The idea of using independent contractors, rather than hiring employees, has been embraced by employers large and small. The reason, of course, is simple — the use of independent contractors can dramatically reduce administrative burdens and costs associated with hiring employees.

But most workers are employees, not independent contractors, and employers who use or are considering using independent contractors must be diligent when classifying workers because there are significant legal differences.

To assist employers in properly classifying workers, the Department of Labor released guidance on July 15, 2015, which describes the “economic realities test” developed from the Fair Labor Standards Act to assist employers in properly classifying workers.

[Image credit: Bloomberg]
[Image credit: Bloomberg]

Many employers issuing IRS Forms 1099-MISC, Miscellaneous Income, and the individuals who receive them are not familiar with the recent DOL guidance and continue to believe that Form 1099-MISC is the sole factor determining employment status. Now that the 2015 tax filing season has arrived, a review of the rules for determining employment status may prove helpful.

Economic realities rest

The FLSA standard is a very broad definition and depends upon an individual’s economic dependence on the employer or employers to which she provides services. A list of the factors considered, as detailed in the official DOL issuance, is provided below. Each factor is analyzed in conjunction with the other factors and no one factor is more determinative than the others.

1. The extent to which the work performed is an integral part of the employer’s business. If the work performed by the worker is integral to the employer’s business, it is more likely that the worker is an employee.

2. The worker’s opportunity for profit or loss depending on her managerial skill.

3. The extent of the relative investments of the employer and the worker. The investment, even if substantial, must be compared to the employer’s overall investments in the company, not just to the worker’s job.

4. Whether the work performed requires special skills and initiative.

5. The permanency of the relationship.

6. The degree of control exercised or retained by the employer. A worker must control meaningful aspects of the work performed so that it is possible to view the worker as a person conducting her own business.

Many practitioners have noted that this interpretation by the DOL signals the agency’s position that most workers are considered employees under FLSA, and that FLSA will be the likely standard the DOL uses when reviewing worker classification.

Effect on retirement plans

If an employer misclassifies workers as independent contractors and those workers are later determined to be employees, they may be entitled to benefits under a retirement plan. An employer can limit exposure to a lawsuit from misclassified workers by examining the eligibility provisions of its benefit plans.

Many retirement plans allow an employer to properly exclude those workers to whom the employer does not wish to provide benefits. A common exclusion found in retirement plan documents is for those workers “incorrectly determined not to be an employee.” In short, if an employer incorrectly determines that a worker is an independent contractor but it is later determined that the worker is in fact an employee, this exclusion from eligibility will limit the employer’s exposure to claims for benefits. Without such a provision, an employer would need to use the IRS’ Employee Plans Compliance Resolution System to correct its failure to cover misclassified employees.

Finally, many workers who believe they are independent contractors (e.g., because they receive a 1099-MISC) look to establish and fund employer retirement plans. Such plans cannot, however, be established by workers who have been misclassified as independent contractors but are really employees of the company for which they provide services.

The determination of whether a worker is an employee or an independent contractor is complex. As illustrated above, many factors can be used to determine the classification and no one “bright-line rule” exists. To help make sense of it, our team reviewed the FLSA testing factors and how each can be considered in a recent article on our site. Above all, employers should be cautioned to consult with their legal or tax advisers to obtain an opinion if there is a possibility of misclassifying their workforce.

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