Are They Employees or Independent Contractors?

By Brady, Teresa | Management Review, January 1998 | Go to article overview

Are They Employees or Independent Contractors?


Brady, Teresa, Management Review


Hiring independent contractors - wisely, that is - can help a company contain costs and reduce legal risks.

Temporary workers of various types now make up some 30 percent of the U.S. workforce. That figure is expected to exceed 50 percent within the next three years, according to workplace analysts. And the United States is not alone in its employment of contingent workers. Japan has long used such workers. Europe is increasingly getting on the bandwagon.

In 1995 alone, the IRS received 73,820,787 Forms 1099, the form used by companies to report income paid to independent contractors. What a contrast to the 1950s, when the "organization man" worked for one organization full time for the balance of his career.

Today's workplace requires companies to contain costs, and the use of independent contractors helps rein in employment expenses. However, these workers are not without their disadvantages. A company must consider both sides of the coin when hiring independent contractors and take care to distinguish them from employees.

Presently, there is no prevailing or all-encompassing test that conclusively determines whether someone is an employee or an independent contractor. And the classification issue continues to plague employers, as evidenced by the high-profile case involving Microsoft. When the IRS found that some of Microsoft's freelance workers were employees, they successfully sued for the right to participate in a savings plan. A court has since decided that the benefit plan administrator may determine the employees' eligibility for benefits.

A good rule of thumb when classifying workers is the "restatement of agency" test, which focuses primarily on the hiring party's right to control the means, methods and tools of a person's work. Absent that right to control, the worker is an independent contractor. In addition, companies may use four other methods to determine a worker's status:

* The IRS's 20-factor test. The 20 factors contained in this test help classify workers as employees or independent contractors. But the test is considered to be complex, and companies may use it more as an aid in analysis than a conclusive determination of a worker's status. Some of the factors considered by the test are whether the employer provides the training, tools and materials to do the job, whether the hours and place of work are set, the type of reporting mechanism used and whether the worker can offer his or her services to the general public.

Although the 20-factor test is a start, it has been highly criticized for several reasons. One is that no single factor seems to be more important than another. In addition, the application of the criteria sometimes appears to be subjective and unrealistic to employers. Even with the test, the IRS may look beyond the facts as they "appear on paper" and focus on what is really happening in the employer-worker relationship.

If the Home Based Business Fairness Act had been passed, a simple gauge of a worker's status would have replaced the 20-factor test. Instead, the Taxpayer Relief Act of 1997 was signed into law by President Clinton on August 5, which kept the 20-factor test in place.

* Economic realities test. This test states that individuals are employees if they are financially dependent on the organization to which they render their services.

* The hybrid test. This test is a combination of the common-law agency test and the economic realities test. With this approach to classification, a court will examine whether the worker is financially dependent on the employer and whether the employer has the right to control the means and manner of the person's performance. Of the two, the latter is the more controlling factor.

* The courts. The courts have considered three other factors in determining independent contractor status. Those factors are the level of skill required by the worker's job, the intent of the parties in their relationship and the employment practices in the industry at hand. …

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