Avoid worker misclassification with these six steps.
By Nathan Gibson
Recent reports have offered conflicting opinions as to whether the number of independent contractors is growing or declining. The Freelancers Union says nearly one in three working Americans is an independent worker and MBO Partners says that “the independent workforce … is expected to grow to 24 million strong by 2018.” On the other hand CareerBuilder and Economic Modeling Specialists Intl. (EMSI) report that the number of self-employed workers has declined 5 percent since 2009.
Justin Fox of the Harvard Business Review looks more closely at the situation and discovers that whether you think independent workers are increasing or decreasing may depend on how you define them. His research also indicates that the number of some self-employed occupations is increasing while others are decreasing. For example, the number of self-employed farmers and ranchers is declining, while the number of web designers is increasing. While individual occupational categories may be increasing or decreasing, 27 percent of the total workforce is expected to be contingent labor in 2015, according to Aberdeen research.
Engaging with independent contractors can present risks if not done carefully. Federal and state regulators are focused on independent contractors for a number of reasons. According to the Budget of the United States Government, Fiscal Year 2015: "When employees are misclassified as independent contractors, they are deprived of the benefits and protections to which they are legally entitled, such as minimum wage, overtime, unemployment insurance, and anti-discrimination protections. Misclassification also unfairly disadvantages businesses who comply with the law and costs taxpayers money in lost funds for the United States Treasury, and in Social Security, Medicare, the Unemployment Trust Fund, and State programs."
The IRS and Department of Labor are now sharing information about the misclassification of workers as independent contractors with 16 states, including California and New York, both of which signed memoranda of understanding in 2013. The challenge of engaging with independent contractors is properly classifying them. There are different federal and state tests, and some states have multiple tests. At the center of all of these tests is the question of who has the right to control how the work is performed. If the company has the right to control the manner and means of how the work is performed, the worker is an employee. And misclassifying a worker as an independent contractor instead of an employee can be costly.
Best Practices for Compliance
In addition to the many government guidelines, there are some common practices for businesses that engage with independent contractors to take to minimize the risk of worker misclassification.
1. Document all engagements with a written agreement.
A well-crafted contract and statement of work (SOW) helps make the case that a worker is an independent contractor. The written agreement should clearly document the intent to establish an independent contractor relationship between the parties. The SOW should delineate the deliverables and should clearly state the independent contractor, not the business, will control the manner or means by which the results are achieved.
2. Review benefits plans to exclude independent contractors and pay independent contractors like a business, not like an employee. The core element of an independent contractor relationship is that the independent contractor is, in fact, independent—a separate, unconnected business. Accordingly, companies who engage with independent contractors should not provide benefits, such as health insurance, paid holidays, or vacation. The IRS training manual states: “If a worker receives employee benefits, such as paid vacation days, paid sick days, health insurance, life or disability insurance, or a pension, this constitutes some evidence of employee status." In addition, independent contractors should price their services like a business, with consideration of all costs, benefits, and profit. While my plumber may charge time and a half for fixing my stopped-up toilet on the weekends, the best practice for a business is not to pay time and a half to independent contractors for overtime hours. Even though some professions—skilled trades, attorneys, and freelancers—may charge an hourly rate, the best practice for an independent contractor is to be paid when the engagement or project is completed, or once established milestones have been met. If paid hourly, a total estimate of the hours needed and cost should be negotiated and documented in an SOW.
3. Hire independent contractors who have established themselves as a business. Avoid being an independent contractor’s first client and be cautious when engaging with “part-time” independent contractors who work or have worked as a W-2 employee within the last 12 months. Independent contractors that are incorporated have taken the time and made the investment to establish themselves as a business, and are more likely to be considered independent contractors. Even though the IRS has said that the corporate form is generally recognized, they and many state agencies will look to determine whether the services are provided by the worker as an employee of the corporation or as an employee of the company who has engaged the worker.
4. Exercise extreme caution when contracting with former employees. Former employees who return to a company to perform similar work, with similar responsibilities, will mostly likely be considered as employees—save highly unusual circumstances. It might be possible, for example, for a computer programmer to retire and start an office cleaning business and contract to clean his/ her former employer office space, but these types of circumstances are rare.
5. Engage independent contractors for non-core work. In the best case, an independent contractor should have special expertise that the business does not internally possess. Workers who are hired to perform services that are part of the usual course of business for the company are likely to be considered employees.
Some states, for example Massachusetts, have adopted what is known as the “ABC test” for determining if a worker is for an independent contractor, which includes reviewing whether the service is performed outside the usual course of the business of the employer. The risk of misclassification rises significantly if a business has employees who perform similar services to those performed by the independent contractor. The best practice to follow: An independent contractor fills a unique non-core need for a specific length of time.
6. Ensure proper vetting and engagement management to protect against reclassification and other risks. Whenever a worker is classified as an independent contractor, the business must be able to defend the classification. Be sure to collect documentation to support the classification. Along with a contract and statement of work, an organization should collect documentation to substantiate the business-to-business relationship and confirm the worker is eligible to work in the United States. The project managers making the determinations should be proficient in both federal and state agency classification criteria, as it can change frequently. Businesses engaging with independent contractors should require independent contractors to carry workers’ compensation insurance and sufficient liability insurance that names the business as an additional insured.
Organizations should also conduct regular audits to ensure these policies stay in effect for the time of the entire engagement.
Because of the complexity and special skills required to make the initial classification, and the time it takes to monitor and ensure the contractor remains independent (and does not begin to look and act like an employee), many businesses are engaging third-party companies to classify workers and monitor compliance. By using an independent contractor engagement specialist to manage the classification of workers, an organization can focus on its core competencies and not worry about staying up-to-date on classification criteria and compliance best practices.
Working with independent contractors is a great strategy to fill the need for special skills, benefit from the experience of specialists for distinct projects, and provide flexibility and cost savings. With the increasing population of highly skilled self-employed workers, it is critical that organizations embrace the free agent movement and be prepared to meet the unique engagement needs and legal requirement to capitalize on this unique talent pool.
Taking advantage of the skills and expertise that independent contractors deliver involves additional steps to ensure compliance with the various classification requirements. Sometimes workers need to be reclassified, but other times, a business just needs to adjust how it engages with independent contractors. As an employment lawyer, Robert Shea of Morse, Barnes-Brown & Pendleton notes, “Many times, when we evaluate the situation, we see that the employers can make small changes in the way they use the independent contractors. That will allow them to continue using them, but also reduce their legal exposure significantly.” Now is the right time to review how you engage with independent contractors in order to make sure you properly classify workers, and take any additional steps to protect your company from potential liability for misclassification.
Nathan Gibson is vice president, payrolling and independent contractor solutions at Randstad Sourceright.
Avoid worker misclassification with these six steps.