Independent Contractors: Make Sure They Qualify!

This article by Doyice Cotten originally appeared in Fitness Management, but is as timely today as ever. Owners and managers who erroneously classify parties as independent contractors when they are actually employees face stiff penalties.

4284213425_bb260aba00Fitness Plus, Inc. offered fitness classes for corporate clients on the premises of the client. Fitness Plus would assess the needs of the client, contact one of about 30 instructors, negotiate a fee, bill the client, pay the instructor regardless of profit or loss, pay the instructor every two weeks, and report their income on a 1099 form.  Most of these procedures fit the conditions required for independent contractor classification.  In selecting the instructors, Fitness Plus conducted interviews, checked background, training, certification, experience, and usually observed them in a class — seemingly meeting the requirement that they select qualified contractors.  Instructors worked generally one to six hours weekly and signed an agreement that their status was that of an independent contractor.  The Unemployment Insurance Appeal Board ruled that they were employees and the court determined that there was sufficient evidence that Fitness Plus exercised sufficient direction and control over the services of the instructors to support the ruling. Fitness Plus was ordered to make additional unemployment insurance contributions for all such employees. (Herbert, D.L. Independent Fitness Instructors Deemed to be Employees, Fitness Management, Oct., 2002, p. 46.)

An independent contractor is an individual or a company that contracts to perform a particular task.  Examples of persons often classified as independent contractors include referees, aerobic specialists at health clubs, team physician, or a diving business that teaches SCUBA for a municipal recreation department.

Service providers use independent contractors for two major reasons.  The first reason is to reduce the amount of liability faced by the service provider — in general, if an injury results from the negligence of the independent contractor, the liability lies with the independent contractor and not the provider.  The second reason is that the provider might save money in terms of federal income taxes owed, state income taxes owed, FICA, workers compensation costs, and unemployment insurance costs.

Criteria for Independent Contractor Status

Often, whether one is an employee or an independent contrac­tor is not easily determined.  There is no federal list of criteria, however the IRS has adopted criteria for determining status and if the claimed status is challenged by the IRS, the burden of proof is placed on the company to prove that the classification is correct.  In general, the IRS and courts look at the totality of circumstances.  The major factor, however, is the right to control the manner and method of the work.  With an employee, the employer can control manner, method, and result, while with an independent contractor, the employer can control only the result – how the result is achieved is up to the contractor.

There are more minor factors involved in the determination than is possible to list here.  Some of them include:  1) Workers required to obtain prior approval before acting; workers who are told when, where, and how to work; and workers who are integrated into the company (i.e., uniform, company vehicle) are more likely to be classed as employees.  2) Workers who have a capital investment in the work; workers who pay their own travel and business expenses; workers who perform services for multiple companies; workers who do not receive a “salary”; and workers who furnish their own tools and equipment are more likely to be classified as independent contractors.  And 3) workers who must personally supply services; workers whose assistants are controlled by the provider; workers who do not have a written agreement specifying contractor status; workers who may be discharged by the provider; and workers who may terminate their relationship at any time are more likely to be classified as employees.

But remember, this is not an exact science.  There is no set formula.  The status will depend upon the totality of the situation.

Importance of the Correct Classification

The distinction is important from a financial standpoint because the classification can affect the amount owed for 1) unemployment contributions, 2) workers compensation, 3) FICA, and 4) federal and state income withholding.  The IRS and other relevant agencies can levy heavy fines for failure to pay sufficient taxes or fees when parties have been improperly classified as independent contractors.  Potential penalties for misclassification include 1) retroactive payment of all premiums that would have been due, 2) payment of interest on the unpaid premiums from their due date, and 3) payment of a penalty of a certain percentage of the past due premiums.

Recommendations

If your company uses independent contractors, you should 1) consult with a tax attorney or advisor, 2) use an independent contractor agreement, 3) report payments on IRS form 1099 MISC, 4) require proof of liability insurance from the contractor and request listing as an “additional insured,” and if there is doubt about the classification, request clarification from the appropriate agency.