Making the Critical Distinction Between Employee and Independent Contractor

Among the thorniest concerns facing Texas business owners, large and small, is the issue of whether they are properly classifying certain types of workers as employees or independent contractors. As there are clear advantages to designating individuals as independent contractors, some businesses are deliberately making incorrect classifications, whereas others are making these errors inadvertently and subjecting themselves to onerous penalties and fines. The attorneys of Murray-Lobb regularly advise business clients on properly classifying workers in order to remain in full compliance with the U.S. Department of Labor, the IRS and the Texas Workforce Commission, and we offer the following guidance to help illustrate the potential pitfalls.

Common Reasons for Misclassification

The benefits of designating a worker as an independent contractor as opposed to an employee are many. An employee will potentially be eligible for federal and state minimum wage, overtime, unemployment insurance and worker’s compensation benefits. They will also require necessary equipment, training and supervision, all things thatcan prove costly to employers. In contrast, independent contractors will be entitled to none of those expensive benefits and will require little to no additional training. Therefore, it is easy to see why many employers frequently select this classification, even if it is arguably inaccurate when applied to the facts at hand.

There can be serious consequences when a business fails to correctly classify workers as employees or independent contractors. Those with true employees are required by the IRS to withhold income taxes, social security taxes and medicare taxes, and neglecting to make those deposits can leave companies vulnerable to additional liabilities in the form of interest, penalties and other unwanted scrutiny. Further, the Department of Labor has recently signaled its intention to enhance audit efforts with regard to companies it believes are out of compliance in this regard and to utilize its powers to impose burdensome penalties.

Determining Proper Worker Classification

Muddying the waters further for companies wishing to remain in compliance with all relevant governmental agencies is the fact that each one uses its own set of criteria for determining which workers are properly considered employees and which ones are truly independent contractors. The Department of Labor focuses on a so-called “economic realities” test that uses six factors to aid businesses as they attempt to choose the correct classification for workers, including:

  • Whether the work being performed is integral to the employer’s business;
  • Whether the worker’s managerial skills impact his or her opportunity to realize profit or loss;
  • How a worker’s relative investment stacks up against the company’s investment;
  • Whether the work being done requires specialized skills and initiative;
  • Whether the relationship between the parties is permanent or of an indefinite nature;
  • The degree and nature of the company’s control over the worker’s activities, including where, how and when work is performed.

The IRS utilizes a test involving 11 distinct factors, focused heavily on similar criteria to those used by the Department of Labor. The employers financial and behavioral control of the worker are again pivotal to determining correct classification. The Texas Workforce Commission has promulgated a 20-factor test to assess worker status, which a company can use when facing an audit to overcome the presumption present under Texas law that all workers are employees. Under the Texas law presumption test, some specific hallmarks of a genuine independent contractor relationship include:

  • Absence of company-provided training for the worker;
  • Payment upon completion of projects, not by hourly wage;
  • Worker does not use company e-mail accounts;
  • No benefits are provided to the worker;
  • No tax withholdings are made and a 1099 is issued at year’s end;
  • The worker submits invoices for work performed;
  • The worker has a roster of other clients.

Though none of these factors are determinative in and of themselves, taken together they can help create the total picture from which an accurate classification can be made.

Remaining Mindful of Common Pitfalls

Many businesses that find themselves out of compliance when it comes to their classification of workers have not intentionally sidestepped the law, but have simply fallen victim to certain common misconceptions. For instance, some believe that execution of a simple contract declaring the worker to be an independent contract will provide the necessary clarity. However, while Texas will generally defer to the right of parties to contractually define an employment arrangement in this way, the Department of Labor will still use its own test to determine proper status. Further, allowing a worker to work flexible hours in a location of their choosing does not automatically confer independent contractor status. Depending on the work being done, the Labor Department may still find that such individuals are in fact true employees. Ultimately, it is necessary to undertake a global analysis of a wide range of factors in order to make correct classifications and remain on the right side of the law.

Mitigating the Risks of Misclassifying Workers

As stated earlier, many businesses that are out of compliance when it comes to classifying workers have not knowingly made such errors, but have simply misunderstood or misapplied the traditional tests used by key governmental agencies. Fortunately, in addition to seeking guidance from a skilled Texas business lawyer, there are other steps that can be taken to mitigate the risk of improper classification of workers. Some may choose to restructure or re-document their existing independent contractor relationships with greater precision and with an eye toward explicit legal compliance. Others may simply choose to reclassify their independent contractors altogether, and certain businesses may opt to redistribute such workers to workforce management enterprises or dedicated staffing firms.

Essential Guidance for Texas Businesses

Depending on the size and type of business involved, getting worker classifications right can be a very high stakes proposition. The potential sanctions for making improper categorizations can be substantial, and remaining in full compliance with governing agencies must be a priority for all business owners. Bringing decades of business law experience to bear, the attorneys of Murray-Lobb stand ready to provide clients with a comprehensive review of their worker classification practices as well as invaluable guidance on how best to structure the relationships so vital to the success of every enterprise, big or small.

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