes. Thus, it’s often in a company’s financial interest to call a worker an independent contractor.

Misclassification results in lost payroll taxes and tax revenues to both the state and federal governments.

A 2009 report prepared by the U.S. Government Accountability Office concluded that worker misclassification is a “significant problem” with “adverse consequences” because it reduces tax revenues flowing to the government. The report estimates that the misclassification will cost the Treasury Department more than $7 billion in lost payroll tax revenue over 10 years. And, it is estimated that states lose about $198 million each year in unemployment insurance funds.

It’s no wonder that the states and feds view the independent contractor status with a critical eye.

The misclassification can be expensive: the imposition on your company of fines, penalties, and back taxes by both the state and IRS.

Employers and workers are both interested in proper worker classification.

Workers want to ensure they are paid as required by law, and are protected under federal and state employment laws (eg: Fair Labor Standards Act, Age Discrimination in Employment Act, and laws prohibiting discrimination in the workplace). These law don’t apply to independent contractors. Workers also want to preserve their eligibility for social security and receive employer benefits (health insurance and 401K contributions).

Employers need to ensure they are properly paying payroll taxes and complying with the minimum wage or overtime, and other wage-and-hour law requirements such as providing meal periods and rest breaks.

This is how it often begins: Company engages the services of an independent contractor, subsequently terminates those services, and the independent contractor files a claim for unemployment insurance benefits. The company responds to the unemployment insurance claim by stating that the individual is not entitled to benefits because he or she is an independent contractor.

The state unemployment insurance division begins an investigation into the claim and, often, commences a full audit into the company’s payments to all independent contractors.

Another way in which a classification may be challenged is when the independent contractor fails to pay the double rate of social security taxes due as a result of the “self-employed” status.

That’s what happened in a case decided by the federal tax court. In that case, the individual taxpayer was responsible for managing a group home for adults. The company issued him a Form 1099 reporting the compensation, which the taxpayer filed with his tax returns. On audit, the IRS determined there was a deficiency because the taxpayer did not remit the self-employment taxes.
The “independent contractor” challenged the classification. The tax court found that he should have been properly classified as an employee, and therefore was not responsible for the (double) self-employment taxes.

According to the IRS, the question of whether an individual is an independent contractor or an employee is determined upon both: a) consideration of the facts and b) application of the law and regulations (both state and federal) in a particular case.

Previously, IRS Revenue Ruling 87-41, more commonly known as the IRS Twenty Factor Test, was often used to determine what type of relationship existed. Although this ruling remains valid, the IRS has grouped the more relevant factors into three main categories:
1. Behavioral: An employer-employee relationship exists when the employer has the right to control and direct the worker not only as to the results to be accomplished but also as to the details and means by which the result is accomplished. The three indicators of financial control include financial investment of the contractor, opportunity for profit or loss, and method of payment. This includes factors such as a) when and where to do the work; b) what tools or equipment to use, c) degree of instruction; d) type of evaluation system; e) whether there is on-the-job training or ongoing training,
2. Financial: The three indicators of financial control include financial investment of the worker, opportunity for profit or loss, and method of payment. Are the business aspects of the worker’s job controlled by the company? These include things like how worker is paid, whether expenses are reimbursed, who provides tools/supplies, etc.
3. Type of Relationship: Are there written contracts or employee type benefits (i.e. pension plan, insurance, vacation pay, etc.)? Will the relationship continue for a long term, and is the work performed a key aspect of the business?

Here’s the IRS link for further explanation:

The criteria in these categories are many, nuanced and dependent on the specific fact situation. They are often difficult to apply. It’s advisable to consult with a knowledgeable labor/ employment attorney if you have any doubt about whether the individual is an employee or independent contractor.


Leslie Marell is a business and commercial law attorney with over 25 years of experience in business contracts, purchasing and sales law, technology law & day to day business legal matters. She heads her own Los Angeles firm which specializes in providing legal services to the manufacturing, industrial and high technology industries. For more information about the firm, click onto If you’d like a complimentary consultation, call Leslie at 310.372.8663

In addition to her legal practice, Leslie has presented contracting and business law seminars and workshops throughout the country since 1990 to thousands of sales, marketing, and purchasing professionals. She has given in-house presentations to companies such as Applied Materials, Eastman Chemical, FMC, Goodrich, Hanes, Hewlett Packard, Hitachi Data Systems, John Deere, Northrop, Texaco, Unum Insurance, University of California, 3M, Unocal, and Verizon. She is a frequent speaker at the Institute of Supply Management International Conference, the Electronics’ Independent Sales Representative’s Association, Manufacturer Agents’ National Association (MANA), and local purchasing and sales trade associations.

Leslie’s workshops are a blend of lecture, dynamic coaching, and audience participation.  She brings her contract knowledge to the corporate classroom in lively and valuable workshops, translating “legal mumbo jumbo” into understandable, useful concepts in an entertaining way.

Leslie’s workshops will enhance your purchasing and sales organizations contracting and negotiating skills and ensure more effective contracts.