Independent Contractor or Employee? How to Legally Classify Workers

Virtually every young company struggles to properly classify workers as independent contractors or employees. Initially, when everyone involved in a startup is working on a part-time basis and pursuing other interests, it is easier to justify an independent contractor designation for most workers. But as the organization increases in stability and the first few hires start working 40-hour work weeks and more, when is a founder in danger of illegally classifying someone as an independent contractor? What is at stake for the company when workers aren’t properly classified?

1. General Overview of Independent Contractor Law

The issue of whether an independent contractor is properly classified is a dense, confusing, multi-layered analysis that invokes at least 48 different factors, weighed differently depending on whether federal or state law is applied. For example, the IRS uses one particular test to determine if an employer should be subject to withholding obligations, the Dept. of Labor uses another test to determine if an employer has violated federal minimum wage laws and states apply yet another test to determine if an employer is liable for failure to pay unemployment tax or to secure workers’ compensation insurance. In short, there is no slam dunk when it comes to assessing whether an employer is properly classifying workers as independent contractors. This is totally unfair and annoying for employers, but especially startup founders, where employer liability is simply untenable in the early days.

With that said, there are some guiding principals to keep in mind when thinking through whether to classify someone as an employee or an independent contractor. Despite the many factors courts/government agencies consider, fact finders are essentially trying to determine whether:

The individual has an independent business and contracts to work according to his own methods; and

Whether the employer controls only the result of the work, not the means by which that result is accomplished.

If the above statements are generally true, the worker is properly considered an independent contractor.

2. Factors that Support Independent Contractor Classification

Here, the following common factors can be used to support classification as an independent contractor:

The Company hires a a contractor with a specific expertise that no one else on the founding team possesses by virtue of her unique background (in other words, the company does not train the hire in this area).

Both parties intended to create an independent contractor relationship, which is evidenced by an Independent Contractor Agreement.

The company does not direct the contractor’s work and does not have authority to require her compliance with any specific directives in terms of how to accomplish her deliverables.

The contractor is responsible for supplying the tools and equipment needed to support the services she provides to the company and to her other commercial pursuits.

The contractor is not subject to a company schedule and is permitted to come and go as she pleases based on her determination of how to best execute her services.

The contractor is solely responsible to structure her own work schedule based on her independent judgment and develops her own goals, method or manner of completing work, forms her own priorities regarding completing assignments, etc.

The contractor is not held to a full-time schedule and is not prevented from securing outside work. Importantly, there should be no exclusivity arrangement or non-competition clause in an independent contractor agreement (or else very narrowly construed) that would permit a company to restrict her commercial activities.

3. Common Areas of Vulnerability for a Company

The following issues could be problematic to a Company if the relationship were ever scrutinized by a court or governmental agency:

The consultant’s services are inherently directive, meaning that the position occupied by a contractor is operational in nature and inherently subject to the direction/control established by management and less likely to be viewed by a court as an area where independent expertise is required.

The contractor is hired for an indefinite period of time and paid a salary. (Ideally, an independent contractor would be hired for a set project or a specific duration of time and would invoice for its services).

The contractor is the recipient of any employee benefit, such as stock options.

There is no liability if the contractor were to terminate her business relationship at any time (in other words, there is no specific deliverable that was contracted for her services).

If the contractor does not in fact hold herself out to the public as providing the particular service that she offers to the company, this would undermine her economic independence. (does she have business cards? a website? advertisement in the phone book or any other way that she secures additional projects?)

This is not an exhaustive list as there may be other factors that may detract from a contractor’s economic independence or reflect an impermissible level of company control. Also, not all the above factors are considered depending on which type of scrutiny is applied (for example, the workers’ compensation board may look at/ place different significance on different factors than the IRS).

4. Enforcement Mechanisms

If a contractor were inclined to pursue a position that the Company had wrongly classified her as an independent contractor, there are a couple of ways she could go about it.

If she argued that she was entitled to certain employee benefits provided by the company for employees, she could file a lawsuit against the company in federal or state court.

She could file a claim with the federal Dept. of Labor if she were to contend that she did not receive federal minimum wage for her work or sufficient overtime pay.

She could also file a claim with the IRS for the Company’s alleged failure to pay Social Security/Medicaid taxes and to properly withhold her portion of those taxes.
She could file a claim with a state Worker’s Compensation or Unemployment Insurance Agency claiming that she is improperly classified as an independent contractor and that her employer is not properly paying unemployment or workers’ compensation insurance.