American poet James Whitcomb Riley once wrote, “When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck.” With increasing regularity, government agencies and courts throughout the country are applying this same “duck test,” and other legal tests discussed in this article, to find that the “independent contractors” so often used by small businesses and elsewhere really have all the appearances of actually being “employees,” and they thus should be treated as employees for purposes of payroll taxes and other employment matters.

A growing concern facing car wash companies today, and all industries, is correctly determining whether a particular worker, or entire group of workers, truly fits the definition of being an independent contractor, or whether they should actually be considered an “employee” under federal or state law. The U.S. Department of Labor describes the issue as “one of the most serious problems facing affected workers, employers and the entire economy.” Businesses have certain inherent incentives to classify workers as independent contractors in order to avoid requirements to withhold payroll taxes, pay FICA, Medicare, and other withholdings, or make workers’ compensation and unemployment insurance contributions under state law. Unfortunately, simply labeling workers as “independent contractors” or “1099 workers” is not enough to make those workers actually independent contractors under the law.

In recent years, the U.S. Department of Labor and many states have been progressively more focused on the issue of proper classification of independent contractors. Making the wrong decision in how you classify a group of employees could result in major consequences for your business, including investigations by state or federal agencies or court cases brought by workers who claim they should have been treated as employees with all of the benefits that accompany that classification (such as minimum wage, overtime, worker’s compensation insurance and other benefits).

For example, in December 2014, the U.S. Department of Labor obtained a court judgment of $380,000 in back wages against a business that was found to have misclassified its employees who installed drywall as independent contractors. Other large judgments recovered by the Department of Labor against companies who misclassified employees have ranged from thousands to millions of dollars in back wages, damages and penalties. This type of case (and the resultant large judgment against the employer) is not uncommon as agencies and plaintiffs’ attorneys have increased the number of claims they bring regarding employee misclassification. In fiscal year 2014, investigations by the U.S. Wage and Hour Division alone resulted in collection of more than $79 million in back wages for more than 109,000 misclassified workers. The increase in claims and investigations related to employee classification makes sense given the fact that the U.S. Government Accountability Office estimates that 40.4 percent of the U.S. workforce is made up of contingent workers. Of that number, 12.9 percent represents independent contractors who provide a product or service and find their own customers.

To assist in navigating this tricky issue, we first look at some of the current legal battles regarding misclassification. We will then provide a discussion of common criteria used to determine whether workers qualify as independent contractors or employees, as well as some additional practical suggestions on ways to help minimize risk and ensure that your company does not fall into the trap of assuming that calling your workers “independent contractors” and giving them a 1099 is enough to make it so.

Legal Battles over Worker Classification

One of the most significant lawsuits in recent news regarding misclassification of employees involves Uber, the operator of the popular cell phone app that allows users to place trip requests with private car drivers from their smartphones. Uber considers its drivers to be independent contractors as drivers provide their own vehicles, may work for multiple driving services, set their own schedules, and are responsible for their own gas and vehicle maintenance. Uber drivers, however, have filed a class action lawsuit in federal district court in California alleging that they were misclassified as independent contractors rather than employees and whether they were owed certain tips they were not paid.

The drivers state in their complaint that they “are required to follow a litany of detailed requirements imposed on them by Uber, and they are graded, and are subject to termination, based on their failure to adhere to these requirements…” On Sept. 2, 2015, the judge in the Uber case granted in part the drivers’ motion to certify the case as a class action. If Uber drivers are ultimately determined to be employees, not independent contractors, Uber may be potentially liable for payroll taxes and other unpaid employee benefits such as minimum wage, reimbursement for expenses, overtime, required withholdings, etc. Such a decision would seriously impact Uber’s entire business model and could lead to significant costs for Uber — both in the form of a judgment and in operating costs moving forward.

A similar lawsuit was brought by FedEx Ground drivers who claimed they were misclassified as independent contractors. The Ninth Circuit Court of Appeals ruled in that case that FedEx had misclassified 2,300 drivers as 1099 contractors who should have been treated as employees.

While it may be tempting to look at the Uber or FedEx cases as litigation that is only relevant to industries that rely on drivers, this would be short-sighted. Lawsuits like these are significant for all industries and businesses that categorize groups of workers as independent contractors. Such lawsuits are indicative of a growing trend in employment law to challenge the classification given by businesses to their workers. Many times, a business does not worry about protecting itself or ensuring that its workers are properly classified until a lawsuit has been brought or an investigation opened, and it is too late at that point to fully avoid the consequences of misclassification.

Overview of Independent Contractor Issues

How do you decide whether your worker should be correctly treated as a 1099 independent contractor or as your employee? The determination of whether a worker is an employee or an independent contractor is generally made pursuant to a facts-and-circumstances test that seeks to determine whether the worker is subject to the direction and control of the business with regard to the nature of the work performed, including the circumstances under which it is performed.

As the courts or agencies that interpret such laws provide varying but similar factors to be considered, we will take a brief look at the most prevalent tests: the Common Law Right to Control test, the Economic Realities test and the ABC test.

The Common Law Right to Control Test

In general, the common law right to control test (the “common law test”) is applied to determine whether a worker is an independent contractor or an employee for federal tax purposes.¹ Under this test, an employer-employee relationship exists when the company has the right to control and direct the worker who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished. The company need not actually direct or control the manner in which the services are performed, but only have the right to do so. But, in general, if the worker is subject to the company’s control with regard to the result of the work but not with respect to the means and methods of accomplishing the result, the worker is considered an independent contractor.

To assist in making this determination, the Internal Revenue Service (IRS) set forth 20 non-exclusive factors that should be considered in determining a worker’s classification. The degree of importance of each factor varies depending on the factual circumstances of each individual case, and additional factors not listed below may be relevant. The 20 factors identified by the IRS are as follows:

Instructions: A worker who is required to comply with a company’s instructions about when, where and how he or she is to work is ordinarily an employee.

Training: Worker training (e.g., by requiring attendance at training sessions, working with an experienced employee, attending meetings, etc.) indicates that the company requires that the services are to be performed in a particular manner indicating employee status.

Integration: Integration of the worker’s services into the business operations of the company is an indication of employee status. If the success or continuation of the company is dependent to an appreciable degree upon the worker’s performance of services, the worker is ordinarily an employee.

Services Rendered Personally: If the services are required to be performed personally, this demonstrates that the company is interested in the methods used to accomplish the work and therefore indicates employee status.

Hiring, Supervision and Paying Assistants: If the company hires, supervises or pays assistants, this generally indicates employee status. However, if the worker hires and supervises others under a contract pursuant to which the worker agrees to provide material and labor and is only responsible for the result, this indicates independent contractor status.

Continuing Relationship: A continuing relationship between the worker and the company indicates employee status.

Set Hours of Work: The establishment of set hours for the worker indicates employee status.

Full Time Required: If the worker must devote substantial hours — hours equating to full-time employment — to the company, this indicates employee status. An independent contractor is free to work when and for whom he or she chooses.

Doing Work on Employer’s Premises: If the work is performed on the premises of the company, this indicates employee status, especially if the work could be done elsewhere.

Order or Sequence Test: If a worker must perform services in the order or sequence set by the company, this demonstrates that the worker is not free to follow his or her own pattern of work, and indicates employee status.

Oral or written reports: A requirement that the worker submit regular reports indicates employee status.

Payment by the Hour, Week or Month: Payment by the hour, week or month generally points to employment status. However, payment by the job or a commission indicates independent contractor status.

Payment of Business and/or Traveling Expenses: If the company pays business or traveling expenses, the worker is ordinarily an employee.

Furnishing Tools and Materials: The provision of significant tools and materials to the worker indicates employee status.

Significant Investment: Investment in facilities used by the worker indicates independent contractor status.

Realization of Profit or Loss: A worker who can realize a profit or suffer a potential loss as a result of the services (in addition to profit or loss ordinarily realized by employees) is generally an independent contractor, but the worker who cannot is an employee.

Working for More Than One Company at a Time: If a worker performs more than de minimis services for multiple businesses at the same time, this generally indicates independent contractor status.

Making Service Available to the General Public: If a worker makes his or her services available to the public on a regular and consistent basis, this generally indicates that the worker is an independent contractor.

Right to Discharge: The right to discharge a worker is a factor indicating that the worker is an employee.

Right to Terminate: If a worker has the right to terminate the relationship with the company at any time he or she wishes without incurring liability, this factor indicates employee status.

More recently, the IRS has identified the following three broad categories of factors that should be considered in applying the common law test to determine the classification of a worker: behavioral control, financial control and relationship of the parties.

Behavioral Control:

The type of instructions given to the worker.

The degree of instruction given to the worker.

Whether an evaluation system is in place that measures the details of how the work is to be performed.

Whether the worker is provided training.

Financial Control:

Whether a significant investment is made by the worker.

Whether the company does or does not reimburse business and travel expenses.

Whether the worker has an opportunity for profit and loss.

Whether the worker’s services are made available to the market.

The form and method of payment by the company.

Relationship of the Parties:

Whether a written contract exists indicating the status of the worker.

Whether the company does or does not provide employee benefits to the worker.

Whether permanency is lacking in the relationship.

Whether the services provided are a key activity of the business.

The Economic Realities Test

The common law test was deemed too restrictive by some courts to encompass the broader definition of the employment relationship contained in the Fair Labor Standards Act (FLSA). Therefore, some courts construing the FLSA have adopted the “economic realities test,” under which individuals are considered employees if as a matter of economic reality they are dependent upon the business to which they render services. The economic realities test focuses not so much on whether the company controls the manner and means by which the worker performs the work but rather on whether the worker is, as a practical matter, economically dependent upon the company.

In applying the economic realities test, courts consider the following five non-exhaustive factors: degree of control exercised by the company, extent of the relative investments of the worker and the company, degree to which the worker’s opportunity for profit or loss is determined by the company, skill and initiative required in performing the job, and permanency of the relationship.

The ABC Test

Some courts have adopted a hybrid test, combining the economic realities test with the common law test. Usually, however, the right-to-control factor is still paramount. For instance, many state unemployment insurance statutes use what is commonly referred to as the ABC Test. Under the ABC Test,² services performed by an individual for remuneration will be entitled to unemployment insurance unless the following factors exist:

A. The individual performing the services has been and will continue to be free from control and direction in the performance of services, both under the contract of service and in fact; and

B. The services are performed outside all of the premises of the service recipient or the services are performed outside the usual course of the business for which the service is performed; and

C. The individual performing the service is customarily engaged in an independently established trade, occupation, profession or business of the same nature as that involved in the services performed.

Additional Practical Considerations

As you examine your workers to determine how they should be properly classified, the primary determinant is generally whether the company truly controls the time, place and manner of the person’s work, or whether the individual truly has independent judgment and discretion in how they get their work done. You may also want to keep the “duck test” in mind — to what extent does the worker you would like to classify as an independent contractor appear to be basically the same as the company’s other, “real” employees, and to what extent is the purported independent contractor treated differently?

Conclusion

Ultimately, the determination of whether a worker is properly classified as an employee or an independent contractor is a highly fact-intensive inquiry that must be performed on a case-by-case basis. Companies that fail to analyze and consider the underlying reality of their worker relationships when classifying employees may find that misclassification as independent contractors can have far-reaching monetary consequences for their companies.

Matthew W. Clarke and Megan F. DeLockery; Smith, Gambrell & Russell, LLP; Atlanta, Georgia; (404) 815-3500.

¹ While many states use the ABC Test under their unemployment statutes, some simply use a combination of A and B or A and C.

² In addition to federal tax law, the common law test applies to the following laws: (1) the common law of most states to determine the liability of employers for the torts of their employees; (2) the National Labor Relations Act; (3) the Employee Retirement Income Security Act of 1974; and (4) federal employment discrimination laws in some circuits. In addition, the worker’s compensation and unemployment insurance laws of many states utilize a modified right to control test.

Making the wrong decision in how you classify a group of employees could result in major consequences for your business.

While there is no set list of things not to do that will always ensure your workers are properly classified, there are some practical things your company can keep in mind in trying to maintain a distinction between its true employees and its independent contractors, such as:

Have a written agreement with your contractor expressly stating that the person is considered an independent contractor, that he is not an employee, that the company will not withhold payroll or other taxes from the payments the worker receives, and that the obligation to pay taxes is solely on the contractor.

Avoid having independent contractors perform the same work as employees.

If the contractor has a business card, they should not have a company business card.

Contractors should pay for their own business cards that do not look like cards used by employees, or they should at least expressly identify the person as a contractor.

Ideally, the contractor should have his/her own email address, not a company email address. If they do have a company email address, the “signature block” of the email should include disclaimer language clearly signifying that the person is a contractor.

Do not provide the independent contractor with employee benefits, e.g. health insurance or vacation pay.

Require that the company’s independent contractors incorporate.

If the contractor is incorporated, issue all checks from the company to the contractor’s corporate name.

If the contractor is not incorporated, it is preferable for the contractor to use a business name as a sole proprietor. Checks should be made out to the business name.

Contractors should not have or use company credit cards.

Ideally, the independent contractor should pay for his/her business overhead. The company should not pay for the contractor’s normal transportation costs, equipment, pagers, beepers, telephone bills, business cards, letterhead, etc.

If the contractor regularly uses some of the company’s equipment, they should, in effect, lease or rent it from the company.

If the contractor does need to be reimbursed by the company for an expense, i.e., airline travel to visit a customer, then it is preferable for the contractor to bear that expense him/herself and have the company later provide reimbursement for it rather than the company paying that expense directly.

Require the independent contractor to provide his or her own tools and equipment.

Avoid requiring the independent contractor to have constant contact with the company, to regularly come to the company’s location, or to attend “employee-only” meetings.

Permit the independent contractor to reject work.

Pay the independent contractor by an invoice with the independent contractor’s federal tax identification number.

Pay the independent contractor by the project, a fixed fee, achievement of goals, or some other method other than by the hour.

Require the independent contractor to obtain workers’ compensation insurance and provide evidence of the coverage.

Allow the independent contractor to set hours of work.

Manage for results and avoid giving instructions about how to achieve the result.

Keep independent contractor files with other vendor files and away from employee files.

Do not have independent contractors complete an employment application.

Do not provide the independent contractor with an employee handbook.