Employee vs. Independent Contractor

Article by Joanne Cassidy

Business owners frequently want to categorize workers as independent contractors rather than employees.  Employees typically require training, equipment, supervision, and benefits including workers compensation and unemployment insurance.  An independent contractor, however, requires no training because he is expected to already know how to do the job.  He also is not entitled to benefits typically provided to employees, including workers compensation and unemployment insurance.

Properly Categorize a Worker

The failure to properly categorize a worker as an employee or independent contractor can have serious ramifications.  For instance, the Internal Revenue Service (IRS) requires an employer to withhold FICA (social security and medicare) and income taxes for employees.  Failure to do so and to make the necessary deposits may subject the employer to liability for payment of those taxes.  According to a report from the Department of Labor, “the IRS, which estimates it is losing billions in tax revenue each year due to mis-classification of employees as independent contractors, has cracked down in recent years.”

In addition, the Department of Labor regularly conducts audits of companies to determine whether the company complies with employment laws such as the Family and Medical Leave Act, the Fair Labor Standards Act, and the Worker Adjustment and Retraining Act. The department can impose penalties for non-compliance.

Tests to Determine Whether a Worker is an Employee or an Independent Contractor

The issue of who is an employee and who is not can be confusing because different agencies use different tests to determine which workers are employees and which are independent contractors.  For instance, the Department of Labor and Social Security Administration use an “economic reality” test.  A number of states, although not Texas, use what is called the ABC test, which lists 3 factors to balance.  The Texas Workforce commission (“TWC”) and the Internal Revenue Service “IRS” use similar, although not identical, tests to determine whether a worker is an employee or an independent contractor.  Basic to all the tests is to what extent the company has the right to direct and control the worker in the performance of his duties and whether the worker is in a position to realize a profit or loss by his labor.

The IRS uses an 11 factor test, divided into behavioral control, financial control and type of relationship to determine whether a worker should be classified as an employee or independent contractor.  The Texas Workforce Commission (TWC), which administers unemployment tax in Texas uses the former IRS 20 factor test, which is summarized below.

Prove that the Worker is an Independent Contractor

In Texas, the law presumes that a worker is an employee.  If audited or challenged, it is incumbent upon the company to prove that the worker is an independent contractor.  Basically, the company must show that the worker is self employed and that the company is merely a customer of the worker.

Independent Contractor Relationship

In an independent contractor relationship, under TWC policy:

  1. The company generally seeks out the worker
  2. The company and worker negotiate the terms of the engagement
  3. The company does not train the independent contractor
  4. Payment is for a finished product or service, not hourly wages
  5. The independent contractor does not sign a non-compete agreement
  6. Any non-solicitation agreement must be narrowly defined
  7. Any non-disclosure agreement must be narrowly defined
  8. The worker does not wear the company uniform
  9. The worker does not have a company e-mail account
  10. The worker has no company benefits or wage advances
  11. The company does not withhold taxes and issues an annual 1099
  12. The worker has his own business cards
  13. The worker invoices the company on his own letterhead
  14. The worker provides goods or services to other companies
  15. The worker is self-employed and is in a position to make a profit or loss

To further complicate the employee versus independent contractor classification, each state has its own laws that can trip up even the most conscientious employer. For instance, I had a client who retained workers from all over the world to provide certain services for her company.  She carefully complied with Texas TWC rules.  However, when a worker who lives and works in another state filed for unemployment benefits in that state, she discovered that in that state, for the worker to be classified as an independent contractor, the worker was required to file a form with the state government stating that she was an independent contractor.  In the absence of that filing, the worker was considered an employee entitled to unemployment benefits.

Business Lawyer Help to Determine Employee Vs. Independant Contractor

My recommendation for companies that are uncertain as to whether its workers are employees or independent contractors:  do your research and ask your business lawyer for help.  If in doubt, the worker is most likely an employee and must be treated as such.